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Distribution in the '20s

by Scott Benfield

The start of a new decade brings out the prognosticators. Expectations are that 10-year cycles are important milestones. With some trepidation, we forward a forecast for the B2B Durable Goods Distribution sector in North America, a $3.5 trillion sector carved out of the industrialization of the economy four or so generations ago. This uber-mature, stalwart, salt-of-the-earth sector is entering an interesting chapter in its history. Depending on how one reads the tea leaves, many firms will lose sales and enter visible decline and will learn to change to compete, or not.

Tea Leaves or Smoke and Mirrors
B2B e-commerce began in earnest in the last decade when software platforms for B2B relationships began to appear. Earlier attempts at B2B e-commerce were mildly successful as the software was adapted from B2C companies and did not give a “sales-assisted” level of service to the customer. It is no coincidence that many made-for-online supply chain firms that started around the Great Recession or after, today compete very well against traditional full-service distributors. In the past five years, much has been written about the need for change among traditional branch-intensive and sales-intensive distribution. Among the most memorable messages was the Coming Shakeout in Industrial Distribution report, authored by McKinsey. The research shows that traditional distribution will be in a battle for customer loyalty as channels digitalize. A new age of competition has begun as business is moving online and traditional distributors struggle to make the existing model digital-competitive.

The motivation for distributors to change has been mitigated as the economy is on a roll and any loss of share to new business models is not immediately visible. The fact
that nearly half of all online B2B transactions are laundered by new made-for-online firms is too small to really be concerned about (The Best Response to Digital Disruption, Sloan Management Review, MIT). Today, B2B online transactions represent approximately 15 percent of all transactions. If half of the transactions are done by newer made-for-online competitors, the math says they sell 7 percent to 8 percent of all online demand. This less than double-digit share, totaling $500 billion in historically fractious markets and high-growth GDP, is not noticeable. The upshot for many distributors is that all the talk about disruption is just talk.

Among the warnings, however, are these nagging findings:

• Made-for-online competitors are mostly a decade or less old and transact over $500 billion in North American sales, representing almost half of all B2B online sales
• These firms have limited branches/sellers and use the cost savings to go to market at a reduced price, often 10 percent or less than traditional distributors
• The number of value chain configurations represented by these firms is somewhere between 12 to 14 different business models; they slice up the value chain in ways that most distributors don’t recognize as competition
• In just one decade, many of these firms have grown larger than third- or fourth-generation distributors and grow much faster, averaging an 8 percent compound annual growth rate.
• New additions appear frequently, which means there is room in the channel for these firms

These facts, coupled with the statistic that some 70 percent of distribution firms don’t sell the online average of 15 percent of revenues, should concern
distributor executives.

Whose Money is it Anyway?
In 2018, we researched the MRO/Industrial/Institutional/Contractor markets for vendor funds to wholesalers. The research included co-op, marketing development, special pricing allowances (SPAs) and volume rebates. The skinny on these funds is that distributors averaged 7 percent of cost-of-goods on these monies, with standout performers getting 16 percent of COGS in funds. The fund difference was largest in SPAs, and a sliver of firms more aggressively use technology to secure at-large funds. Exception pricing is mostly a function of more and better pricing information because of e-commerce, with two-thirds of distributor customers checking price and availability online before purchase. The larger picture says that distribution firms averaging 3 percent return on sales have two to three times of their profit in post-sale monies from the manufacturer. In short, the manufacturer is footing the bill for distribution; the value-added talk about distribution’s contribution to the channel wouldn’t mean much without post-sale vendor funds.

In a real sense, however, distribution is not possible without manufacturer discounts on product (pre- or post-sale) that compensate distributors for the channel services they undertake. The fact that manufacturers pay for many (most?) of the value-added in the channel is no slam against distributors; it’s the way the channel works and has worked for generations. But is this post-sale funding through various programs, special pricing and cooperatives the most efficient channel design?

Within this vendor-funded channel, however, are several observations worthy of consideration:

• High performing distributors create fee-based services that add value outside of manufacturer compensation efforts
• New made-for-online distributors that use technology to take branch, sales and administrative cost out of the channel are growing faster than traditional full-service distributors. In the long run, they cost manufacturers less to partner with to reach the same group of customers.
• As new models of distribution grow sales at the expense of traditional distributors, manufacturers will shift channel funding from slow-growth channels to those taking share with new technology

The need for channel efficiency is seen in the number of specialized software bolt-ons used by distributors in their day-to-day business. Today, if a distributor doesn’t have a PIM, CRM, WMS, Punch-out suite, EC transaction platform, vendor funds tracking module, data analysis software, and a host of other specialized programs, they can’t compete. The reason for these specialized software offerings is obvious; the pressure from more efficient models of distribution are driving old-style firms to remove redundant costs and better manage channel investments to remain competitive. In a recent conversation, a seasoned CIO told me that the average number of bolt-ons has reached critical mass of double digits. The expense to reprogram these offerings, every time a new version of the ERP is released, is painful but critical.

Accessorizing the 350 V-8
Our experience finds that at least half of distributors have multiple failures in their online attempts. These include inadequate software or people to do the job, and limited structural and cultural changes to allow e-commerce to work.

E-commerce requires a big change in culture; it means self-serve and not selling. Far too many distributors build out their technology and place it like a cherry on top of a sundae, expecting customers to flock to their online offering. This only adds cost to the channel as the underlying firm is still a costly business model. All the software for online competitiveness and all the bolt-ons are akin to tricking out the old 350 V8 to compete in a world of 4-cylinder turbo-charged engines that create more torque than the V8 while accelerating from 0-60 quicker, with 20 percent better gas mileage.

The old-style, sales-driven firm uses sellers and branches to consummate the sale. It is expensive, slow, and can’t compete well in a digital economy against firms made for digital commerce. Sellers are notorious for ratcheting up service variability to close sales. This, in turn, increases complexity and drives up cost, often faster than revenues.

Culturally, distributor execs are loathe to cut sellers and trim branches. It goes against almost everything that has made their firms successful—in a non-digital world. But old-style firms emerging from an analog chrysalis to a digital juggernaut bear watching. Evidence is found in Grainger which, between 2014 to 2018, reduced branches by a full third. A few years back the company’s stock was pilloried as it announced margin reductions on full-service or core Grainger offerings. Today, the stock trades in the $330 range, almost double its value when it announced a change in pricing strategy. Grainger knew then, and has demonstrated today, that changing the old-style firm requires far more than simply adding online ordering capabilities and best-in-class software. One must reduce existing functions that hold limited value and change to a digital firm that is self-serve, yet retains and improves full service offerings to customers that value it. This is exceptionally hard work and takes every ounce of executive and management effort for several years. Today, half of Chicago-based Grainger’s sales are online. Additionally, the company has created made-for-online divisions including the wildly successful Zoro Tool. Started in 2011, Zoro is nearing an estimated $600 million in sales, with much of this organic growth.

Sellers and close-in branches are expensive. Their full costs add 30 percent to 40 percent or more to total operating expenses. Curtailing these costs and offering a price inducement in a commodity market will attract online buyers rather quickly. It is the reason that lesser known online firms such as Sustainable Supply and Webstaraunt Store, at an estimated $40 million and $80 million in sales respectively, are larger in revenues than many third-generation distribution firms while being only a decade or so old.

In a growing number of instances, traditional distributors are reducing the need for sellers and close-in branches but don’t realize it. Made-for-online firms, especially marketplaces, use distributor partners to fulfill product orders; fees range from 8 percent to 15 percent. Each sale made through an online partner has several effects that are not necessarily evident, including:

• Every sale through an online intermediary means one sale’s worth of seller or close-in warehouse is not needed, as these functions are done by the intermediary or through a central distribution hub. As distributors ship more through online partners, they make sellers and close-in branches obsolete.
• Each sale made through an online intermediary is another sale where the distributor loses first-line customer contact and power to change the value equation in their favor; they become a low-cost logistics provider, often competing against other distributors that sell the same or similar products.
• Each online intermediary sale gives the intermediary knowledge of product sales and customer demographics. With this knowledge, channel partners can put the products in stock and sell direct if volume warrants.

In essence, distribution executives, while hesitant to lean out the old-style model, do exactly that when they sell through new-age channel intermediaries, with the added “benefit” of losing power over the end-customer relationship.

What’s a Distributor to Do?
The distribution channel is near an inflection point, the historic part of the growth curve where business downturns, losing out to new technologies. Inflection points have their own psychology which we can’t fully do justice here. However, inability to change as the environment changes results in “resource and routine rigidity” (Unbundling the Structure of Inertia, Resource vs. Routine Rigidity, C. Gilbert). Resource rigidity (failure to change resource investment patterns) and routine rigidity (failure to change organizational processes that use those resources) are common. In essence, executive unwillingness to understand and recognize a technology and structural change in the market is marked by reticence to change past investment and to alter the underlying mode of operating rules to compete.

A glaring and recent example is found in the print news industry where, as late as the mid 2000s, presses were running near full tilt and many, maybe most, publishers discounted the emerging and quickly-growing online news services and “zines.” In spite of repeated warnings, newspapers didn’t change in time. Circulation decline was visible since the early days of the internet in the mid-’90s. Ten years of research, exhortations and models that showed subscriptions falling and predictions of advertising moving online did literally nothing to spur papers to alter their business models; by 2007 the industry was in visible decline as subscriptions plummeted. Recent reports find vaunted brands lose money in print and can’t make up the loss with online subscriptions, despite respectable formats. Thirteen years after the inflection point was reached, there has been no magic formula to make the old newspaper model work very well.

The consideration for distributor executives is that online commerce is a fundamentally new way of business; disruptive in the fullest meaning of the word. In the retail sector, two decades after e-commerce made its presence, stores and malls continue to close. This year alone, the forecast is for some 9,000 retail store closings and 20 percent or more mall closings in three years. Need more convincing? Pull up YouTube and review “ghost-town” footage of shopping malls that have tried to make a comeback. When there is a fundamental change in technology, established firms have trouble transitioning.

Changes for distribution are entering a growth phase. We expect a slow, protracted movement from old-style distribution to firms that do much, if not most, of their commerce online, with much smaller sales and branch complements. This is only what is visible today; what new models the future will bring is largely unknown. Distributors have witnessed the beginning decade of new made-for-online supply chain firms that have captured close to half of all B2B online sales and grow at three times the traditional distributor growth rate. A question that bears asking is, with a GDP growth rate of 2.5 percent, how does an up-start firm grow at three times this rate? The answers to the question and our recommendations follow:

1) Get online with competitive technology. A competitive online experience requires a handful of software offerings including a PIM, punch-out suite, transaction platform, faceted search, and quotations management. New software continues to be created and improved, but firms with a full suite of the aforementioned outperform their competitors by a factor of 3X. When benchmarking peers, seek out the 30 percent or so of distributors that can verify their success selling above the online average.

2) Migrate activity negative accounts online. Whatever makes sense to get accounts online should be up for consideration. If it takes temporary inducements to get existing accounts online, look for vendor funds or temporary discounting to make this work. But get accounts online and don’t rely on sellers to make this happen.

3) Thoroughly analyze your material flow, counter sales, and customer delivery needs with a goal to streamline your logistics and branch footprint. Most wholesalers sell between $5 million to $10 million per branch and the breakeven transaction for traditional wholesalers is in the $200 to $300 range. Compare this to Amazon, which sells in the billions of dollars per location and whose breakeven transaction is $15 or Zoro Tool that sells over $100 million per warehouse. Leveraging cost in online firms is immense; this is a competitive advantage in the battle for market share.

We often hear that bulky or hard to handle material can’t be trans-ported by marketplaces including Amazon Business. Amazon is undergoing a massive investment in proprietary shipping capabilities and will figure out how to quick-ship a 20-foot pipe or a 1,000 lb. reel of cable soon enough.

Over the years, distributors have worked with suppliers and master distributors to ship direct. This decision, before online competition, made sense. At low gross margin percent, drop shipments were profitable transactions as they didn’t consume many of the most-costly processes of the supply chain. Today, however, many manufacturers and master distributors are placing their goods online and selling direct. They don’t necessarily need
distributors in the transaction trail, especially if the order size is large and creditworthiness of the end customer is good.

4) Review the sales force. Where you have geographic generalists, territories that don’t grow faster than inflation, or limited new product sales at existing accounts, consider that the seller is not getting the job done or that the customer isn’t willing to pay for the job they are doing. Align sellers with accounts that are willing to pay for them while retaining
some capacity for new account development. Consider new sales roles that generate tangible value and territory configurations with an eye on reducing feet on the street.

5) Research and create your own purely online business. Today, Ferguson has purchased made-for-online models while Grainger tends to start them from scratch. Our research finds that these models are fast-growing, contribute billions in sales and are far more profitable than core distribution. We have identified 12 different value chain configurations for online firms; eight that sell product to the customer and four that are post-sale. Our entreaties for distributors to create their own value chains and disrupt their competitors has us blue in the face. But our zeal is intact; why should Grainger and Ferguson have all the fun?

We realize that the prescriptions for the next decade of wholesale distribution are challenging to consider as they run against sales-driven experience. But research argues for drastic and bold moves for traditional wholesalers unless, of course, they want to risk sales loss and vendor support.

Scott Benfield is a consultant for B2B distributors and manufacturers. He can be reached at (630) 640-5605 or Scott@BenfieldConsulting.com.

This article originally appeared in the Jan./Feb. 2020 issue of Industrial Supply magazine. Copyright 2020, Direct Business Media.

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