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Five Keys to Making Money in Distribution

by Jason Bader

I recently interviewed a third-generation distributor about how his company has remained healthy over so many years. He told me it all came down to the fundamentals of distribution. Companies need to understand their core competency and then stay true to that focus. Points of uncertainty and instability can be attributed to the times they took their eye off the ball.

After my conversation with this gentleman, I started to think about all the times someone has said that you need to get back to the fundamentals. But what does that mean? In this article, I will give you an overview of five fundamentals in distribution.

1) Understand Distribution Financials
It took me many years to understand distribution financials because, frankly, I was not exposed to them as a distributor. They just weren't emphasized in my family business. It was only when I started seeking outside coursework and seminars that I began to understand that making money in distribution went beyond selling something for more than I paid for it.

Start with the income statement. It is the most useful tool to look for leaking cash. Once you get a feel for what you are reading, start combing through the operating expenses for areas to correct. A good friend of mine spent about six months pouring through his income statement. He made changes in telecommunications, vehicles, office supplies, even garbage service. When all was said and done, he saved his company almost $20,000 per month. It was well worth his time.

Budgeting in distribution is a tough exercise. Most of us get hung up on the income side. Since we usually feel like our income projections are tantamount to pixie dust, we discredit the whole exercise. The real key is in the expense side of the exercise. Cash flow trouble keeps most business owners sleeping like babies (waking up and bawling every two hours). A great deal of this anxiety is fear of the unknown. A budget helps alleviate some of that fear. Again, the income may be significantly different from your budget. As it fluctuates, you can make adjustments within the framework of a bigger plan. Going without a financial plan is a recipe for a lot of sleepless nights.

Skipping cash discounts is like signing up for a high-interest credit card. When we skip a discount, and hold on to our money for an additional 20 to 25 days, we are essentially signing up for a loan from the supplier. If we are offered cash terms of 2% 10 net 30, the supplier is willing to give us a 2% discount on the entire invoice if we pay within 10 days. If we skip the discount and pay in 30 days, we forfeit the 2% savings. Holding on to our money for the 20 days at a 2% penalty doesn't sound like much until you run that interest rate out to a full annual percentage rate. It adds up to about 37%. Ouch. Most of us can borrow at a much better rate than this. This works the same way if you are giving cash discounts to customers. Quit doing this. At least quit giving cash terms to your least profitable customers. Need some more incentive? Ask your A/R people how many customers take the cash discount and still pay you in 25 days or more.

If you don't feel comfortable around financials, ask for help. Most distribution companies were started by salespeople who thought they could do it better than their previous employer. Face it, most salespeople are not closet accountants. Swallow your pride and get some education. There are great seminars and workshops focused on finance for non-financial managers, and books written in plain language. Finally, ask your CPA for help. Understanding cash flow will help you survive some of the deepest sales recessions.

2) Understand Your Core Competencies
Why do your customers buy from you instead of your competitors? Have you ever asked? Most distributors think they can answer this question but have never done the research to back it up. I recently helped a client understand the difference between sales and marketing. Marketing is not sales. Marketing makes sales more effective.

You will learn a great deal about your company, both positive and negative, by asking your customers. If you have an Internet savvy customer base, Web-based surveys might be your best bet. If your customers prefer personal interaction, you might have to conduct phone interviews or focus groups. The point is, don't guess about your core
competencies, ask your customers.

Many of us have tried to take our company outside the current market. Sometimes this means looking at another trade type or customer segment. Other times, we make geographic moves that cause us to lose our identity. I have personally experienced both.

As many of you know, I grew up in construction supply. Every few years, we would decide to court the industrial contractor. The products were the same, so why not? There was a very big why not. Industrial contractors do not have the same service needs as the job site contractor. It's like apples and oranges. Both are fruit, but the two are very different.

I also learned painful lessons about entering into a different geographic market. This time, we worked with the same type of customer, but the geographic differences in application proved to be the insurmountable obstacle.

In both cases, I did not honor what made me successful. I am not advocating that you rest on your laurels. First, do the research and ask yourself if it fits within your core competencies. Are you built to do business the way the market requires? If not, you might be trying to jam a square peg into a round hole.

3) Analyze Customer Profitability
Are your biggest volume customers really the most profitable? You would be amazed how many people in your organization subscribe to that correlation. Your largest customers often have the highest cost to serve and the lowest contribution to net profit.

In order to rank your customers by net profit, you must understand cost to serve. What does it cost you to process an order? One way to arrive at that number involves using activity-based costing software to determine the amount of money allocated to every order processing function. It involves time studies and process analysis. Although it can be highly accurate, the time involved is generally not worth the aggravation. The easy way is to take your annual operating expenses and divide it by the number of orders you processed in the last year. This will give you a ball park number suitable for making decisions. It isn't perfect, nor does it have to be.

Once you know how much it costs to process an order, look at the number of orders you have processed for a customer. Take that amount of money and subtract it from annual gross profit received from selling to this customer. If it is positive, rejoice in the knowledge that someone is helping your bottom line. If it is negative, it's time to start making some decisions.

Once you determine the profitability of each customer, place them into logical groups. Group A is the net profitable customers. Group B is the large group of customers that are negative contributors, but provide volume. Group C is the customers that are very negative and tend to string you out on payment. These are the bloodsuckers of your bottom line. The next step is to determine a course of action for each group. You can't service them all the same.

Start at the bottom. Fire them. Perhaps that is a tough pill to swallow. After all, it doesn't feel natural to fire a customer. Unless you like making donations to them on a monthly basis, you need to start evening the playing field. There are all sorts of ways to fire a bloodsucker. The easiest way is to raise their prices. Quit giving them credit. Don't spend extra processing dollars on these accounts. No special orders. No transfers. Invoke minimum purchases. You would think they would get the hint and just leave. Some of them will stay. This time it will be on your terms.

Group B isn't as cut and dried. Subtle changes will help change the profit picture. With this group, I tend to look at price increases. Look for margin improvement in slower moving inventory. What percentage of a category or vendor line do you think your customers actually know what they should pay? Chances are the percentage is very low. They know the price on a few dozen highly competitive items. As the popularity of an item goes down, the margin can go up.

Group A is the precious list of customers that actually contribute to your bottom line. They pay for everyone else to use your services. They need to be rewarded, not with discounts, but with praise and attention. These are the folks you want to take to sporting events, golf outings, lunches and other miscellaneous events. If you don't tell them you care, they will leave you.

Is it easier to sell deeper into an existing account or sign up a new customer? Any salesperson worth their salt will tell you the former is true. Sell deeper. Better yet, sell deeper into the accounts that are actually profitable. I recently helped a client analyze their Group A customers. Out of a potential 39 categories, most customers purchased from fewer than 10 categories in the last year. Your best customers are probably not aware of everything you have to offer them. Enlighten them.

4) Utilize Variable Compensation Programs
Where is all the money stored in a distribution company? It's in the warehouse. This is why I encourage all distributors to refer to it as a vault. Typically, who are the lowest paid employees in a distribution organization? It's the folks who manage all your money. Worse yet, we typically pay hourly wages for this category of employee. Can you expect superior results when you provide less than superior compensation?

Create incentives based on desired behaviors. I generally set up no more than five criteria when designing an incentive program. The criteria can change over time, but too many
criteria become confusing. If all five are met, the full bonus is paid to every member of the team. If four out of five are met, each team member receives 80% of the bonus.
Cleanliness is next to godliness in wholesale distribution. I generally make this my first criteria. I can usually tell the accuracy and efficiency of a facility the moment I walk in the door. After that, you can look at several other criteria: inventory accuracy, damage, picking accuracy, shipping accuracy, time loss accidents, equipment maintenance, etc. Again, keep it to five and adjust as needed.

There may be other departments where you can institute a variable compensation plan. Could you come up with performance criteria for purchasing agents? What about accounts receivable professionals? Don't convert their entire income to variable comp. Try a small percentage, perhaps 20% of overall compensation. Make sure these bonuses come on a monthly basis. Anything longer in duration will diminish the effectiveness of your program. You are trying to modify behavior.

5) Learn to Manage Your Inventory
I have worked with several clients who neglect basic inventory management during times of prosperity only to be thrown into a financial crisis when the economy goes south. They find themselves saddled with a mountain of aging inventory and very few places to turn it into cash. This can be avoided with a perpetual inventory management program. The good news is that most of you have already paid for it.

The distribution software package is the cornerstone of any inventory management program. A majority of them have adequate inventory replenishment and performance measurement modules. Unfortunately, many distributors don't know how to tap into these resources. I am stunned at how few distributors perform regular system audits. This is where you invite your software provider to visit your company, for a small fee, to assess your utilization of the package. Understanding the inventory management controls and settings is how you make the system work for you. A little time spent up front will allow you to manage several thousand SKUs with a very small staff. If you are going to buy the package, make sure you know what it can do for you.

Learn to measure inventory performance. Get very familiar with the terms: inventory turn, hits, carrying cost, service percentage and return on investment. These are all measurements of your largest cash asset. Monitoring them and looking for slight improvements will help you avoid trapped cash when the sales folks are looking at a bleak forecast.

Never get emotionally attached to inventory. Every item has a product life cycle. Products are hot sellers one year, dogs the next. This is due to the fickle nature of customer
preference. When a product is no longer being sold, consider this item to be dead inventory. The date of death is up for some debate. Most distributors define death as zero sales in the last 12 months. Some tighten up that date to zero sales in six or seven months, while others push the death envelope out to 18 to 24 months. I had one client try to negotiate a 36-month date of death with me. Unless you are in the appliance parts business, where things don't start moving until they have been out for seven years, 36 months is a bit long in the tooth.

Dead and slow stock management is how distributors take unproductive assets and reinvest those dollars into high-turning products. I generally like to see distributors carry less than 3% dead inventory by the 12-month definition. I also like to track slow-moving inventory. Why not get ahead of the problem? Items with fewer than four hits (orders in the last 12 months) are usually on their way to the great warehouse in the sky. Scrutinize these products and decide whether you should get out before the market dies. Inventory is just cash; the trick is to turn it back into the green stuff.

Finally, know what you have in the warehouse. Inventory accuracy isn't something we do to appease the bean counters. A lack of inventory accuracy affects your ability to serve your customers.

The distribution business is a relatively simple business. We buy stuff, we consolidate stuff and we sell it to someone else. We tend to get screwed up in the details. We add cost by making the business more complicated than necessary. I challenge you to go back and look at your processes. Have you added more steps than necessary? Are these steps stealing net profit? I have given you five fundamental areas to explore. I urge you to take a critical look at the things that made your company successful. It's time to get back to basics. Good luck.

Jason Bader is the managing partner of The Distribution Team, which specializes in helping distributors become more profitable through operating efficiencies. The first 20 years of his career were spent working in distributor operations. Today, he is a regular speaker at industry events and spends much of his time working with individual distribution companies. For more information, call (503) 282-2333 or contact him by e-mail at Jason@Distributionteam.com. Also visit www.thedistributionteam.com.

This article originally appeared in the Jan./Feb. 2011 issue of Industrial Supply magazine. Copyright 2011, Direct Business Media.

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