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How to improve gross margins without harassing your supplier

by Jason Bader

When I work with private distributors or groups, I almost always hear someone complaining about shrinking margins or margin squeeze. They want to point fingers at the infidelity of suppliers, the cost of transportation, the saturation of distribution in the market, etc. I always find it humorous when every city I visit is "a really competitive market," as if there was some utopia where competition didn't occur.

While it is true that there has been clear margin erosion over the last several decades, distributors have become narrowly focused on the silver bullet of improving gross profit percentages: negotiating better buys with their suppliers. This "club in hand" approach to margin improvement may buoy margins temporarily, but it doesn't produce lasting results. Perhaps a shotgun approach would be more effective.

Over the last several years, I have been exposed to several ways to improve gross margins in a distribution organization without asking the supplies for lower prices. This article outlines several ways to improve gross margins using internal operating methods. All of these methods are time-tested and can be implemented with very little cost. It will just take some concentrated effort and diligence.

Raise Prices on a Regular Basis
When do most distributors raise prices? When the suppliers raise their price. This isn't too difficult to understand. No one wants to be the bad guy here. We adopt a "don't shoot the messenger" mentality. Don't blame me, the manufacturer raised prices. For most of us, this only occurs once or twice a year. So why don't we raise prices on our own timetable? What are we afraid of?

If we were to do a global increase on our pricing matrix, raise prices by a 1.05 multiplier, what would the reaction be? Since this would result in a 5 percent increase, we would probably alienate several customers. What if our multiplier was 1.005 instead? How many customers would we alienate? When I have posed this suggestion to most distributors, many agree that there would be very little objection or notice. What did we just do? We raised our gross margin percent by half a percent. If you do this a couple of times a year, significant improvement can occur over time.

Leverage Manufacturer Price Increases
Leveraging our traditional price increase method of waiting for the supplier to raise prices can also work to our advantage. When a manufacturer comes out with a price increase of 10 percent, does that mean we can only raise our prices by 10 percent? Is there any rule of distribution that says we can't raise prices by 11 or 12 percent when this occurs? You may want to be strategic and stagger the increase based on popularity of the item. Popular items may only get the standard 10 percent increase, but as items wane in popularity, raise the selling price by 11 percent or 12 percent. This will allow you to keep price increases under the radar.

Unfortunately, this strategy can be thwarted by manufacturers that publish their price list to the end-users. This is a terrible practice that handcuffs distributors from making money in a market. The excuse of "this is the way we have always done it" doesn't wash in a modern economy. Note to manufacturers: stop publishing trade list prices. Your customer is the distributor, not the end-user.

While preparing for this article, I solicited ideas from distributors who are consistently at the upper end of the profit spectrum for their industry. One of these companies uses a "mark to market" approach with their inventory. When a price increase occurs, the distributor marks up their inventory to the new cost basis from the supplier. This forces the sales team to adjust their quotations and pricing strategies very quickly. This company eliminates the practice of salespeople selling older inventory at a reduced price. In fact, they are capturing greater gross margin on the sale of this older inventory.

Adopt a Standard Cost
I published an article on this practice several years ago and was accused of furthering the accounting chicanery of Enron and the likes. Let me set the record straight. This has nothing to do with fudging the books and everything to do with raising prices. The basic idea is to create a savings plan for the organization based on the cost-of-goods sold. This practice is sometimes referred to as a landed or loaded cost.

Many software systems have many cost fields available (last cost, average cost, base cost, standard cost, etc.) Unfortunately, salespeople generally see all of these on their screen. Which one are they going to pick when they quote price? The lowest one, of course. The first step is to show only one cost to salespeople. This reduces the confusion. Even if you don't go down the standard cost trail, limit the screen to show base replenishment cost. This will save you margin.

When personal financial planners teach us how to save for retirement, do they tell us to take out a chunk when we first get a paycheck or after we have paid our expenses? If you take the example of a 401(k), the savings percentage is taken out before the money is in your hands. A standard cost percentage functions the same way. We carve out a percentage of the cost-of-goods-sold on every transaction to create a rainy day fund for the business.

The mechanics are fairly simple. Take the base replenishment cost (this is the one that comes from the supplier price sheet), and add a nominal percentage to that figure. I suggest half a percent to 5 percent depending on the popularity of the item or product category. The result, after adding the percentage bump, becomes the new standard or loaded cost. This is the cost that your salespeople will see in the system. Most salespeople have an acceptable gross margin in their head. We are just starting them at a higher place. In some packages, this new cost field is referred to as a "commissionable cost" because it is what sales commissions are based off of. I tend to shoot for an overall accumulation in this fund of 3 percent of cost-of-goods-sold.

Rather than hiding the fact that you are doing this, I encourage you to talk to the sales team about the practice. The additional dollars in the standard cost account pay for all sorts of cost-of-doing-business items, such as fuel prices or health insurance premium increases, that we can't simply pass on to the customers. It can also allow us to save for technology improvements that will improve our overall customer service offering.

Promote a Pricing Matrix Guru
One of the most underutilized features in any software package is the pricing matrix. In most packages, this module has a huge capacity for capturing additional gross margin. A good matrix can handle 80 to 85 percent of the transactions. The remaining transactions will need some sort of sales pricing intervention. Unfortunately, most distributors ran out of steam when they were setting up the matrix and settled for something less simple and ultimately less effective. It's time to reenergize your
pricing matrix.

The first step is to create a pricing matrix guru. This person must be detail oriented and profit motivated. He or she must be willing to get into the matrix and figure out how it really functions. The guru will be responsible for updating all pricing from the suppliers, implementing price increases and creating special pricing agreements. This will probably require some additional training with your software provider, but the return on investment will be phenomenal.

One of the best ways to maximize gross margin potential is to adopt a velocity-based, or popularity-based, pricing model in the company. For example, many distributors set up a matrix where a particular customer type receives a flat discount off of list price, or multiplier on cost, for the entire line. Unfortunately, distributors tend to base this discount on the most popular item in the line. What percentage of a vendor line do you think your customers know they should be paying? I suspect that it is less than 5 percent of the line. It is the most popular items that get shopped around. These items should receive an attractive discount. Everything after that should receive a lesser discount or higher gross margin. This is what a good price matrix set up can do for you.

Building Packages
Individual items on a quotation can be scrutinized and shopped around but bundles and packages tend to make your customers look more at the total value vs. cost of the components. In order to create effective packages, sales teams need to understand how the customer will utilize the products. How can the package reduce the cost of implementation or utilization? When creating a package, think in terms of application.

As many of you know, I grew up in the construction supply business. On job sites, OSHA requires that contactors regularly test electrical extension cords for grounding. Specific colors are used for each quarter. The cords are generally marked with colored electrical tape around one or both ends. This shows the inspector that the cord has been tested and is fit for use.

In order to help contractors stay in compliance, we put together a little kit that included the different colored electrical tape and a card with the chart for each quarter. The idea was to sell tape. Rather than slugging it out with every other contractor supply house on tape, the kit masked the price of the tape and created an overall improved gross margin.

When doing bid work, resist the urge to show component prices. Bid the entire package when applicable. This may require reviewing building plans or drawings. You may be successful bidding individual details on a drawing. If you can include light fabrication to the package, it just helps improve the overall value of the bundle.

Sales Compensation
Sales compensation plans can be fairly complicated and generally a pain to administer. On the contrary, a well thought-out plan can help you achieve goals in your organization. I have said this for years: managing salespeople is not difficult. You grab them by their wallet and direct them where to go. This may be overly simplified but the basic premise is true. Productive salespeople will focus on individual compensation opportunities.

When designing compensation methods, distributors have a tendency to flatline the percentage of compensation. They may offer short-term rewards for promoting specific products, but most of the time, compensation is based on some fixed percentage of gross profit. Why don't we reward those who help us improve our overall gross margin percentage?

I would like you to focus on a graduated compensation plan based on improvement in gross margin. For example, the current plan pays 5 percent of the gross margin at an average of 25 percent gross margin. The salesperson who averages 22 percent gets the same rate as the salesperson who achieves 28 percent. Establish a baseline gross profit average for the company. In this example, it is 25 percent. Reward those who are pushing the average. Offer a rate of 5.5 percent to a sales rep who hits 27 percent. Offer a 6 percent rate on anyone who hits 29 percent.

A graduated compensation methodology helps drive your overall margin improvement, rather than promote the status quo. Salespeople are the catalyst to margin improvement. We just need to get creative and give them the opportunity to shine.

Promote Education
Several times a year, I teach a class designed to help manufacturer sales reps work with distribution companies. We talk at length about margin erosion and what they can do to help sell through distribution. I remind them that it all boils down to mindshare with the salespeople. Product knowledge is the cure for weak margins.

When a salesperson doesn't understand the features and benefits of a product, they generally resort to price reduction. This is a zero sum game. Someone will always have a better price or a lower cost of distribution. Unfortunately, price wars establish low price points throughout the market and they take a long time to recover.

On the contrary, when a salesperson understands the application of the product and can speak intelligently on the value proposition, margins can improve. As familiarity becomes stronger, the salesperson will learn to recognize new opportunities for the product or group. The value of product knowledge can't be discarded. As I am constantly reminded, distribution is still a face-to-face business. People buy from people: educated, confident, solutions-oriented people.

Every one of these solutions is an internal change in the status quo. The good news is that you are not reliant on asking for some price concession from your suppliers. Rather than bemoaning the poor economy or lamenting the good old days, refocus your energy on the internal opportunities. Don't let the market dictate how much money you are going to make. There are plenty of nickels, dimes and quarters available for those of you willing to look. As always, I am here to help. Good luck.

Jason Bader is managing partner of The Distribution Team, which specializes in helping distributors become more profitable through operating efficiencies. He spent the first 20 years of his career 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 at Jason@Distributionteam.com or www.thedistributionteam.com.

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

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