The downside of rebates
Is your company relying too much on this form of supply-chain compensation?
Three years ago, we presented a proposal for distributor research on the trends and usage of vendor rebates.
The proposal was received with enthusiasm and the ensuing presentation demonstrated sincere and substantial interest from the distributor panel. However, the proposal didn’t make the final cut as the legal issues were too sensitive.
We were disappointed that the research did not get funded. Looking back on the entirety of the process, the turn-down may have been a blessing in disguise. Our work in preparing the research and ensuing exposure to rebates finds there are significant misconceptions regarding the funds. In fact, there is a downside to rebate dollars that we liken to an addiction.
The rebate addict
Since the Great Recession, traditional box-in/box-out (BIBO) distribution has endured an increasing array of external pressures including:
Growing usage of e-commerce by customers to check price and availability with the end result being suppressed prices.
Outside entrants into B2B channels including Amazon and Google that directly compete with distributors on a lower cost basis or enter into the channel and take value away from the distributor.
Foreign manufacturers who align with billion-dollar distributors and whose price to market is 15% to 25% less than domestic brands.
Use of transaction costing and e-commerce to disaggregate sales costs from the product and reduce the overall price to the customer.
In short, the pressure(s) on traditional BIBO distribution is/are substantial and will increase as more customers use technology and new entrants emerge — all of which drives down product price. The options for distributors are limited and include investing in new technology to compete, moving further into the value chain and engaging assembly and service businesses, or selling the firm and cashing out. What is not a reasonable expectation is staying within the BIBO platform and hoping things will get better — they won’t and yet, today, this is where we find many distributors.
Our hypothesis is that a preponderance of distributors have not engendered new technology and taken cost out of the traditional business or moved further into the value chain. Instead, they’ve flooded buying groups and aggressively negotiated with manufacturers for increased channel compensation in the form of rebates.
Rebates are a long-standing form of compensation for channel services between manufacturer and distributor. They trace their roots to retail entities in the distribution of household goods and groceries. Rebates are almost always rewarded on purchases and often have substantial sums tied to incremental gains. Incremental gains may be on overall purchases or specific to key products including new technologies. However, there are several problems or misconceptions with rebates that many distributors don’t consider and these issues, over time, find their way into the cherished beliefs of management despite being increasingly false.
First, rebates are considered “sheltered income,” which alludes to the fact the dollars are not included in the product price but rewarded on a quarterly or year-end basis. Hence, the belief is the rebate dollars don’t end up in the customers’ hands. In our work, we have challenged this belief and find, more often than not, rebate dollars leak their way out into the product price.
The process on affirming this is not hard science, but the data is difficult to dismiss. The analytical process, in case you are interested, is as follows:
Add the rebate percent of sales, specific to a vendor, to the gross margin percent for an adjusted gross margin. Average all adjusted gross margins and compare the vendor in question to the average. Is it higher or lower? A lower than average reading implies margin leakage to the marketplace.
Take the adjusted gross margin figure and review it over a three- to five-year period. If the overall measure is going down, it is likely that the rebate is offsetting deteriorating pricing in the greater market.
Compare the trend of the adjusted gross margin percent of sales to overall sales and margin dollars. But we often find where sales and margin dollars are growing but adjusted gross margin percents are falling. Again, the implication is that the rebates, or at least part of them, are ending up in the marketplace.
The preceding analyses aren’t foolproof, but they do imply the vaunted rebate dollars (or some portion) are winding up in the marketplace. Too often distributors believe rebate dollars received in a different time span (quarterly, annually, etc.) or placed in a different category on the income statement (other income) means the money is sheltered. Unfortunately, in competitive markets where legislation requires comparable access among multiple competitors to earn rebates, the idea that any product cost advantage remains sheltered in a thin-margin, commodity-driven business is wishful thinking.
The destructive potential of rebates is seen in several behaviors we dub the “symptoms of addiction,” including:
Over-reliance on rebates creates a culture where gaming of product cost and attempts to “hide” margin take precedent. Unfortunately, in this scenario sellers don’t trust management and we’ve found few good long-term outcomes when sellers give up, quit or grouse about the situation. Like it or not, in a commodity business where 60% to 70% of the goods are differentiated by price, hiding rebate dollars is a game that is often destructive in its outcomes.
Attention is taken away from good pricing management and controls as the distributor doesn’t grapple with the vagaries of pricing such as: who can discount, how much, when and where? Funding a modern-day pricing discipline takes money, time, patience and is a vigil. Trying to outdo pricing with rebates is a big part of the problem. As one of our clients, exasperated by its own rebate addiction, repeated, “We wouldn’t have this problem with rebates if we had control of our pricing.”
The competitive issues in distribution stemming from new entrants, technology that gives instant access to price and availability and low-cost global supply chains are not solved with rebates. These issues have to be engaged head-on by distributors and new knowledge and investment in e-commerce, transaction costing, new sales configurations and expanding to global suppliers are the competitive disciplines of today and tomorrow. In short, if distributors don’t have a plan for these challenges, they simply are denying the problem and over time will lose to the more progressive competition.
Rebates create a greater dependency on vendors who, like their distributors, have significant competitive issues especially with low-cost producers from around the globe. At some point, vendors can’t issue incremental rebates, and this leaves the distributor at significant risk. To us, it makes more sense for the distributor to take control of its destiny by engaging marketplace changes rather than relying on the vendor.
When to stay put
Not all rebates are problematic and distributors should, where it makes financial sense, maximize the rebate income. In general, we find that rebates make financial or strategic sense when:
The vendor is asking for the distributor to do something out of the ordinary chain of value and the rebate offsets some or part of this cost.
The distributor is cementing a long-term relationship with a vendor in a crowded space and the rebate is a type of loyalty insurance.
There is a new product or technology that takes considerable investment and the rebate compensates for this.
The distributor is helping the vendor take cost (read legitimate and measurable) out of the channel and is compensated in the form of rebates.
Of course, when any rebates are offered the distributor should understand in detail the offer and make a strategic decision to pursue or not.
Often, we largely have semantic discussions that buying groups and purchasing leverage is not the same as a rebate. In most instances, however, the goal of the buying group and negotiating the proprietary rebate are the same. The buyer is rewarded with incremental income from greater purchases. There is philosophically and practically nothing wrong with this goal. Greater volume for manufacturers reduces breakeven cost.
Our argument in this column is that the distributor is clamoring for rebates to cover or offset cost pressures in the model of business including efficiencies from new technology, new knowledge and the effects of globalization. In the short run, rebates may give the distributor quarter from these challenges. In the long run, they make the company dependent and weakened to the competitive environment.
When to walk away
If your company is relying on rebates to compete in a changing environment, we suggest reviewing the issues for the increased competition. If lower-cost competitors, more price-conscious customers who use technology and global “off-brands” are creating the competitive issues, then you may be over-relying on rebates to fend off these threats.
At some point, the rebates will flatten out or run out and you’ll be left with stronger competitors and behind the eight ball on proper solutions. It is our belief that many distributors are relying on rebates for solvency in a fast-changing and increasingly competitive environment. They will end up disappointed and, perhaps, much poorer.
In a recent incident, one of our clients, an acquisitive firm with above-average earnings, reviewed an acquisition of reasonable size and geographic presence. The CEO, who is hands-on and reviewed the books, found that the preponderance of operating earnings came from rebates, and less than a handful of vendors. In essence, the company’s management had not engaged good pricing management, global supply sources and new technology to take cost out of the service platform.
In the words of the CEO: “I walked away from the deal as quick as I could. There was nothing I wanted to buy; the operating profits were too risky. The management was wholly reliant on their vendors and not their own ability (ies).”