Interview with Scott Benfield on Improving Valuations for Wholesalers
Here's the text of an interview with Scott Benfield of Chicago-based Benfield Consulting Company about his upcoming book on improving valuations for wholesale distributors.
Industrial Supply - The last time we spoke you were working on a book regarding a new means of measuring and driving profitability.
Benfield - I've just completed a manuscript called Building Value: Driving Wholesaler Returns through Strategic and Tactical Investment. It is in review and will be published in the next several months.
Industrial Supply - Isn't it about customer profitability? Isn't that a crowded space?
Benfield - We go over the subject but fundamentally the book is about investment and creating and securing value in the wholesale firm.
Industrial Supply - How is that different from profitability enhancement?
Benfield - It's light years away from the standard advice on profitability enhancement including customer profitability.
Industrial Supply - How so?
Benfield - Value is measured as Capital Returns/Capital Investments. Most profit improvement in distribution uses financial accounting concepts such as sales, margin dollars or margin percent and attempts to secure greater value using these constructs. We believe that the accounting approach is fundamentally flawed, as accounting numbers won't allow one to measure the value generation of any particular part of the investment horizon.
Industrial Supply - This isn't going to be one of those technical discussions is it?
Benfield - No, actually the idea and practice is pretty simple. We believe that the investment horizon for wholesalers is sellers, customers, services, branches, programs and products they sell. But you can't understand if these are good investments by looking at their sales or gross margins. You have to have their expenses attached to them to understand if they make money or not.
Industrial Supply - But the cost-to-serve accounting models do this, don't they?
Benfield - Not really. For instance, most cost-to-serve models talk about profits of the customer or profits as a percent of sales. Take for example an account that has $500,000 in sales, 25% gross margin, and $118,000 in cost-to-serve expenses. Most cost-to-serve models and customer profitability gurus would say the account earned $7,000 in cost-to-serve profits or 1.4% operating profits as a percent of sales. We don't care so much about those numbers, at least the way they are presented and thought about.
Industrial Supply - You mean you don't care about sales and margins and operating profit?
Benfield - As an investor, not really. What we care about is if the investment made a profit over the corporate hurdle rate.
Industrial Supply - What?
Benfield - Say the wholesaler's hurdle rate or expected rate of return is 15%. The account we just reviewed earned $7,000 but it took $118,000 of services to deliver the profit. So, the investment ROI – what we call Transaction ROI – is $7,000/$118,000 or 6% and the investment is well below the return desired by management. We do this for any investment on the wholesaler's investment horizon.
Industrial Supply - OK, but you can do the math with any cost-to-serve model. It is just a matter of comparing expenditures specific to their returns.
Benfield - There are a couple of problems with that. First, most cost-to-serve models don't allow an accurate calculation of investment returns. Their methodology is crude, such as average order size, or they have disparate measures that have little to do with each other. Essentially, their allocations don't conform to the latest and best recommendations for cost-to-serve modeling. Secondly, only a small part of building value has to do with cost to serve modeling and measurement. A much larger part of value creation is where the firm puts its strategic efforts.
Industrial Supply - I need more explanation.
Benfield – First, cost-to-serve modeling came out of Activity Costing. But the inventor of Activity Costing, Robert Kaplan of Harvard Business School, recanted the discipline back in 2006. He basically said that the models were too complex and didn't deal with measurable entities. In essence, businesses don't readily measure activities and talk about them. So, he came up with two primary standards for new cost-to-serve models. The first was that the model should have one baseline logic and the second is that it should measure capacity. We use transaction types as our baseline logic and we can very closely model capacity. Without these two constructs, the allocation models can, and often do, give a bunch of gobbledygook output. They have no singular logic, which means there is no primary means of evenly allocating costs and they assume 100% capacity. We call our work Labor Differential Transaction Costing or LDTC. We shy away from many of the models as we don't think their output is reliable. For instance, we hear a lot about average order size but we recently did a project for a leading wholesaler who was big into the concept of increasing average order size. We found absolutely no correlation between average order size and the transaction ROI of any of their investments. We developed 14 transaction types for their firm and they ranged from $50 to $350 in processing cost. So, if you averaged them, you basically mute or destroy any detailed knowledge and you can't really tell much of anything from averages. As we told them, "Averaging is dangerous; the average person has one breast and one testicle."
Industrial Supply - What about strategic value efforts?
Benfield - Much of what distributors do is tactical value generation. In other words, they sell existing products, bundled with existing services, to existing accounts. The problem with these efforts is that everybody bundles the services and products together and does everything in basically the same way. The investment returns are low, as some 60% of accounts have a negative or low investment. So, doing the same old thing, especially in distribution, doesn't create a lot of value. Strategic value is added in new products, new services, new models of business and acquisitive strategies that have a high chance of success. Value can be created, generated, perpetuated, captured and destroyed. Strategic value involves more creating and generating activities, and we detail these concepts in the first half of the book .
Industrial Supply - I thought it was commonly accepted that 40% of what you term the "investment horizon," such as customers, have a negative profit?
Benfield - That's actually true, however, another 20% of the investment horizon fails to generate value equal to the hurdle rate which is, again, why value-based approach is superior to the financial accounting approach.
Industrial Supply - You look for aha! moments in your work. What are some of those from the text?
Benfield - There are a lot of them but the biggest, and probably the hardest to swallow for distributors, is that you don't drive superior profits by focusing on operating profits or earnings; you drive superior profits by focusing on investment returns. Accounting profits are really counts in a time period and can't and don't tell you if an investment is worth it or not. Value-based management has a time period component but the focus on the returns on capital is very different from a financial accounting approach. Most distributors don't think of value and investments but our work, in the past five years, has uncovered some real stunners. For instance, we can unequivocally tell you that 30% to 40% of the outside sales territories yield a negative profit and it makes no sense to put an outside seller on a negative profit account. It just makes the return worse. Too, we can tell you that compensation for sellers on margin dollars, whether in bonus or commission form, destroys value as much as it creates it. Compensation on margin dollars means the seller gets paid on margin dollars and the distributor has a 60% chance of a low or negative return. Too, we can absolutely reduce price and increase value. We do this by driving transaction size and transaction type. If you can control these variables, you really can use decreased pricing to drive returns. We call this transaction size pricing or variable transaction size pricing and we cover the concepts in the text also.
Industrial Supply - I bet you get some real stares on the transaction size pricing?
Benfield - We do. A lot of distributors, brought up in the financial accounting world, can't fathom what we're talking about. Even when we go into explanations regarding supporting concepts of flow sales and time period labor capacity, they still can't believe it.
Industrial Supply - What do you mean by flow sales and period labor capacity?
Benfield - Over time, distributor sales are like the flow of a river. Sales volume typically rises with the economy and material flows at a predictable rate. The distributor sizes its labor capacity for a predictable flow and typically keeps a little excess capacity, say a 5% or so buffer, if business ramps up unexpectedly. If there are large sales jumps in any one time period, the capacity buffer is overrun and the flow, or extra sales, has to be contained by issuing overtime or quickly hiring more people. The problem with capacity fluctuations in a thin margin industry is that they can have disastrous bottom-line impacts. If the sales increase comes from an account, segment, or type of business that yields negative profits, the distributors' capacity is used at a rate faster than margins are generated. Without an accurate cost-to-serve model, however, the distributor thinks sales and gross margins are rising and this is a good thing but it's really not.
Industrial Supply - Why not?
Benfield - If the new business is really labor intensive, then it will eat through the capacity buffer. This may not happen until a later time period – a month or a quarter – but what seemed like a good thing when the business was first recorded is really a not so good thing in later time periods, as the incremental flow business reduces bottom-line profits, all because it costs more to fulfill than it yields in margin dollars. Financial accounting, however, doesn't pinpoint this all that well because sales, margins and margin percent are not good filters for securing business that brings positive profits.
Industrial Supply - You mean the new business destroys profitability in later time periods because it costs more to serve than it generates in margin dollars and standard accounting and allocations don't capture this.
Benfield - Exactly. And because of this, bad things happen. Distributors think falling margins are the culprit and they try to raise prices on accounts that may have low margins but really good transaction ROIs. Or they wail on sellers to increase sales but their compensation systems reward margin dollars, not operating profits, and the sellers go out and pull in business that saps even more capacity at a faster rate. In essence, when the distributor relies on sales and margins to filter new business and solicit it, they are making a big mistake. Unless they can serve the business properly, they should think twice about soliciting it.
Industrial Supply - What's the fix?
Benfield - We advise distributors to profile new business based on the type of transactions it generates, the size of those transactions, and their mix of transactions. For instance, if a customer generates small counter transactions and a lot of non-stock transactions, even if the gross margin is good, it probably costs more to serve than it generates in margin dollars. So we give distributors the tools to profile a potential account's business before they consummate the sale.
Industrial Supply - Do you think distributors will follow your advice?
Benfield - A lot of my clients do. I can say that if distributors don't know the transaction profit potential of their incoming new business, they will continually chase labor capacity and blame falls in operating profit on the wrong things. Too, they will almost never have a long-term reduction in their service cost because they don't align the sales goals with the ability of the firm to profitably process the new sales. Hence they won't be more productive and, over time, their value will slide.
Industrial Supply - You talked earlier about new products and new business models. What does the book say about these things?
Benfield - If you look at distributors who earn the best profits, who have the best valuations, you find that most of them have a pretty well-established new product development effort. In essence they have product managers or some type of product specialists who are charged with growing new technologies. So, I have a chapter dedicated to product management, new product introduction, and new product selling. As new business models go, I spend some time on transactional distribution and how it will be more common in the future.
Industrial Supply - You wrote about that subject for us many years ago. You might want to refresh our readers.
Benfield - About a decade ago, I began to run into distribution companies who shunned the full-service model. They took a thin slice out of the value chain, usually some sort of product/application niche, and took it away from the existing distribution with great prices. They got the great prices by severely reducing their support costs and passed the price on to the customer. I tell people to think of Southwest Airlines of the 1990s, Aldi Supermarkets or Nucor Steel. Most distributors have had a local market get-all-the-business-you-can strategy, and they have a lot of cost complexity in performing a lot of services to many different customers for many different products. The transactional distributors select only a few products and few services and, hence, their operating costs are low. They then pass these costs on to the customer at prices the full-service guys can't match.
Industrial Supply - What's changed in the modern day?
Benfield - Today, we have a slow-growth, price-sensitive economy and customers are very value conscious. Too, we have global sourcing where distributors can, if they hook into the right supply source, buy quality products significantly less costly than their long-time domestic brand names. Finally, we have acceptance of e-commerce as a business model and a keen understanding of transaction costs. When you combine these things, transactional distribution is assured.
Industrial Supply - Can you give me an example of this?
Benfield - Sure. About a year ago, I was talking to a top 20 U.S. HVAC/Refrigeration distributor about transaction costing and management and I went into the chance for a transactional strategy. In HVAC markets, there are a bunch of fragmented brands that spend excessive sums on trying to differentiate their products to dealers. The problem is that there isn't a whit of a difference in one three-ton unit versus another – it's all a bunch of marketing hype and the end customer doesn't much care whose unit you put in, they just want their climate at a livable level.
Industrial Supply - This is going to be detailed isn't it?
Benfield - A bit but bear with me and I'll work this out on paper as we go along. Using transaction size pricing, dealers can level load their inventory and buy fairly large transaction sizes and so you can set margins at 10% for a $1,500 order and generate great returns if you know how to do it. First, most of the ordering is rote, so you can let the dealer order online using e-commerce and offer them little sales support. Where the processing cost of the invoice is $150 with full sales support, it is now $50 with limited support. So, where the order makes $0 at full sales support, it makes $100 by using limited sales support and e-commerce. If the order makes $100, that means its transaction ROI is 200% ($100/$50). If the distributor can tap into global sourcing on things like motors, line sets, filter driers and maybe condensing units, they can reduce the purchase cost 20% or so. This now brings the cost of goods from $1,350 ($1,500-$150) down to around $1,100. So the distributor could pass along part or all of the cost savings and the price could go down as much as another $200 or so if all of the savings were passed along. In essence, you could price the order at $1,220 ($1,100 at 10% margin), which is a discount of close to 20% over the original price. Now, the real beauty of this...
Industrial Supply - You are really getting excited about this! Are you sure you don't need professional help?
Benfield (laughing) – Look, you can run this model with a really small warehouse, limited number of employees, small inventory and limited management. So the $50 transaction cost can be cut to $30 and the transaction ROI would be $110/$30 or around 300%. In fact, you don't really have to buy bricks and mortar for this but you can rent space and get deliveries made by an outside carrier or offer the dealer a small discount to pick up the material.
Industrial Supply - Could this really work? Is anybody doing it?
Benfield - It's being done in several industries that I know of and there are probably others. But think about this. The distributor I talked to charges, on average, a margin in the upper 20s for products and makes maybe 2% to 3% return on sales. They have to do this because they have a convoluted platform of lots of customers, leagues of sales people, and lots of counter and non-stock business that is almost always transaction negative. In short, their model is so all-over-the-place with only a few customers making money and supporting all the other stuff that really loses money, that it's a cinch to pick off their top paying customers with a transactional strategy. They would charge the customer $1,800 or so for the previous order and if you came in at $1,200 do you think the dealer is going to say, "Boy I really do value your sales guys, and full inventory, and counter, and all your great services and I'll just look the other way for a $600 savings."
Industrial Supply - I guess not.
Benfield - Absolutely not! And we find where full transactional strategies using e-commerce, limited sales support, transaction size pricing and low-cost, globally sourced goods can often give discounts of 30% or more over full-service distributors. Imagine if this dealer placed this type of order 50 or 100 times in a year? Do you think they are going to turn down a $30,000 to $60,000 savings?
Industrial Supply - But I still don't see much of this going on.
Benfield - Those that are doing it are very quiet. They don't want people to know. Plus, it is still in its inception. I am contracted to do one of these models in another industry and I'm talking to investors in some dealer-based industries also. The HVAC industry is just an example and it's an example I use in the book. But the model can be done in most distribution industries. Right now, most distributors haven't figured this out and most, even if they did figure it out, are loathe to do it because they can't get over the idea of cannibalizing their existing model of business. But my mantra is if you don't cannibalize yourself, someone else will.
Industrial Supply - Your stuff is always a bit on the edge; some would say radical. Are distributors ready for all this?
Benfield- You know, I've researched that statement pretty well. In 2008 and 2009, I had some tough years and began to wonder if the research, writing and consulting I did was just too radical for the customer base. In other words, was I pushing the envelope too much? So I went out to past clients and supporters and asked them.
Industrial Supply - What did you find?
Benfield - I was told that I was overreacting. Nobody, during that time, was spending much money on consulting. I learned that my stuff has a reputation as high-end, in-depth and is poised for the future. I'm not content with researching subjects that are well established; I don't think relentless work on old subjects does any good. My books on marketing, pricing and fee-based services were the first in their field. My books sell well and they have life cycles that are two to three times other publications. If I look at my consulting, I typically do well with the $100MM -plus or more progressive firms. My projects are long and my relationships can last for years. My clients are often, but not always, in the top quartile of earnings or they really want to do better. And, I sell a lot of material to the top earning billion dollar firms.
Industrial Supply - Do you think your views will catch on with the vast middle of distributors?
Benfield - It's more like the vast middle will come to me.
Industrial Supply - What do you mean?
Benfield - I mean that distributors are getting more sophisticated and the managers coming in are better educated, many have their MBAs, and they run the businesses for profit and not control. And they don't put up with soft soap consulting. Too, consolidation means these firms are getting larger and I do better with larger firms. Also, I believe we'll find outsiders who will come into distribution and make some big changes.
Industrial Supply - That's been tried before but seldom works.
Benfield - Yes but the landscape is changing so much and the economy looks to be slow-growth for years to come. There are some outsiders with deep pockets who've been reading my recent work, who are looking at distribution and think there are some ways to get a sustainable competitive advantage. I recently talked to a representative from Berkshire-Hathaway about the industry and they normally don't get into anything unless it is a win. Too, I am talking to some industry insider investors about transactional strategies and acquisitive strategies that are much better than the sloppy roll-ups of the past decade. When it comes to the "vast middle" of distributors, their associations and bodies of knowledge, I don't know much is changing there. The associations, at least most of them, have shrunk because of consolidation. Many of them don't lead with knowledge like they did years back, maybe they are afraid if they challenge their members they will lose them. The big players and progressive players, the ones I consult and research for, don't go to the association meetings much. They tell me there's nothing much for them – the knowledge is watered down and the buying power is with the buying groups – so they go to the buying group meetings instead. Too, a lot of the third-generation owner–operator types want to take small steps for incremental improvement. They don't want to rock the boat much since they typically manage for control and not superior profits. They have lots of extended family shareholders and value consistency of dividends over more risky strategies. Because of this, they commission studies on the more comfortable and assuring subjects like compensation or customer profitability.
Industrial Supply - But aren't sales compensation and customer profitability perennial subjects of great interest? And, aren't distributors very interested in profitability because of the small profits of the business?
Benfield - I'll answer the second part of your question first and we go over this in detail in the book. Distributors are interested in profitability but mostly at a "safe" or reliable level of profit where they don't take excessive risks and can keep control. The research on this is well-documented. Belen Villalonga, a Harvard faculty member, has done a lot of work on this and finds that family-controlled businesses lose value, over the generations, versus comparable businesses run by professional managers. We call this the control premium, which means that family owner-operators value control over profits but they pay a big premium for this. Our findings are that family-owned and operated wholesale businesses, versus ones run by professional managers, fetch a price that is 20% to 40% less in the open market.
Industrial Supply - That's a lot.
Benfield - Yes, it's a ton and because of it most distributors sell for asset value. We advocate for family firms, if they want to sell, to bring in professional help several years before they market the firm.
Industrial Supply - What about the first part of the question, the propensity to research and study "comfortable" subjects?
Benfield - We think compensation is one of the most hackneyed and over-rated subjects in distribution. When you look at the full cost of outside and inside sales, which includes support costs, they are often 50% or more of operating expenses. Furthermore, when you consider that most of the goods are commodities that customers can buy online without much, if any, sales assistance, what good will compensation do you? What's there left to compensate when the transactional models take hold? And, as far as customer profitability goes, it is an old subject with checkered results. The problem with the subject, and we discuss this in the book, is that account-based profitability has as much to do with how you choose to serve the customer as it does with the way the customer buys. In fact, the focus on the customer as an element of profit is one-dimensional; profitability can result from transaction types and the way the wholesaler chooses to process the business, from the types of segments the wholesaler chooses to invest in, and a host of other dimensions that aren't customer specific. The biggest problem we see, the big hurdle that wholesalers need to clear but are stymied over, is that selling as we know it and the interface with the customer is changing rapidly.
Industrial Supply - What do you mean?
Benfield - I mean that the old belly-to-belly, sales guy-to-customer is a tired model and very expensive. It is viable with technical sales, really big customers and consultative selling work but, for the run-of-the-mill commodity, it is dying out.
Industrial Supply - That's been said many times before but it never really seems to catch on.
Benfield - I think it's for real these days. Let me give you a recent example. I finished a sales audit for a sizable industrial house earlier this year. The company is a good performer and I know the management and have confidence in them. They've been on an acquisition trail and called me in to see what, if anything, I could do about their sales capacity. I went through their outside sales force and told them they had 30% to 40% overcapacity. A lot of their sellers were deployed on accounts that lost money and their house accounts were growing as fast as their outside sales assigned accounts. But the real shock came when I was looking at their inside sales group. They had never done much definitional work and structuring of labor on the inside sales function and I looked at customer requests by type including quotes, expedites, price checks, availability checks, technical advice, accounting disputes, and returns/warranties. What I found was that over 50% of the requests came in via e-mail. Not phone, not fax, but e-mail!
Industrial Supply - OK, but I'm not following you. Why is that so surprising?
Benfield- It means that the customer prefers to do business online. It means that the phone is a slowly dying way of communicating. People can communicate more quickly, enter orders or RFQs more accurately by going online and they can blast their requests to suppliers for auction pricing. They don't have to spend time being chatted up by a seller; they don't want to spend time being chatted up by a seller.
Industrial Supply - That sounds extreme.
Benfield - I would have agreed a year ago but here's the rest of the story. This client had just put a big sum into upgrading the phone system but they really had no idea that e-mail was the preferred way to do things. The top guys were operating off a paradigm that was formed years ago when the phone and phone skills were the means to transact business. What if they had put money into their e-mail capabilities instead?
Industrial Supply - How do you put money into e-mail capabilities? E-mail is e-mail.
Benfield - That's what I thought until a few weeks ago. I write a blog for Supply House Times and have been doing my latest installments about the pending conflicts between e-commerce and the old belly-to-belly. A recent piece on the cost differences between e-commerce orders and sales assisted orders went viral. I started getting correspondence from wholesalers about their struggles between e-commerce or e-business and the sales force. Many of these companies have had e-business development efforts for several years and the conflict with their sales force(s) is becoming more and more contemptuous. I got a call from a large East Coast firm about the issue and we talked a bit over the phone and they paid for me to come out and review their situation. What I saw there really blew me away and it became obvious to me that e-business and belly-to-belly selling will become less compatible over time.
Industrial Supply - OK. You've got me interested. Explain this a bit more.
Benfield – Well, the e-business at this company was the most advanced I've ever seen. These folks had e-commerce specialists. That means they did things like stratify and analyze the incoming e-mails. For instance, with quotes, they have developed software that searches the RFQ for the last time the customer was quoted on the item(s), if the quote was successful, what the margin and quantities were, what other similar quotes were priced at, what substitute items would make the quote more competitive, etc. The systems could do this in a flash. It seems the sales force didn't trust the system and would bypass it and rely on past experience and cost-plus pricing to do the quote. Yet, they had solid proof that qualified sellers, armed with their e-mail analyses, improved the hit rate by 20%. They were asking me what to do about sellers that refused to use the new technology.
Industrial Supply - What did you say?
Benfield - Get rid of 'em and replace them with folks who had experience and would work with the technology.
Industrial Supply - Just like that?
Benfield - Just like that. Look, this company has millions of dollars of quotes that pass through their hands every month. If they can improve the hit rate by 20%, they've scored big time. If you've got some seller who grew up in the belly-to-belly, chat-me-up world who wants to put 25% margin on everything and hope he lands a quote, then let them work for the competitor.
In the end, what I'm finding is that today's twenty and thirty-somethings who are new to their careers in distribution or as buyers of distributed products, expect to communicate via e-mail and transact business with e-commerce. They don't want a lot of hand holding and small talk. They are often under tremendous pressure to get competitive prices for their purchases and they buy lots of stuff. It's much easier, more efficient and cost effective to use e-mail and e-commerce.
Industrial Supply - Most distributors use e-commerce to complement the sales force. It appears to be a common practice.
Benfield - Yes but remember that e-commerce is, maybe, 10 to 12 years old for most distributors. What is happening is that new knowledge about how to manage incoming e-mail for advantage by using smart systems is just being developed. Too, there is now a lot of knowledge on how to successfully solicit with e-mail including targeting buyers with not only pricing and product but with suggestions on how to improve their purchasing power with substitutions, drive down costs of ownership with shared usage data, and work with their supplier on any number of special capabilities. When you combine the smart systems with using sellers at the right time and place, you get a much higher close rate. And, for many commodities, you really don't need sellers like you used to. You need a good price, reasonable delivery and accurate systems for inventory and billing.
Industrial Supply - Do you give a timetable for these changes?
Benfield - Not really. I think that a lot of these events were set in motion in the last decade when e-commerce, globalization of supply, and researching products on the Internet became common place. What's happening now is that the technologies are reaching a critical mass and they are starting to have an effect. As I look at wholesaling, as I've known it for three decades, I'm not sure the name is all that fitting. Wholesalers, the ones of the future, will be supply chain businesses offering the best global solutions for their customers.
Industrial Supply - When is the book coming out?
Benfield - The end of the year or first quarter next year; I've got some clean up to do and then it's off to press.
Industrial Supply - Thanks for your time.
Benfield - Thank you.