Growth in an Amazon Supply World
Scott Benfield
Part 3 of a Series
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Distribution Research Project |
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From Moving Boxes to Diversified Supply Chain Firm
How distributors are moving forward in the value chain and, in the process, increasing the profitability of the staid old wholesale firm.
In our third and final installment in this series on growth, we discuss what a handful of distributors are doing to increase sales and profits, while moving away from the old model of distribution to new ways of creating value and securing customers for the long haul.
The previous installments discussed changes to the sales force and the use of technology to supplant parts of the sales effort in Part One and, for Part Two, seven new means of using e-commerce to drive incremental sales.
We return to the basic model of distribution called box-in/box-out or BIBO. Traditionally, distributors have aggregated different products from numerous manufacturers and bundled them in a transaction where the margin dollars are greater than the cost of fulfilling the transaction. Over the decades this model has remained economically viable, but its ability to generate profits above the historic cost of capital has slipped to the point where many distributors are slowly destroying value. Additionally, our proprietary research in durable goods distribution finds that distributors’ share of the U.S. GDP has fallen from 20% in 1995 to 14% by 2010. These observations, and other studies, find that BIBO distribution is slowly losing its grip on the customer. New, lower-cost models of distribution, retail entities entering into the traditional distribution chain, and e-commerce entities including Amazon, Google, and eBay are slowly eating away at the established model of business.
Our goal in citing the previous research is not fear mongering but an honest attempt to understand what is happening, why, and what distributors can do about it. In the previous installments of this series, we’ve given an overview of the cost advantage of new models of distribution and how e-commerce and e-business have given outsiders and progressive distributors a chance to substantially reduce operating cost and pass part of the savings on to the customer. While we believe that the BIBO platform is under duress and traditional distributors will need to engage e-commerce to drive operating costs out, there is a small but growing group of companies that is integrating forward into the value chain and finding new means of growing the business and cementing relationships with the customer. We call these distributors Diversified Supply Chain Firms, which is a definition-in-name moniker. These companies are springing up in many B2B markets and their earnings and growth rates are impressive.
The Diversified Supply Chain Model
The BIBO model of distribution has quietly existed at the back end of the supply chain for a century. Originally, these small and entrepreneurial firms covered trading areas in key population centers. These companies have consolidated for their three to four generation history to where, in the current day, 60% or more of a sector’s volume comes from 10% or less of the existing firms. Consolidation remains a viable (perhaps the best) method for driving the BIBO platform but consolidated companies, more or less, are still in a BIBO world with challenges from outside entrants. In our consulting work, we find that consolidation takes cost out of the back door operations of the wholesale firm and can, to a certain degree, leverage volume for greater discounts. The downside of BIBO consolidation is that the model is still based on an original platform of aggregating products from different vendors to create value.
In Exhibit 1, we have listed growth options for the traditional wholesaler.
In the center of the Exhibit, we can see the traditional wholesaler whose business model is traditional BIBO in the southwest part of the growth horizon. To the right, directly south, is the strategy of Acquire BIBO, which is consolidation in the industry that has been ongoing for the better part of a generation. Reading counter-clockwise from this point, the other parts of the growth horizon and their definitions are found in Exhibit 2 along with strategic implications.
For instance, we find wholesalers moving further into the value chain and engaging assembly and light manufacturing companies. There are numerous durable goods/industrial products that have to be assembled to complete an application. Increasingly, customers turn to their suppliers for these services and matching the correct components for a trouble-free application. The movement into light manufacturing often comes with engineering talent and some machining or product altering capabilities. Too, we often find CAD/CAM software and capabilities in these businesses.
Redefining the supply chain has limited applications but is a powerful means of growing the firm. In these models, the distributor literally outsources much of its BIBO value added in the supply chain to outside logistics firm(s). In one instance, we found a distributor that outsourced communication cable to a 3PL firm. The logistics expertise of the new partner was able to move partial containers from Shanghai to San Francisco with ease and versus full containers of product that the wholesaler was trying to fill complete with the hassles of long lead times and unbalanced inventory. The outsourcing effort freed up capital for the wholesaler who was able to reduce on site inventory and storage facilities. The 3PL firm then worked with the distributor on reducing national warehouses from five to two while improving lead times. The end result was a redefined supply chain where the wholesaler outsourced filling containers and worked with the logistics firm to reduce warehouse space while decreasing customer lead times. Redefining supply chains are big change events and typically involve partnering with a powerful firm with significant expertise. Most of the redefinitions we have seen involve logistics but other models have involved manufacturing and knowledge-based services.
New Service Development is, as the name implies, developing new services for sale. This subject has been tabled in years past and interest appears to be on the rise as traditional distribution faces cost pressure. Key to New Service Development is a process for synthesizing fee-based services. A New Service Development process (NSD) is key to financially viable service launch(es), and the process closely parallels manufactured product development, with some notable exceptions. Luckily, there is established literature on new service development including the Product Development Management Association (PDMA.org) and wholesaler specific guidelines on the process.
Beyond new service development, diversified supply chain firms are acquiring services. An example would be a Jan/San wholesaler that initiates a service repair arm for cleaning equipment. As the company expands, it finds that there are many small service entities that need operating capital, professional training, information technology, and marketing expertise. The company acquires service facilities and provides needed capital and expertise to allow the local firms to grow. Growing a service arm generally follows existing segments and vendors. The customer base is familiar with the wholesaler and buying a service capability is less risky because of the distribution relationship. Too, existing vendors have a high level of comfort and support for existing distributors with product knowledge and an established business model that can enter into the service arena.
As the world of big data and e-commerce links grow, opportunities arise for brokered relationships. Brokering is, as the term implies, making the sale but not supporting it with fulfillment, credit, and collection services. In a brokering relationship, the selling firm charges a fee to the firm that fulfills the order. Brokering relationships exist as mega-content sites grow and wholesalers develop networks of collaboration. The attractiveness of the brokered transaction is that it is extremely profitable from a return basis. Brokering the order costs “nickels and dimes” and transaction fees of a few percent per $100 valuation of sales yields returns 5x to 10x or more than the investment in systems and content. Amazon has set up significant brokered relationships and we believe the firm finds them financially attractive. We expect wholesalers to develop product communities where brokering opportunities are significant and trade-off leads as sales opportunities arise.
The final growth opportunity for distributors is a Transactional arm. Transactional distribution was covered extensively in the first installment of this series. Transactional distributors are distribution firms that use e-commerce, limited product offerings of A and B products, and limited services to greatly reduce the cost associated with fulfilling an order. Transactional distributors can typically go to market at 20% to 30% less than full distribution while earning 2x to 3x (ROS) or more. While full-service distributors have developed transactional entities, the change required is large-scale and difficult. Entirely new entities dedicated to low cost/limited service platform(s) are needed along with new corporate names and mission(s). Trying to take full-service sellers and populate a Transactional growth strategy is, more often than not, a disaster. However, because of the open field run for Transactional strategies, we expect distributors to try them as they are highly disruptive, difficult to compete against, and offer exceptional returns.
Switching Costs and the Power Curve
Acquisition of the BIBO platform has been ongoing for a generation. Adam Fein’s well received research on consolidation in the sector is now 16 years old and was done at the height of the trend. Today, consolidation is ongoing but it is not the growth engine it once was, as consolidation reduces cost through combining operations and assets but does not change the basic model of business. In short, BIBO consolidation won’t protect a distributor against a low-cost (Transactional) entity and won’t develop new growth streams of services and manufacturing unless, of course, these skills are part of the consolidation.
The ultimate battle in distribution markets is the large customer who places large orders. Research has consistently found that 40% of customers comprise 140% of operating profits and these customers tend to be large, well-managed, and with significant holdings. Distributions’ sales to these customers are highly contested and have followed a pattern of ever increasing efforts, outside of the product, to add value. Product augmentation, kitting, integrated supply, product specialists and a host of other events are part of the history of increasing value to the large customer while assuming more work of the traditional value chain. However, most of these distributor efforts have been organic and they have added capabilities that are not always efficient.
Today, however, efficiency of these organic value-added efforts is being tested by low-cost models of distribution that use e-commerce and e-business to disaggregate services from the product. In essence, a large company that outsources much of its indirect material to a distributor including the services to procure it and manage the technology can, today, quickly understand the value of these services in real dollars. How? By simply accessing price and availability from a Transactional distributor on products, they can understand the cost and approximate the value of the full-service distributor. Consequently, we expect many BIBO distributors that have developed organic services for their top customers to be severely tested by cost-out models. And, we expect that many of these distributors will lose out, over time, to low-cost entities that offer a no-frills service platform with rock-bottom prices.
For the diversified supply chain firm, growth options of moving into manufacturing and services offers a strong defense against Transactional strategies. Why? As manufacturing and service capabilities are acquired, they strengthen the relationship of the wholesaler at the large, complex customer; they greatly increase switching costs. This concept is called the Power Curve Effect and it is seen in Exhibit 3. In the Exhibit, the BIBO platform is reinforced and grown by the integration of the distributor into light manufacturing and service acquisition efforts. We have seen where these entities can double the sales to the large customer. In essence, an account that purchases $1 million in BIBO sales can often purchase an equal amount in services and light manufacturing. A good example of this is AAR Corp.
Initially, AAR Corp. was, at its beginning, a distributor of aviation parts located in Chicago. The firm began to aggressively diversify into services and manufacturing capabilities all within the aviation sector. Today, AAR Corp. boasts sales of $2.06 billion, operating profits of $130 million, with services comprising 33% of sales. The firm has grown 53% since 2010. The Power Curve Effect targets acquisitions that add value to the large customer and purchases products from the existing BIBO model. Too, since the acquisitions in manufacturing and services often use existing vendor relationships, the company strengthens its relationship with existing vendors. The idea of the power curve is relatively new to BIBO distribution but has been a part of manufacturing strategy for some time. It holds significant merit for growth strategy in distribution where organic growth is difficult in the full-service model and acquisitive growth in the BIBO platform is challenged by low-cost firms.
Summation
The growth opportunities for traditional box-in/box-out (BIBO) distribution are limited, and organic growth selling commodity products is increasingly hard to come by. Lower-cost entities using e-commerce are disaggregating full-service platforms and offering prices that are 20% to 30% less. Also, acquisition in the BIBO platform has limited appeal unless acquired entities offer light manufacturing or service capabilities outside of traditional products. The Power Curve effect offers a solid value proposition in the supply chain including increasing switching costs to large customers and leveraging relationships with vendors. The Diversified Supply Chain model is being reviewed and tried by a growing number of wholesale firms. We believe it is a strategy worth considering if one has a traditional full-service and predominantly BIBO business platform.
Scott Benfield is a consultant for distributors and manufacturers in B2B supply chains. He is the author of six books and numerous research studies on B2B supply chains. He can be reached at (630) 428-9311 or scott@benfieldconsulting.com. His firm is located in Chicago and can be seen at www.benfieldconsulting.com.
Benfield, S. Sales Growth in an AmazonSupply World, March 2013 at: http://www.industrialsupplymagazine.com/pages/Management---Sales-growth-in-an-AmazonSupply-world.php
Benfield, S. Sales Growth in an AmazonSupply World, May 2013, at: (http://www.industrialsupplymagazine.com/pages/Management---Sales-growth-in-an-AmazonSupply-world-%28Part-two%29.php
Katz, D. “The Wholesalers,” CFO.Com at http://www.cfo.com/article.cfm/14621766, March 2012
Benfield,S. “Building Value: Driving Wholesaler Returns,” Chpt. 3, pg. 50-63, 2012, Bencon Press, at www.benfieldconsulting.com
See WayPart at www.waypart.com or Thomas Register at Thomasnet.com
Fein, A. “Shakeout and Consolidation in Wholesale Distribution,” Univ. of Pennsylvania, January, 1997, Abstract at: http://repository.upenn.edu/dissertations/AAI9814840/
See “Islands of Profit in a Sea of Red Ink,” Byrnes, J., 2010, Penguin and “Building Value: Driving Wholesaler Returns,” Benfield, S., Bencon Press, 2012.
From AAR CORP 10Q, ppg. 16, 31, 2012.
Power Curve concept from Copeland Corporation, now part of Emerson Climate Technologies, circa 1989 and specific to the remanufacturing/aftermarket business.
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The November/December issue of Industrial Supply magazine features an in-depth cover story about Kimball Midwest. Plus, we're featuring articles by contributing writers Dirk Beveridge, Frank Hurtte, and Mike Marks, as well as interviews with numerous product and distribution industry experts.
