Many years ago as a business student, the common mantra from my wizened professors was “you can’t be all things to all people.” The logic was that if you were indiscriminate in your marketing, you couldn’t make money because the operating costs of serving disparate customers would overtake the margins generated by those customers.
Somewhere in the early ’90s, this dynamic, largely because of Integrated Supply and VMI agreements, changed to “be all things to select customers.” The idea was that integrating disparate vendors through one wholesaler who handled all the transactions would trim supply costs for the end user. Hence, numerous industries and large MRO and OEM customers signed onto Integrated Supply agreements.
Benfield Consulting’s view of Integrated Supply, even though it remains popular, is dim. We use a convention called Differential Costing to measure the profitability on these vendor managed agreements and find a full two-thirds of them are not profitable. Why? Simply put, the leviathan customer typically off-loads all profitable and unprofitable transactions to the wholesaler.
Our favorite example of this is the plight of Industrial Distribution Group (IDG), which was a public roll-up of industrial suppliers for approximately 10 years until they recently sold out to Luther King Capital Management. The company started out at around $250 million in sales in the late 1990s and sold, around a decade later, at slightly over $500 million in sales. A large part of IDG’s sales were via Integrated Supply and the firm, listed on the public exchange, never really sustained acceptable profits anywhere close to other sizable industrial suppliers such as Grainger, MSC Industrial, or Motion Industries. Even though studies show that Integrated Supply is growing, we caution wholesalers against entering into these agreements unless they have accurate means to allocate service costs to Integrated Supply accounts.
Beyond Integrated Supply, many contractor-based distributors have been brainwashed into pursuing all orders for key customers. The idea is that it is easier to grow with existing customers than it is to find new ones. The prevailing advice is to target the 20/80 customers and get as much business as you can from them.
But the prevailing logic, based on our research and consulting work, is that by going too deep in the customer portfolio, wholesalers unknowingly pick up a lot of unprofitable transactions. If wholesalers can change the dynamic and limit the loss on these transactions, they can offer a much better price, more consistent service and grow market share much easier than slugging it out for business at select customers. Hence, the customer dynamic is moving away from the model of “be all things to select customers” to “perform a few profitable things for many customers.” The strategic challenge moves away from selling and marketing to developing an operating model that minimizes money-losing transactions.
Some transactions, most of the time, don't make moneyApproximately five years ago, we began testing the discipline of Activity Costing using causal statistics. The idea was that the purported drivers of activity profits - including limiting sales to small customers, driving gross margin dollars, increasing average order size, etc. - should show a positive correlation to activity profits. Our findings refuted those of many of the prevailing distribution gurus. Our research shows that “firing” small customers, driving gross margin dollars, and increasing average order size have weak or non-significant influences on increasing activity profits. After further testing, we found the problem was two-fold.
First, margin dollars, average order value (AOV), and “small customers” are only one part of the profit equation. They measure sales, margin dollars, or order size but don’t connect these to expenses incurred by those conventions. For instance, we found that while aggregated small customer sales were activity negative, 30% to 40% of transactions to small customers were activity positive (they made money). Simply firing small customers, as some gurus recommend, would delete a lot of profitable transactions.
Also, the concept of AOV proved to be spurious. This concept got significant attention several years ago in the customer profitability craze. The idea is that increasing the size of an average order will increase operating income significantly. The problem, to us, is that there is no such thing as an average order. Wholesaler orders are compiled of transaction types (stock, stock transfer, counter, cash, back-order, direct shipment, and non-stock) and each of these transaction types has different cost and profit profiles. Finally, we found that the concept of customer profitability, using activity costing, was flawed.
Customer sales are composed of transactions, and transaction economics of transaction type, mix, and size needed to be considered to determine if the account, branch or seller was profitable. Activity costing was concerned with activities and not necessarily transaction types, which are the fundamental building blocks of profit and loss. Also, customer profitability has as a common solution making individual customers more profitable by negotiating service and product options. The issue here is that doing this for any substantial group of accounts drives service and product permutations through the roof and operating costs grow exponentially. Any hope of scale economies are gone using this logic. Thus, we found much of the activity costing logic to be very limited in increasing operating profits. Without considering transaction economics, growing margin dollars, increasing average order value, or making customers profitable were tactics with minimal correlations to activity profits.
Why the lowly transaction has not been duly explored is difficult to explain. However, much of the problem exists with the predominance of rather low quality research in distribution markets. Much of distribution “research” is simply differing opinion and anecdotal writing on old topics. Much is done without properly trained researchers or solid statistical methodology, and with poorly conceived research instruments. We’ve found entire books without footnotes, 25-year-old subjects and knowledge delivered as “new and improved,” and surveys that engender response bias from the beginning of the research project.
Secondly, much of the research is delivered as “infotainment” (information plus entertainment) with the idea being that humor must accompany the presented research or distributors won’t pay attention. Wholesaler seminars have, too often, gone the way of the Comedy Channel and the desire and stomach for challenging knowledge is not in vogue.
Within this environment, knowledge about transaction types and their fundamental usage in distribution management has been overlooked. We entreat wholesalers to go back to their associations and push for better researched and more statistically valid knowledge. Forego the desire for a lighthearted and lightheaded seminar, and instead push for challenging, cutting-edge knowledge. Because of the lack of solid research, wholesalers have missed three very important concepts in increasing operating profits faster than sales, namely: 1. transaction type, 2. transaction size, and 3. transaction mix.
Benfield Consulting several years ago developed Differential Costing as a way to measure transaction type profitability. The work uses cost profiles of transaction types to determine the operating profit of transactions, branches, customers, and sellers. The work from Differential Costing has yielded the averages in Exhibit 1.
InExhibit 1, we have listed the common transaction types, their percentage of sales, and their transactional profits. (Transactional profits are the total profits delivered by an individual transaction type, which is gross margins per transaction type, minus their processing costs.) From the exhibit, one can see that different transactions have very different contributions to profitability while many transactions, when summed, destroy profitability. The most common losing transactions and their key negative profit drivers are:
- Will call or counter sales. Their low order value doesn’t
typically generate enough margins to cover their costs.
- Non-stock shipments. These transactions have extremely high costs,
including extra ordering, payment and costly return processes. There are often
no limits on the value of a non-stock order with sellers free to order anything
to satisfy the customer.
- Back orders. These transactions are often small and costly in that their tracking and delivery costs typically don’t cover the margin dollars they generate.
The vast majority of wholesaler profits come from two transaction types: Stock original orders and direct shipments. Without these two transactions, the idea of wholesaling as a profitable endeavor is a bust.
Stock transfers, or the hub-and-spoke model, are often not as profitable as many would believe. The problem is that, in a stock transfer, the picking, packing, shipping, tracking and invoicing are done twice. Plus, the extra handling incurs greater spoilage, and inventory loss. As a general rule, it costs 25% more to process a stock transfer than it does a stock original order. For example, if a stock original order costs $50 to process, the stock transfer costs $62.50. If the inventory is sold at a 25% gross margin, the breakeven stock original order is $200 while the breakeven stock transfer is $250. Often we find that when stock transfer inventory is properly costed, the hub-and-spoke system and satellite branches become much less attractive investments.
However, there are a growing number of wholesalers who understand Differential Costs and how to manage transaction profitability. They subscribe to the new sales dynamic of “performing a few profitable things for many customers.”
Transactional wholesaling and transactional tacticsIn our work and research, we have found wholesalers who perform only the most profitable transactions and give the end customer a very low price on select products. We call them transactional distributors. And, we have also found wholesalers who, while not offering full transactional models of business, perform selective transactional tactics for increased profits.
Transactional distributors often don’t perform or limit their usage of negative transaction types of counter sales, non-stock items and back orders. Instead, they stick to the more common inventory items and prefer stock original orders and direct shipments. They also have very limited sales support, make extensive use of e-commerce, and link transaction size to full freight allowed offerings. Where traditional distributors have to operate on a 20% to 25% gross margin to eke out 2% of sales before taxes, transactional distributors can operate on 10% to 15% gross margins and put 5% or more of sales as pretax profits.
How do they do this? We refer to Exhibit 1 where, on average, 42% of transaction profits are destroyed by three transaction types, namely: counter sales, non-stock orders and backorders. Transactional distributors concentrate on the most profitable transaction types and let other full-service wholesalers do the low to no-profit transactions. They also trim down the costs of service, including sales and marketing, by relying on e-commerce and a few inside and outside sellers. They are also more likely to purchase foreign off-brands that, based on our research, offer a 35% landed cost advantage over domestic brands.
Transactional distributors are growing in many vertical markets and we have witnessed an impressive growth rate in recent years. Our advice to full-service wholesalers or those who want to “be all things to select customers” is to be prepared for transactional distributors. They can easily take the majority of sales from your key customers with great prices and leave you with the specialty, low or no-profit transaction types.
Transactional distribution is a model that is often repeated in other industries, including by companies such as Wal-Mart, Southwest Airlines, Costco, and Sam’s Club. These companies don’t try to be all things to select customers or all things to all people. They don’t rely on better selling or marketing or a broader inventory or even better product knowledge. Their innovation and market viability is in developing low-cost business models by disaggregating the value chain, picking the most profitable products and transactions and offering a low-cost service support where the customer has to participate in the ordering process to get a super-low price.
For example, Costco and Sam’s Club operate on margins that are a full 50% or so less than traditional retailers. They also sell in bulk, which, akin to transactional distributors, is an attempt to drive order size. Southwest Airlines, depending on the study, has a cost per passenger mile that has been historically 20% to 25% less than their competitors. Southwest flies out of less costly airports, doesn’t provide the frills of full-service airlines, flies one type of jet, and avoids puddle-jumper routes. Transactional distributors, like Costco and Southwest Airlines, trim their services, drive order size, have a few large warehouses strategically placed, and select the most profitable transactions. After years of witnessing what transactional distributors can do, our advice to full-service distributors is to prepare now. If you don’t prepare now, you can prepare later to cede beaucoup parts of your business to low cost, transactional distributors.
We call the preparation of full-service distributors for transactional distribution, transactional tactics. This means that traditional full-service wholesalers need to understand where their transactional losses are, engage Differential Costing, and mitigate losses on certain transactions. These transactional tactics can run the gamut but some common fixes to transactional losses are:
- Honor back orders
only on full freight allowed (ffa) stock original orders.
- Link ffa order size to cover the processing costs of a stock
- Raise prices on counter sales to small customers and set minimum
order sizes for counter sales.
- Move away from rewarding sellers on gross margin dollars to rewarding
them on transaction profits or operating profits.
- Allocate expenses to branches using Differential Costing logic and
not gross sales.
- Trim back on satellite branches with a high transaction mix of
counter, non-stock, back-order and stock transfer sales.
- Set minimum order values for non-stock sales and raise prices significantly on non-stock sales .
These tactics can help stanch losses and allow the full-service distributor to bank profits that will help in the fight against transactional distributors. In the end, however, we believe that well-thought-out and well-executed transactional distribution will grow and win the share of market battle against full-service distributors who try to “be all things to select customers.”
Understanding Differential Costs, Transactional Tactics and Transactional Distribution is, in our view, not optional. The understanding and management of transaction profits and costs takes time and severely challenges the existing paradigms of the “be all things to select customers” set.
Big change requires sweat, work, hard learning, and solid research. But our experience says you don’t want to wait for a transactional distributor to come calling on your customer. Too often, the nails are in the coffin of the full-service distributor before they make the first call.