DISTRIBUTOR BACK-ORDER COSTS INTO PROFITS
Inc. (MD) recently measured the “total” costs for both back-orders (B/Os) and
credits. The results were astonishing: on $20MM in annual warehouse sales
volume, the cost of all B/Os (and the related, one-line, special orders from
suppliers) was estimated to be approximately $1MM or about 5% of sales. (The
cost for credits was another $400K or 2% of sales; transforming that cost into
profits will be another “quantum profit case study”.)
Is your company (unknowingly)
burning a magnitude of 5% of sales on B/O costs? If so, is it tempting to think
about all of the tactics – in priority order– that you could pursue to transform
at least half of the cost (loss) into profits? For (15) how-to opportunity ideas,
follow MD’s (abridged) train of thought and action plays below, and then
discuss the applicability of those ideas to your business. (See Exhibit 1 for a
summary of the opportunities)
“5% OF SALES? NO WAY!”
MD has been a subscriber
of Waypoint (Analytics’) Quantum
Profit Management Service
(QPMS) since the beginning of 2009. MD initially pursued “high-leverage
account, selling plays” supported by QPS’s “5
x 5 Sales Rep Dashboard” reports. When management recently
began to focus on B/O costs, everyone initially thought the 5% figure was too
high. After some dynamic, what-if, cost-allocation re-modeling efforts with
Waypoint consultants, the general conclusions were:
1. Modifying cost-modeling
scenarios made little difference to the total cost figure which could be made
to vary from 4-6% of sales.
2. Creatively reducing
B/O costs – whatever they were truly were – by at least 50% was a big profit
businesses have a lot of hidden (“overhead”) costs that everyone (reps
especially) should be aware of in order to be part of all “cost-to-serve”
4. These hidden
costs are not “fixed”, but rather quite variable and can be flexibly reshaped in
line with new, customer-niche and supplier-line, profit improvement plays.
5. Each new,
insight from the QPMS seemed to raise a new round of questions/opportunities
for which the service could then be used again to find the next-level, deeper
and eventually root-cause answers. It was exciting to be pioneering in such a
lucrative new frontier!
BREAK A BIG PROBLEM
INTO SMALL ONES TO SOLVE SEPARATELY
Because QPMS can
calculate costs and profits at the line item level and then sum those
increments to category levels, MD looked at ranking reports for back-ordered
lines divided by total lines ordered from a number of viewpoints including by:
a. Every customer
b. Each pool of
customers within different industry-segment/size bands (A-D “strata”)
c. Individual Stock
Keeping Units (SKUs)
d. Grand totals for
all SKUs for each supplier on a report that also included columns for “total
sales” and “total net profits” for the supplier.
e. Special orders
that were also small orders (under $500) by supplier
Sales Rep Territory
g. Most popular SKUs
(ranking report) for a customer niche (pool of customers) with columns for:
a. percent of
customers that bought the item (the ranked factor);
b. total picks;
c. percent backorder
d. average investment
in each item; and the…
investment in all of the items.
(All of these
reports - and the thinking that went into their design and use - are now instant,
documented, upgrades available to all QPMS users.)
REPORTS “A-G” ABOVE?
To derive meaningful,
action plays from the reports above, MD
blended a combination of: their own customer and supplier insights with some distribution-channel-ideas
from QPMS consultants in short, as-needed, “go-to-meeting sessions” in which
all shared the same on-screen MD data/reports. Although each distribution
firm and branch within a distribution chain will discover different, unique-to-local-context
opportunities, here are some of MD’s conclusions generically described.
From report “a”: Customers with
the lowest B/O rates as a percent of total line items bought (at the bottom of
report “a”), tended to be accounts that:
Bought a narrower range of most popular, commodity items on a
very steady, repeat basis,
They, in turn, were doing a focused, high-volume, standard output
for their customers (and often had a better understanding of process efficiency
including the cost of a purchase order, so they had larger, average order sizes).
Had lower average margin percent rates, but were still quite profitable.
Why? How? Although buying in bigger volumes of more commodity
items would naturally lower the margin rate, the total cost-to-serve per order for
these accounts was much less than the total gross margin dollars in the order. These accounts averaged 2-4 times the return
on sales as the company average.
Opp. #1: What
should MD do to: protect, grow and find more accounts like these ones?
- at the top of the report - were often custom-work, job-shops that provided (semi)
unique solutions for their customers. These unique outputs often required small
quantities of odd items from MD creating more, small, B/Os. These B/Os, in
turn, often required a dedicated purchase order to special order the item from
a supplier on an expedited basis. The total-channel, people and paperwork costs
for these small, special orders were many times the margin dollars (even at a high
margin percent markup) in the item/order.
supply chain, business-model innovations might MD explore with suppliers that
have the highest incidence of small, rush special orders?
(MD did have about
2% of all of their suppliers – 10 out of 200 – that were big profit losers,
some of which had many small, big-money-losing, special orders.)
customers – a now identifiable niche – were typically small and slow-growing at
best, because custom-work does not typically scale easily. Their margin
percentage rates were high, but they were typically still net profit losers,
because their total margin dollars were not enough to offset the high
transactional costs of their small orders, back-orders and special orders.
Opp. #3, this niche of customers will have to get- from MD- a
new set of pricing, terms and unbundled services (like doing special orders for
This action may
cause some customers to choose to switch to a supplier that will unknowingly
subsidize their service needs. (Note: MD is not “firing” any customers, nor are
they “refusing to do business” with any customers. MD just wants each customer
to be profitable on a standalone basis and not be subsidized by all other
If some customers
do leave, then for every dollar of margin lost, MD will free up more than $2 of
cost-to-serve slack. MD will then have to decide what to do with the measurable
slack (thanks to a QPS activity-tracking report). Should they:
1. Redirect the slack to providing better service to
super-profitable (target) accounts?
2. Lay off more slack costs than lost margin dollars to boost
3. Some combination of both?
From report “b”(customer niche) and “g” most popular SKUs per niche:
MD had already
done extensive, customer-profitability-ranking report analysis which included
looking at the aggregated profits from all of the customers within different “niche
pools” that were defined by two dimensions: “customer/industry segment” and 4
levels of volume (“A-D” with A accounts being big enough – more than $400 in
margin per month – to support outside sales force coverage.) Out of 12 different customer-niche
pools, two A-strata niches generated 130% of the internal profits to offset the
30% combined losses from the other ten. (MD’s traditional, full-service,
wholesale model was generally too expensive for the small, average, order-size flow
from the B-D strata customers. This was a business model innovation opportunity.)
The B/O percentage
for the #1 niche was, however, below the overall average. Why? Theory: the cumulative
demand from this large, homogeneous pool of customers’ had helped to
unknowingly shape and tune the fill-rates for the most popular, common items to
a high, consistent level.
How to test this theory? Report “g” summed up all
item activity (re-ranked by the column which reported the percent of customers
in the pool that bought each item). By going down the column for percentage of
line-picks back ordered, MD could find the higher-back-ordered, lower-fill-rate
items. Most of these items came from a few supplier lines for which MD buyers made
infrequent (6 times or less) line-buys on an annual basis.
Opp.#4: By looking at the cumulative investment in the most
popular items, the company hypothesized that by selectively beefing up the most
frequently back-ordered items, there would be a significant positive trade-off
amongst these factors:
Mild negative: the investment in tweaking some of the top 5%
of all active items was instantly knowable. The additional carrying cost of the
incremental investment was low, because the item investments were so precisely
targeted, and they were proven winning, turning items.
Big positive: the back-order costs would drop (to be tracked
Biggest (hidden) positive: high flow-through of the incremental-margin
dollars in better filled orders to the bottom line. When more volume is added to
an already profitable order (and most #1 niche customers already averaged,
profitable-sized orders), then 50% of the incremental margin dollars in that
line will flow-through to the bottom line. Why? Because all of the costs
assigned to the transaction have already been incurred and covered by the current-order,
margin dollars, the only extra costs for bigger or more line items were for: carrying
costs, perhaps a line/pick and variable, sales compensation. The most profitable marketing programs possible for distributors are:
selling more of already-stocked-items to the same, existing/active customers on
a larger-order-sized basis.
Good positive: customer satisfaction/loyalty with better
service should support better retention rates and more last-look + pricing
premiums. (No immediate way of tracking these in contrast to what is happening
As a by-product of
this analysis, MDS was able to define – to a sufficient degree of accuracy – “the critical mass of inventory and sales
volume for a customer niche pool.
inventory is: the SKU breadth and depth of aggregate inventory investment”
needed to serve each target pool with the highest effective fill-rate in the
local, competitive marketplace.
sales is the annual level of sales needed to get the inventory turning at a
high enough rate to make a good, turn-earn ROI.
Critical-mass inventory investment and sales volume for a “niche
pool” are both an invisible service edge for
a distributor and barriers to entry for competitors.
Opp.#5: MD subsequently created new goals for capturing between
50 to 80% of the net profits from each niche pool that they pursued.
Opp.#6: They are also seriously considering exiting some niche
pools in which they are too far below the critical mass numbers that entrenched
competitor(s) already have.
supplier-centric reports, “c-e”:
Looking at all
three of these reports together, there were some supplier lines that were
serious losers for several different reasons:
Too many redundant lines in a product category spread the
total customer demand over too many duplicate, substitutable items. Spreading
out demand had demoted many items - in the smaller volume lines - to “C”
(slow-turn) status. The automated forecasting formulas had, in turn, programmed
in lower target fill-rates which would create more back-orders.
Opp.#7: In one case, MD identified three duplicate lines that
could be consolidated into the one best line for the long haul, the benefits
The remaining line/items would receive higher fill-rate
could make more frequent line buys from the one, best supplier which would
allow them to further fine-tune the line to minimize both excess stock and stock-out/back-orders.
Reps would more enthusiastically sell what was stocked,
because it would have such high fill-rates and lower back-order frustration
And, QPS could quickly create reports for each sales
territory of the customers that had been buying items from redundant line #2
and #3 that were targets for switching over buying to the #1 line.
Opp.#9: The switch-over
reports dramatically reduced the
anxieties that everyone (may have) had about how much business would be lost by
asking customers to switch lines.
Get serious about getting enough new sales for a redundant
line to turn it well and re-order it often or don’t add it and sell what you
And, weed out existing, lagging lines – on a regular basis – to
consolidate better buying economics, frequency of purchase and fill-rate levels
on the best line(s). Don’t accumulate redundant lines.
Hard, measurable data is necessary to do new plays;
otherwise, enough people will imagine that (unmeasured) negative side effects
will be much greater than they really are to stall change.
Concept: fill-rates increase and back-orders drop exponentially with the more
frequently we can re-order a line. Wal-Mart achieves, for example, 99%
fill-rates for its top 6% SKUs which generate almost 70% of its sales, because
those items are replenished daily on an automated basis from the distribution
Opp.#10: Most distributors could achieve breakthrough
turn-earn, highest, total fill-rate economics if they could figure out how to
partner with some type of master-distribution entity (or factory coop like
CoLinx.com) for not just their slow items, but also their biggest volume ones!
category of super-losing supplier lines involved mature, equipment lines for
which MD had a big installed base and customers were now buying primarily replacement
parts and pieces. The history for these lines was: “in the beginning”…there
were three segments to the equipment line that had built in cross-subsidies:
Initial equipment sales (often on a drop-ship basis) which are
typically quite profitable, especially if: the distributor has an exclusive
territory; and the product is in the growth stage of its life cycle with a good
Common maintenance parts which turn well and make good
“C and D” parts and pieces which are ordered infrequently and
often on a breakdown, need-it-now, rush basis. These items barely turn or are
not stocked and must be special-ordered at a transactional-cost loss basis for
everyone in the channel (including down time costs for both the end-user and
How then might this three-part story become unprofitable as
the life-cycle goes into its commodity stage?
The equipment becomes a profitless commodity that too many
competitors give away in order to win the volume maintenance parts business.
The “A”-volume parts get cloned in Asia;
And, a big installed base of equipment for users are ordering
an increasing number of slow-moving parts and pieces.
Conclusion: the “parts and pieces” small, rush,
special-order, back-order problem is always a loser, cross-subsidized by equipment
and maintenance sales. When the profitable segments of the line erode in the
commodity stage of the life cycle, then a
new, supply chain solution is required.
Opp.#11: There are channel precedents for manufacturers -
that share common distributors - to stock 100% of the inventory in a central
co-op location and sell end-users direct while re-intermediating their channel
partners. There are software-as-a-service and robot-picking technology solutions
that can be applied to this type of opportunity which will collapse total
channel costs while getting parts-and-pieces to end-users faster and more
reliably which will increase the value (differentiation) of the now-commodity equipment
From Report “f” on
percentages simply reflect the mix of customers that a rep might have. The rep
is typically not the original cause of or the immediate, main answer to a high B/O
percentage problem within a territory. Often a company has historically hired a
rep to be a product and/or customer category specialist, but the end-result for
the new niche fell economically short. How?:
Service Model Mis-Match: the (full-service) business model offered
by the distributor has costs per transaction that exceeded the average margin
dollars per transaction from the target customer.
The target customer niche pool required a broader and/or
deeper critical-mass of one-stop-shop items and services for which the
distributor fell short on in contrast to the entrenched, more focused-on-that-niche
competitor(s) that already had achieved critical mass economics and barriers to
If the problem is
one of falling short of critical mass, then how weak are we in light of the
Opp. #12: In customer niches where we are short of critical
mass economics, should we redouble our efforts to dislodge the dominant
distributor, or exit to free resources to bet on other niches were we can
become a dominant #1 or a strong #2 to a sleepy #1?
TACTICS TO IMPROVE FILL-RATES, REDUCE BACK ORDERS
MD dusted off their DVDs from “High Performance Distribution Ideas for All” and
reviewed the operational tactics that will reduce back orders considerably
without any more investment and without any supply-chain innovations.
These specific measures are:
Opp.#13: Receive all in-bound warehouse
goods before the start of the next day. Overtime costs to receive big slugs of A-item goods
today is more than offset by reduced back-order costs tomorrow which would occur
if the goods had not been properly put away and registered into the available
inventory levels seen at the order entry desk. If goods that have arrived are
shipped anyway – before being properly put away and entered into the computer – then cycle count problems/costs will
Opp.#14: Achieve housekeeping systems that
allow for 95% cycle count accuracy on some number of A+ items that are counted
will minimize back-orders that result from the computer saying the inventory is
available, but the warehouse not being able to find that inventory, because it
is in the wrong place. It also will reduce mis-picked items which create
credits to correct shipping the wrong item that was in the wrong picking
Opp.# 15: Teach inside sales people both
the art and science of not back-ordering a small order, if and when possible, by:
partially filled lines as “complete”, if it is for customer replenishment stock;
substitution items IF the demand for the substituted item is then assigned to
the original item the customer wanted. Otherwise, the computer will buy
increasing amounts of the substituted item and decreasing amounts of the
initially desired item.
orders are more expensive - for every member of a channel - than most realize.
because back orders have always been part of the channel scene, doesn’t mean
that we can’t use quantum profit mechanics and management (QPM) to dramatically
reduce back-orders, improve service quality and satisfaction and improve
play by the old rules and take the “good with the bad” if you can shrink the
bad and maximize the good to significant degrees?
technology and economics have changed so much in the past two years that
dramatic new profit improvement plays and tools are now available for both
distributors and manufacturing distribution divisions for a low, monthly
subscription fee. Request either a Waypoint demo or watch a taped, webinar at
5. Stay tuned for more case studies on
MD’s progress as well as other solutions from other Waypoint QPS clients.
SUMMARY OF BACK-ORDER OPPORTUNITY PLAYS
(For each play rate: how important the play could be for
your business: A,B,C; how easy it would be for teammates to understand and
execute: A, B, C; and how good your analytic information capability is to
support the opportunity: A,B,C.)
1. What should MD do
to: protect, grow and find more accounts like the high-volume,
few-commodity-item, large-average-order-sized customers?
2. What supply chain,
business-model innovations might MD explore with suppliers that have the
highest incidence of small, rush special orders?
3. To become
profitable, this niche of customers (small, custom-job shops) will have to get-
from MD a new set of pricing, terms and unbundled services (like doing special
orders for a fee), which may cause some customers to choose to switch to a
supplier that will unknowingly subsidize their service needs.
4. By looking at the
cumulative investment in the most popular items, the company hypothesized that
by selectively beefing up the most frequently back-ordered items, there would
be a significant positive trade-off amongst these factors:
5. MD subsequently
created new goals for capturing between
50 to 80% of the net profits from
each niche pool that they pursued.
6. They are also
seriously considering exiting some niche pools in which they are too far below
the critical mass numbers that entrenched competitor(s) already have.
7. In one case, MD
identified three duplicate lines that could be consolidated into the one best
line for the long haul.
8. Buyers could make
more frequent line buys from the one, best supplier which would allow them to
further fine-tune the line to minimize both excess stock and stock-out/back-orders.
The switch-over reports dramatically reduced
the anxieties that everyone (may have) had about how much business would be
lost by asking customers to switch lines.
10. Most distributors
could achieve breakthrough turn-earn, highest, total fill-rate economics if
they could figure out how to partner with some type of master-distribution
entity (or factory co-op like CoLinx.com) for not just their slow items, but
also their biggest volume ones!
11. There are channel
precedents for manufacturers - that share common distributors - to stock 100%
of the inventory in a central co-op location and sell end-users direct while
re-intermediating their channel partners. There are software-as-a-service and
robot-picking technology solutions that can be applied to this type of
opportunity which will collapse total channel costs while getting
parts-and-pieces to end-users faster and more reliably which will increase the
value (differentiation) of the now-commodity equipment brand.
12. Should we redouble
our efforts to dislodge the dominant distributor, or exit to free resources to
bet on other niches were we can become a dominant #1 or a strong #2 to a sleepy
13. Receive all in-bound warehouse
goods before the start of the next day. Overtime costs to receive big slugs of
A-item goods today is more than offset by reduced back-order costs tomorrow
which would occur if the goods had not been properly put away and registered
into the available inventory levels seen at the order entry desk.
14. Achieve housekeeping systems that
allow for 95% cycle count accuracy on some number of A+ items that are counted
15. Teach inside sales people both the
art and science of not back-ordering a small order, if and when possible.
© Merrifield Consulting Group, Inc., Article