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Battle for capacity

Will the branch-centric model of distribution fade away?

by Scott Benfield and Steve Griffith

In five years of reviewing transaction profits of B2B wholesaler distributors, we have found that 40% of all transactions cover their weighted average cost of capital, 20% have a positive return but fail to cover their capital costs, and 40% of transactions have a negative profit. Investments that fail to cover their weighted average cost of capital (WACC), which is typically 8%, are said to destroy value.

Our research findings, launched in November of 2011, were only one data point describing the predominant issue as value destruction, and therefore, needed additional research to corroborate or refute our observation. On March 2, 2012, in CFO magazine, the Accounting Lab at Georgia Tech released a Wholesale Industry report on 122 publicly listed companies. Using forensic accounting, the report described the industry as having a negative free cash flow profile of -7% and was 39th of 44 industry sectors in the measure. Free cash flow is a key ingredient in shareholder value creation with the accepted formula of Value=Free Cash Flow/WACC. In their analysis, the Georgia Tech Lab discovered that nearly half of the wholesalers were borrowing to fund growth opportunities because their existing base of business was generating a negative cash flow profile. Without a positive free cash flow, the business cannot fund growth, at least not for very long. To get growth, the firm extends the credit line. Unfortunately, this leverages the corporation and leads to debt service that further takes cash away from long-run investments.

If signs point to the wholesale industry destroying shareholder value, the question is why? What has changed in distribution in recent years where the industry is experiencing an untenable path of long-term growth? Our observations are that there have been fundamental changes in technology that give customers power to seek greater value. Coupled with a decline in manufactured costs and better measures on value generation, the traditional branch-centric and sales-driven approach to value appears to be in decline. In essence, the fundamental value proposition of wholesale distribution has migrated to a new dynamic. Many wholesalers will deny this observation and suffer ever decreasing profits as the decade unfolds.

The Power of E-Commerce
E-commerce capabilities have been a part of wholesale distribution for over a decade. Fledgling models began in the late 1990s. Today, approximately half of wholesalers have a functioning e-commerce storefront and the forecast is for this to increase to close to 75% of all firms by 2015. In the early stages of e-commerce, the primary gains are for the providers who secure orders at a lower cost. For wholesalers, the primary gain is in a lower labor cost, as inside sellers no longer have to take the order. Our work in transaction costing finds that e-commerce offers a $2 to $3 per line cost advantage over an inside sales supported order of two to three lines per transaction. Once an industry becomes saturated with e-commerce storefronts, however, the advantage quickly moves to the customer and the price in an industry often stagnates or falls.

With e-commerce in use among half of all wholesalers, the ability of the customer to check price and availability is unparalleled in industry history. Industry research finds that 22% of wholesalers readily admit to customers checking price competitiveness online; this will increase to 44% by 2015. Our proprietary research in sales restructuring believes that price comparison shopping is understated. In recent sales audits, we have found that more than 40% of all orders are price shopped via e-commerce. The ability of the Internet to suppress price increases is further corroborated by the observation that many vertical markets have not recovered margin percent during the economic recovery. This observation is also made in the Georgia Tech research regarding the industry as a whole. We first noticed price shopping in distributor lighting and plumbing showrooms where phone price comparison apps were being used by customers. Today, however, the practice of accessing e-commerce to check price is ubiquitous and growing in all distribution verticals. Secondary evidence has found that contracting industries regularly purchase online from eBay and Amazon. Price shopping and suppression of pricing gains is not, however, the only change brought about by e-commerce.

As the technology of online ordering including product search is increasingly accepted, the need for sales supports decreases. In essence, e-commerce greatly increases the customer service and solicitation capacity of the wholesale firm, while full inside and outside sales efforts can easily cost 50% of total operating expenses and are, arguably, providing declining levels of value to the customer. Our work in reviewing an alternative and growing low-cost model of distribution, named Transactional Distribution, finds that many customers can be persuaded, through price reductions, to place orders via e-commerce with little to no sales support. The interesting and disquieting observation about e-commerce is that it requires only a minimal cost to increase capacity in the wholesale firm. In essence, customer ordering capacity can be increased substantially for pennies on the dollar where, currently, the cost of a full sales-supported stock order averages $50 more in cost than its e-commerce equivalent.

A further problem awaits wholesalers where customers place e-commerce orders for commodity products; the sales and solicitation is largely undifferentiated. In essence, placing an order for wire, pipe, lubricants, chemicals and other commodities through e-commerce is a transaction that leaves little differentiation in the mind of the customer. Sales support becomes commoditized and this forces slow but unwanted adoption of a new dynamic from managers that have, historically, placed much of their value proposition in their sales forces.

Our research points to an industry where changes wrought by e-commerce have been largely underestimated. These changes have been slow to take place as wholesalers have been slow to reduce price with reduced sales support. However, as new and lower cost models take hold, prices paid will fall as efficiencies from reduced sales support are brought to market.

Globalization of Manufacturing and Product Cost Deflation
Four years ago, we researched the propensity of wholesalers to purchase products that were named “off-brands” in that they were manufactured overseas at a significant price advantage. At the time, the average landed cost advantage of “off-brands” made overseas vs. domestic brands manufactured domestically and overseas was an average differential of 30%. Today, our continued review of off-brand products, often labeled “private brands,” finds that there is still a 30% landed cost differential. Furthermore, these products are becoming increasingly accepted. Recent research in the HVAC sector finds fan motors, a major commodity group, are being imported by wholesalers in container loads with some large contractors taking direct shipments of full or partial loads.

The larger concern for wholesalers is that “private brands” will increasingly become a part of the product mix. In a real sense, wholesalers are importing deflation for their cost of goods and this is expected to increase as private brands grow. The upshot of reduced cost is that the buy-side advantages will find their way to the end-user marketplace as wholesalers seek competitive advantage. Additionally, there will be less margin dollars, as product cost falls, to support the existing full-service platform. These changes will take place over time but we believe they are already driving a reduced cost to the customer. Many distributors underestimate the effects of product deflation and e-commerce and their cumulative downward pressure on margins. Many wholesalers are in denial of these forces and don’t associate them with a negative cash flow profile and assume debt to fund growth. The final cost decrease in distribution will come from rearranging the business model to take advantage of capacity misalignment. This will, initially, happen with only a few firms but their cumulative effect on overall structure of the industry will be significant.

The Fundamentals of Value and Transaction Economics
A metric highly correlated with value generation is Return on Invested Capital. However, for supply chain firms, ROIC does not measure the value generated by “investment” in marketing and sales entities. The field of activity costing attempted to allocate operating costs to customers and other marketing entities in decades past to determine their value generating ability. But these attempts were largely dismissed by wholesalers because of complexity and inaccuracy in the original models. From 2003 to 2007, in a series of papers and a book, Robert Kaplan of the Harvard Business School and inventor of activity costing recanted the original discipline and replaced it with time-based ABC. Key to the new discipline was the treatment of labor capacity away from the 100% allocation of operating expenses from the old models. Kaplan’s argument was that capacity should
be allocated at usage with overcapacity treated as an investment or chance for streamlining.

Our review of many of today’s cost-to-serve models, however, finds that there is still a lack of understanding of Kaplan’s design parameters for cost allocations as it relates to capacity. Our work in allocations uses transaction types with labor differentials to estimate capacity. We typically have four to six base transactions, across 10 labor buckets, and further cost them according to outside sales assignment or not, inside sales assisted or e-commerce, and shipped or branch pick up. We call the methodology Labor Differential Transaction Costing. Typically, we have 14 to 22 transaction types for costing purposes and there are substantial differences in transaction costs. Many transactions, in aggregate, don’t cover their fulfillment costs including: non-stock transactions, counter (retail) transactions and small-order value stock transactions. The problem for wholesalers comes in the incongruence of the traditional reward and measurement systems (sales and margin dollars) which don’t consider capacity costs and contribution to operating profit of a transaction or customer. Branch managers, sellers and corporate management often reward their efforts on generating higher sales and margin dollars. According to our research, however, 60% of these transactions destroy value in that they don’t cover their weighted average cost of capital. In essence, sales and margin dollars of a transaction or a customer have no predictive value if the entity covers its fulfillment cost(s).

The danger for traditional full-service distribution comes from new models that understand this misalignment of capacity and take advantage of it. Transactional Distributors target transaction types and customers that are more likely to cover their costs including large stock orders and drop shipments. Furthermore, these firms target the stock Pareto inventory and have fewer and smaller brick-and-mortar locations. Finally, as transaction size in margin dollars and type of transaction is closely related to fulfillment cost, these firms have learned to drive transaction size by linking it to price reductions. The savvier firms discount price at a lesser rate than the order size increases and drive the Transaction ROI of the order even higher.

We dub new business models that target profitable transactions to leverage labor as winning the battle for capacity. The battle is the efficient use of labor matched to transactions which have a high probability of producing a positive Transaction ROI. We expect that new business models, predicated on driving the variables of transaction size in margin dollars and type of transaction, to become increasingly common. They will put significant pressure on traditional firms that will find it difficult to compete. Finally, these models have additional cost savings of targeting A&B inventory (20/80), reduced brick-and-mortar costs, reduced sales costs and reduced cost of goods from using “private brands.” Our expectations for change, however, from traditional distribution to combat or even recognize these issues, is low. This has to do with a general, but not total, failure of traditional players to recognize outside change, engage it and dig into the detail to understand it. In large measure, they proffer hope, bounded by experience, as a strategy and will likely destroy shareholder value because of it.

Value Migration and Bad Industry Structure
Wholesale distribution was geographic-centric 100 years ago. Any particular geography with substantial population was served by the branch. Over time, the branch became the nerve center of the wholesale organization. Thirty years ago, sales were assured as
markets were growing at GDP rates of 3.5% per year. Since the Great Recession, however, the recovery is forecasted to be in the 2% GDP growth range. A generation ago, location assured sales growth. Today, advances in shipping, more shipping and storage options, and better transfer of information has created less dependence on the local storage of inventory.

Product knowledge in the past was a branch responsibility. Today, the need for product knowledge is lessened as many products are mature, their application can be researched online, or product knowledge experts can be housed at the home office and communicate real time via technologies such as Skype. Finally, much of the sourcing (purchasing) and back-office functions such as accounting moved from the branch as IT became integral to their execution. Today, many customers send product specs, gathered from manufacturer sites, to their distributors for ordering.

The problem with the migration of value from the branch to more centralized location(s) is that many wholesalers still operate full-service branches with the exception of accounting and purchasing functions. The branch manager calls the shots on selling and pricing and the branch is replete with inside and outside sales staff. The failure to recognize excessive costs in a full-service branch structure is a big part of the problem and
wholesalers too often have headsets formed a generation ago when the branch-centric model was more viable. The need to rethink and restructure the concept of the branch, get cost out and become more efficient is real, but many wholesaler executives don’t believe in the migration of value or don’t fully utilize technology for efficiency of internal structure.

An efficient structure that recognizes effects of e-commerce, low-cost foreign manufacturing, and transaction economics is essential to competing in today’s environment. Wholesale distribution is nearing what leading business strategists call a bad structure where the following attributes are common:

• An operator’s capacity is indistinguishable between competitive firms
• Technology is increasingly less proprietary
• Technology makes it easier to add significant “chunks” of capacity
• The product(s) are undifferentiated commodities
• Buyers are price sensitive, knowledgeable, and can switch suppliers with minimal costs

In industries with bad structures, making incremental changes to the existing business eventually results in futility as the overall model of business (industry-wide) allows for scant profits. To this end, we believe wholesalers that succeed as the coming decade transpires will need to make bold and significant changes in their businesses and move away from a poor industry structure. However, we expect a significant number won’t change as they are convinced that the current profit malaise and value destruction is temporary and good times will return. They are supported by industry research that targets incremental change including subjects such as compensation, sales management or cost-to-serve models without proper measurement of capacity.

We believe that the aforementioned changes from e-commerce, globalization of manufacturing and transaction economics are real and have already begun to change the profit making of the industry and upset the traditional full-service business model. In essence, wholesalers will need to engage new thinking, a new approach and a new strategy. To quote Richard Rumelt, UCLA strategy professor and author of Good Strategy, Bad Strategy, wholesalers that succeed “…must put aside the comfort and security of pure deduction and launch into the murkier waters of induction, analogy, judgment and insight.” They will have to engage and test the “edge between the known and unknown.”

Scott Benfield is a consultant for distributors and manufacturers in B2B channels. His firm, Benfield Consulting, is located in Chicago. Reach him at (630) 428-9311 or scott@benfieldconsulting.com or online at www.benfieldconsulting.com.

Steve Griffith BS (Engineering), MBA, MA, and Ed.D is a faculty member at Indiana Wesleyan University and University of Maryland University College teaching graduate business courses. Reach him at sgriff2353@mac.com.

This article originally appeared in the May/June 2012 issue of Industrial Supply magazine. Copyright 2012, Direct Business Media.

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