CASE #2: MEASURING
FOR MARGIN POWER
If either a distribution firm or its
association's financial survey wanted to measure factors that support an above
average margin percent, what should be measured? Although there may not be a
universal solution to this question for all distribution channels, with the
right assumptions and measurements we could start down a productive, learning
DO PREMIUM MARGINS EXIST?
Service management research
concludes that firms with superior service levels achieve price premiums that
average 5-10% of their average competitors' gross margin. By example, if an average distributor was achieving a 20% margin rate, then superior
service should be able to earn a 21-22% margin rate on the same sales mix. This extra margin would increase the
average distributor's operating income by 50 to 100%!
A number of association financial
surveys offer indirect proof that service premiums are possible within the
distribution industry. A recent example
can be taken from the Air-Conditioning and Refrigeration Wholesale Assn.'s
(ARW) 1994 Profit Report.
The average firm in the survey earned a margin percent of 27.5%, but the
top 25% performers on an ROI basis averaged 29.4% for a 6.9% premium. Because the top performers were a bit
smaller in sales than the average firm, we might assume that the premium didn't
come from buying better, but from selling distinctive
service. But, what exactly is distinctive?
In one sense, it is a
competition-relative standard. Using
a scale of 1 to 5 for service quality in a survey of customers, if 1
was considered poor, 3 average for a group of possible
suppliers, and 4 better than most, then 4.5+ is distinctive. Well-run
service firms can evolve to a score of 4 in their customers' eyes, and this
will earn them last-look to meet the price.
To get to a 4.5+ score, however, all employees must proactively work
together to rethink the service processes, their jobs and commitment levels.
In an absolute sense, all
distributors face the FedEx service standard comparison. If any distributor
were to offer a zero error and 100%
on time unconditional guarantee,
coupled with equal or better fill-rates, then they would have distinctive service.
THE SUB-ELEMENTS OF DISTINCTIVE SERVICE
Because customers decide who has the
best service and how much more they might pay for it, we should survey our
target customers about service. We could give them a list of every
service factor and ask them to rank the elements on a value scale from 100
(most valuable) to zero.
Remembering that today's best
customer is typically a large, experienced, repeat buyer of the commodities
that comprise 80 to 95% of a distributor's sales, the following priority list
represents a consensus of a number of private surveys:
fill-rates on a one-stop-shop of items
2. zero errors
on order execution
delivery (assuming desired response time)
recoveries for service failures
5. price and
6. quality of
the inside sales service
7. quality of
the outside sales service
price and terms logically trails
items numbered 1 to 4, because what good are price savings if they are exceeded
by the costs of poor service. Ninety percent of distributors who are not in the
top decile for service performance might contend that price should be ranked
higher. But, we must remember that if we are undifferentiated on the top four
service factors, then price for equally excellent commodities
The role and value of the outside
and inside salespeople in achieving margin premiums is crucial and problematic. Annual big buyer surveys are
concluding that 90% of the salesreps
are a waste of time.
This is reflected in the #7 rating for salesrep
value, down from #1 in 1970 for many
reasons. If we want to sell service
for a premium, we would do best with the top decile reps whom buyers think are
worthwhile. Excellent reps can sell
both their own value-added efforts and the company's basic service brilliance
for incremental premiums. We don't
need reps that would consider themselves a success for getting last-look with a chance to meet the
price when the customer is really
buying the 4.0+ service quality generated by items numbered 1-6.
MEASURING FOR SERVICE IMPROVEMENT
Individual firms should invest in
creating an internal scoring system for all employees which balances some
traditional financial goals with service quality trendlines. Then, experiments can be run to discover ways to improve service
levels while also lowering costs and improving margins.
Association financial surveys could
start complementing their strong financial formats with some first
approximation measurements for service quality. For example: dollars
invested per stock keeping unit
would reflect fillrate levels. Do the
high performers average greater dollars per item?
For zero errors and on-time
delivery, several ratios might provide insight. Credits issued annually divided by transactions is easily available data for most
survey participants. When there are
errors, credits are usually issued. Don't
be surprised if the best average a significantly lower ratio.
Low errors and high on-time delivery
rates occur at warehouses that usually pay high wages to warehouse and driving
personnel; FedEx and UPS do this. If
we pay the most, we can hire the best; expect the most; and have the lowest
turnover rates. The longer these
service critical folks stay, the better service becomes, especially if we
measure and seek to improve it.
This service investment strategy
also yields a lower personnel
productivity ratio (PPR). Although
wages are higher per person, fewer, better folks who don't make mistakes,
turnover or need supervisory babysitting can support an even greater increase
in the margin dollar per employee ratio. The
ratio of employee costs to margin dollars is therefore lower than the industry
For heroic recoveries ask
survey participants how much any frontline person can spend if they come in
first contact with a mis-serviced customer.
The Ritz-Carlton Hotel chain, for example, authorizes their maids, etc. to
spend up to $2000 to make any customer happy.
If a distribution business is going
after full-service customer niche(s), better than average margins are possible
with distinctive service. The incremental margin flows mostly
to the bottom line, which is only part of the economic benefit. Excellent service also improves:
employee morale and retention; customer satisfaction, retention and
word-of-mouth; and the company's growth rate.
To achieve distinctive service we
need to spend less time managing financial symptoms in a top down way and more
time developing bottom-up measuring systems that are focused on the sources of
profit power. Then, all of the financial symptoms can improve dramatically as a
This switch to a more balanced
scorekeeping approach can be sparked by adding the service quality perspective
to association financial surveys. As
a first cut, if surveys found high correlations between high performance and
some of the crude service ratios previously mentioned, then average performers
might take notice. More service-quality questions, theories and experimental
requests might subsequently be made. Pursuing
these fresh insights could then lead down a more fruitful path than
reformatting the same old financial data.
ำMerrifield Consulting Group, Inc.,
Article # 3.10