December 13, 2017


















RE-THINKING DISTRIBUTOR PROFITABILITY - A CASE STUDY 1

ABC Bakery Supply (ABC) is a $25M distributor with frustrated management. The company distributes bakery supplies to customer segments that produce baked goods in a channel that is over 100 years old. Although their sales volume is about 3 times greater than the average for a distribution center in the channel, the firm's - gross margin percent of 18.05%, operating profit margin of 1.15% and number of stocking units (3000+) - are quite typical.

Here is what's bothering ABC's management:

1) The profit before interest and tax (PBIT) of $288,036 when divided by total assets in the business yields a bit over 5%. If the shareholders liquidated the business and put their money into muni-bonds, they would get a better after tax return on their investment, have 100% leisure time, less financial risk and more borrowing liquidity. Why are they working so hard to make so little money with bigger risks?
2) The company is growing so slowly it has been having trouble attracting and keeping good, new people. The 12 outside sales reps, for example, have an average age in the late 40's, but figuring out how to renew sales energy is a growing concern.
3) Year-end supplier rebates for 2001 were roughly the entire PBIT total, and the trends aren't good. Over the last few years, the growth rates for sales, profits and rebates have all been declining.
ASSUMPTIONS FOR GROWING PROFITS

When asked: "What are the company's assumptions for how to grow profits?" The following themes emerged from a management discussion:
1) Driving sales volume is vital. More volume earns more supplier rebates, better buying economics and more attention from producer reps that call on them. Fixed costs, which run at almost 20% of all expenses, can be spread over more volume to allow more profit to get to the bottom line for an "economy of scale."
2) To get more sales, ABC has continued to hire more sales people over the years to push into new territories and accounts. The reps generally push products and product promotion deals that are rolled out on a monthly basis, depending upon which suppliers were offering the best deals.
3) Maximizing gross margin percent while keeping all operational costs to a bare-bones minimum is vital. Sales reps are paid on gross margin (GM) dollars generated with a sliding scale percentage that goes up with the GM percent average for a territory on a monthly basis.
After writing down these success assumptions, the following challenging questions were raised:
1) Where are the economies of scale from having 3 times the normal sales volume per distribution center for the industry? Are the rest of the distributors doing worse? How much of the "fixed costs" are really fixed? Do more of the overhead costs vary completely or partially with the number of employees needed for transactional activity or inventory and receivables to support more sales? (It turned out, for example, that half of the overhead costs had been interest on bank debt for inventory and receivables that varies perfectly on a lagging basis with sales volume.)
2) How do GM% and GM$ per transaction relate to each other? What happens to the profits if the margin % drops a couple of points, but the order size goes up 50%+? When comparing average margin dollar per transaction with average cost per transaction is it valid to just look at "incremental costs" of one more order? If, for example, the bottom 40% of all transactions ranked by GM$ generated only 5% of the GM$, but required 40% of all activity costs (which is ABC's case!), then wouldn't any remaining truly fixed costs have to be allocated to each transaction? What should the firm do, if anything, to minimize the small order opportunity?
3) What does a ranking report of all customers by estimated PBIT contribution look like? Is it possible that profitability is driven more by an account's order-size economics first, then volume and margin % third? Is it possible that the specific product mix that a customer buys is a minor profitability issue? We know intuitively that an account that gets a small order delivery every day would be a definite loser. Are there any such accounts in the company's portfolio of customers?
4) Could the company have hit a level of diminishing returns? If reps and trucks are driving further from Center City to smaller, more rural accounts that buy in smaller quantities, wouldn't the costs per sales call (estimated $100/call on average) and per stop of the truck rise while margin dollars per stop drop to create more losing orders and customers?
5) Are there too many sales reps calling on too many accounts that might be more effectively and efficiently covered by telemarketers, direct mail and fax news-grams?
REVOLUTIONARY ANALYSIS WORK

To shed light on the challenge questions the firm did the following analysis work to find out some shocking things:
1) They ranked customers by PBIT using a "quick-n-dirty, sufficiently accurate" method to find out that:
a) 4 accounts generated 77% of the total PBIT.
b) 5 profitable territories out of 12 generated 206% of the PBIT from 37% of the accounts.
c) 7 unprofitable territories lost 106% of the PBIT from the other 63% of the accounts.2
2) When looking at GM% for a territory, there was a slight bias towards lower GM% territories making more money, because their GM$ per transaction average was so much higher. The two highest GM% territories were both losers due to much lower average GM$ per transaction, but the current compensation scheme paid these reps the most.
3) For segmenting customers by sales volume per month or per year to qualify for different types of selling - (A) outside sales, (B) telemarketing, (C) direct mail, (D) cash-n-carry retail - management made the following assumptions:
a) For an outside sale rep to sell, install and maintain a "lowest total procurement cost (TPC) replenishment system" for a customer, the rep would have to call on an account at least once a month. The account would therefore have to produce a minimum of $24K in sales per year in order to keep the ratio of sales expense to GM$ at 25% or less. Only 256 accounts out of 1105 active accounts exceeded $24K per year.
b) Using the same logic pattern for telemarketing coverage, an account would have to do between $12 to 24K in sales per year. Only 187 accounts fell within that annual sales range.
c) For the next two strata of accounts, the "C"/direct mail and "D"/retail accounts the numbers were 501 and 200 respectively.
PSYCHOLOGICAL RESISTANCE

Management was generally disbelieving of what the different reports suggested. How tough is it to admit that you have been working so hard with the wrong assumptions for the last 20+ years? They attacked the activity based costing model for computing PBIT per customer. A second round of analysis revealed that "fixed overhead" costs of the company were mostly variable or semi-variable. After making and testing every assumption that could be raised to make the extremely profitable and unprofitable accounts less so, the net result was that both groups were still extreme. The PBIT ranking was sufficiently accurate, it turns out, to start re-thinking the entire customer portfolio around PBIT/customer and segmenting them for different types of selling.

The next wave of resistance involved questions relating to: "How are we going to rethink all of our sales/marketing methods?" What would the sales force say? A new compensation system would have to be designed, and less outside sales reps would be needed to call on at most 300 customers that qualified as "A" or potential "A" accounts. None of the sales reps could explain the "11 elements of total procurement cost" let alone sell, install and maintain a system that would both lower buying and selling costs for a sustainable win-win relationship.3 They were all addicted to "selling" special price or incentive product promotions. And, the firm didn't have any real telemarketing expertise for the "B" account coverage.

Wouldn't suppliers be upset too? The company would have to stop doing most of the supplier load-up promotions that conceptually conflicted with TPC purchasing system theory. What if sales growth dropped over the next year by 2 to 5% because some customers would switch to the competition instead of changing their buying behavior to become profitable to ABC? Wouldn't supplier rep support and rebate income take hits? Sure, but what if profits quadrupled and target customer penetration growth started to accelerate at a superior rate 6 to 9 months out? Were there other positive possibilities?

PSYCHOLOGICAL HOPE

Brainstorming about what could work for - most profitable, most unprofitable and best target accounts - did raise spirits. Management agreed that if they visited the most profitable 4 to 10 customers, the odds were good that the company could find new ways to better serve, protect and penetrate those accounts. Then, the same new insights could be applied to another 5 to 10 most promising target accounts. If all the employees knew these franchise and target accounts by heart and had permission to give them perfect and extra service as needed, it could make a big difference in growing and keeping them.

As for the biggest losing accounts, they were simply placing lots of small orders that were killing both parties with a number of costs. Most of these accounts just needed help in adjusting their re-order points, re-order quantities and paperwork processing to save costs on both sides. For some of these accounts, the hope was to use the audit, adjusting process as an entrée for getting a lot more volume. The odds seemed good that most of the dramatic losers could be turned into solid winners which would cause a big swing in company profitability.

WHAT NEXT?

All of the resistance was eventually boiled down to a simple choice. "Should we keep on doing what we are doing: working hard, making no money and watching the boat sink? Or, should we forge ahead with new profitability assumptions and methods for which we just have to be one level better than the competitors to unleash new profit growth?"

What do you think they should do? Do you have similar opportunities buried under a lot of empty, even unprofitable activity within your business? How should you better educate yourselves and all of your employees about rethinking your profitability assumptions and using what new methods to quadruple profits and accelerate growth rates? ABC Supply bought the video, "High Performance Distribution Ideas for All" to help their cause. More information about this video is at www.merrifield.com.

Merrifield Consulting Group, Inc.
Article # 2.20 and Bakery Case Study Exhibit

_______________
1 To be emailed a copy of the 4 page case study request it from karen@merrifield.com
2 For the analysis technique see article #2.3 at www.merrifield.com or in Module #3.5 in the video, "High Performance Distribution Ideas for All."
3 More on "total procurement cost" at www.merrifield.com within article #4.2 and video Modules #4.11-13.


Bakery
Case Study
May, 2002

I. Case study of ABC Bakery Supply Company.
A. Key conceptual themes to explore:
Volume is vanity; profit is sanity?
Small order opportunity?
Segment customers and serve differently?

B. Big picture data:

Annual sales
- C.O.G.S.
Gross Margin
- Operating Costs
PBIT
25,000,000 (18.05.%)
20,487,436
4,512,564
4,224,528
288,036 (1.15%)
13 outside sales territories assigned 1,144 active accounts
32,004 transactions for the year

C. Average transactional data:

Sales per transaction
Gross Margin $ per transaction
Cost per transaction
PBIT per transaction
$781
141
- 132
$ 9


D. If we ranked customers by "estimated PBIT" contribution using the following equation:
GM$ (for year) - [#trx/yr. x $132 cost/trx.] = PBIT
and we discovered:

1. Top 10% of customers ®
Top 20% ®
Top 40% ®
Bottom 60% ®
100% ®
95% PBIT
145% PBIT
155% PBIT
(55%) PBIT
100%


2. Bottom 40% of all transactions ranked by GM$/trx. totaled 5% of all gross margin dollars, but required at least 40% of all transactional activity costs. . .

So what?

II. Sales force actual data: (Page 4)

A. What correlation is there between GM% and "estimated PBIT" for a territory?

B. What's the only way to have the highest "profit factor" for a territory?
What might we infer about that rep and that territory?

C. What's the only way to have the lowest "profit factor"? Inferences?

D. Is sales compensation typically tied into the inherent profitability of an account or a territory? New schemes?

III. Segment customers and serve them differently?

A. Assumptions:
1. Average cost/call in the field?
2. Minimum # of calls per year to have a personal and professional rapport with the customer good enough to sell, install and maintain a "lowest total procurement cost" supply system?
3. Target of sales call cost to GM$/call ratio? (20 - 30%?)
4. Minimum amount of sales and gross margin $/month for an account to qualify for outside sales coverage?
5. Same process for telemarketing coverage; mail order?

B. ABC's first simulation for selling stratas.

Strata
A
B
C
D
Sales/year
24K+
12 - 24K
3 - 12K
0 - 3K
# of Accounts
256
187
501
200
How many outside sales people to cover 256 A accounts? 13?

C. What if:
1) 10% of the biggest customers ("A" accounts) produced 50% of a territory's margin and took 30% of a rep's total time?
2) "B" accounts: 40% customers - 40% GM$ - 40% time
3) "C" accounts: 50% customers - 10% GM$ - 50% time
  10-50-40 40-40-40 50-10-30    
  A Accounts B Accounts C Accounts D Accounts Total
Good Sales Rep # 1 10 40 50   100
OK Sales Rep # 2 10 40 50   100
Poor Sales Rep. # 3 10 40 50   100
  30 120 150   300
D. How could we:
1. Downsize, upgrade & re-focus outside sales coverage?
2. Create a new prospective telemarketing territory?

IV. Conclusions/Discussion Questions:

A. Are transactional costs important? Should we focus on PBIT/Customer versus assuming all volume, orders and customer activity is good?

B. How will you break the small order problem into different pieces to manage them in different ways? Here are four segments to consider:
1. Profitable account abusing small order privilege
2. Big, small order offender
3. Small customer, small orders that's wants traditional full, wholesale service
4. Small orders we create on our own internally

C. How will we downsize, upgrade, re-focus and re-invent our sales force?

D. Can you create a telemarketing territory with new prices, terms and minimum orders that will:
1. Increase volume with some accounts?
2. Drive losers to unknowing competitors?
3. Incent customers to routinize their purchases around when a truck is scheduled to role by their door?

E. Can you envision how some "D" customers will either come to pick up smaller orders or go to the wholesale club?

F. What are the psychological push-backs to this data and solutions? For - management, outside sales, inside sales?

1 2 3 4 5   6 7 8 9
Sales Rep # of Accts $ Sales Gross Margin GM % # of trxs. GM$/trx. Profit Factor PBIT PBIT/trx.
1 4 1437691.53 268761.28 18.693946 357 752.83 140.78 221637.28 620.83
2 80 1692797.60 291184.80 17.201395 1063 273.93 47.12 150868.80 141.93
3 61 1085723.29 211375.82 19.468664 663 318.82 62.17 123859.82 186.82
4 180 3387318.35 673083.27 19.870682 3032 140.52 27.96 40803.27 8.52
5 89 1552267.47 343176.52 22.108079 2346 146.28 27.65 33504.52 14.28
6 ? 1135571.02 229665.67 20.224686 1569 146.38 29.57 22557.67 14.38
7 3 2436.31 532.55 21.858877 7 76.08 16.66 -391.45 -55.92
8 48 98932.94 26554.22 26.840626 240 110.64 29.65 -5125.78 -21.36
9 41 630343.37 130948.39 20.774136 1067 122.73 25.53 -9895.61 -9.27
10 119 1209238.31 282505.31 23.362253 2502 112.91 26.42 -47758.69 -19.09
11 196 3233877.09 610556.85 18.880026 5175 117.98 22.30 -72543.15 -14.02
12 130 1403532.13 316240.10 22.531732 3032 104.30 23.47 -83983.90 -17.70
13 154 2805491.02 528093.09 18.823553 5003 105.56 19.85 -132302.91 -26.44
Totals 1105 19675220.43 3912677.87   26056     241229.87  
Column 8 = GM% x GM$/transaction
Column 9 = GM$ - [# of invoices x $132/invoice]

_______________
1 To be emailed a copy of the 4 page case study request it from karen@merrifield.com
2 For the analysis technique see article #2.3 at www.merrifield.com or in Module #3.5 in the video, "High Performance Distribution Ideas for All."
3 More on "total procurement cost" at www.merrifield.com within article #4.2 and video Modules #4.11-13.