When order volumes are off and margins are under pressure, it’s tempting to just accept declining profitability as a result of the times we live in. While economic conditions certainly have an impact on profitability, there are always opportunities to improve. For distributors, some of the most important adjustments to make are often at the branch level.
The Profit Diamond
We use the concept of the Profit Diamond to introduce the different contributors to the profitability of any given distributor transaction.
Beyond a single transaction, these four factors can also be rolled up to evaluate performance at the customer, sales rep, branch, or even product level.
The diamond has four corners:
- Pricing: Is the sales price optimal?
- Cost of Goods Sold: Is the cost paid to vendors (accounting for rebates) optimal?
- Sales Performance: Is there a good mix of the right products at the customer or order level (versus a cherry-picked selection of low-margin items)?
- Cost to Serve: Is the order being sold and delivered to the customer efficiently?
In the graphic above, you see the blue area reflecting a scoring of a single customer’s or transaction’s profit factors – each of the four factors is scored green, yellow, or red for simplicity. The shape of the blue area can be radically different among transactions, customers, sales reps, branches, or product lines. In addition, the overall, net balance of these factors can produce diamonds that vary in color (red = Profit Drain, yellow = Profit Neutral, green = Profit Maker)
Improve Cost-to-Serve at the Branch Level
In many cases, branch-level employees can have an impact on most or all the corners of the Profit Diamond. However, the one they uniquely have the most control over is cost-to-serve, which this article addresses.
Serving customers in a cost-effective manner is critical to a distributor’s bottom line, yet many companies struggle to control it. Customers of the same type and size can have radically different costs to serve, and those that are most costly are losing money for the distributor each time they buy.
Fortunately, there are ways to address the problem. Having worked closely with hundreds of companies over the years, we at SPARXiQ have observed six key, branch-level improvements that can go a long way to reducing customer cost-to-serve.
1. Adjust the Sales Coverage Model
How a distributor (or branch) assigns sales resources to an account is a major driver of cost-to-serve. For most distributors, sales rep (outside and inside) cost is about 15 to 20 percent of sales, and outside reps can be twice as costly as inside sales reps.
There are also several sales cost factors beyond rep compensation: the number of accounts, frequency and duration of rep calls per account, the outside-to-inside call ratio, and customer service utilization levels. All are key drivers of cost to serve and ultimately net profitability.
Efficient, effective call planning and sales resource allocation is always a critical operating competency. With COVID-19 restrictions impacting face-to-face sales activities, and the resulting long-term changes in buyer-seller engagement models, now is an opportune time to reconsider territory planning, outside/inside/hybrid sales models, and more formal call planning processes.
2. Reduce Order Fragmentation
Two customers each purchase $50,000 per year, but one does so via 52 weekly orders, while the other orders 390 times per year, or an average of 1.5 times per day.
This wide variance might sound like a stretch, but we see it quite often. When we recently studied one of our clients’ data set, this variability was quite clear. When we controlled for customer type and size and ranked customers based on their order fragmentation, the average order value of top–quintile accounts (least fragmented) was 5.4 times greater than bottom–quintile accounts (most fragmented).
You can imagine how much more profitable the customers were who ordered the same amount on fewer invoices.
Unfortunately, this wide variance in order fragmentation among customers is completely missing in typical sales and gross margin customer (and product) statistics, and off the radar of most sales reps.
The solution? There are a few ways to remedy this problem:
- Raise minimum order quantities and/or encourage more efficient order aggregation
- Lower the costs of order fragmentation (automation and other operational efficiencies)
- Request vendor cost support for customers who order inefficiently
- Raise prices for small orders and/or costly-to-serve product categories
With clear visibility into the customer, product and branch metrics related to order fragmentation, branch managers can work to continuously reduce the order fragmentation profit drain.
3. Prioritize Your Best Vendors in the Product Mix
Let’s look at another scenario. Two customers each order $25,000 per year of revenue. One orders from your core, efficient-to-serve vendors (having high inventory turns and sourcing efficiency), while another cherry-picks your line card and only buys bottom-tier, convenience vendors from you. Or, even worse, the second customer asks you to source such products from resellers. Once again, the sales and gross-margin customer reports completely ignore this critical underlying cost-to-serve dimension.
There are no instant fixes to this issue, but you can make marked improvements by substituting items that are functionally equal but sourced from more efficient vendors from the top of your sourcing pyramid. If vendor-specific items are required and can only be sourced from less cost-efficient vendors, you can choose to fulfill orders via dropship directly from those vendors. As a third option, you can choose to raise the price if the customer truly requires in-stock availability of high cost-to-serve products.
Like other cost-to-serve fixes, the key is having the necessary vendor performance metrics and building processes, sourcing/pricing structures, and plans that aim to continuously improve.
4. Flex Your Fulfillment Options: Drop Ship vs. Stock vs. Purchase into Stock
Customers (or products) can have varying cost-to-serve based on how customers receive their products. The potentially most efficient method (but potentially least satisfactory from a customer point of view) is shipping products directly from the vendor to the customer, without any internal handling costs. This assumes that the vendor has EDI or other efficient order-fulfillment platforms. Stock products are efficient to pick, pack, and deliver, but there are inventory and handling costs to consider. Products purchased into stock to support a specific customer incur the maximum costs of transaction-specific vendor engagement, along with the usual handling costs of inventory, picking, packing and delivery.
Understanding, attributing, measuring and optimizing customers’ sourcing behaviors is again key to managing costs.
Potential resolutions can include:
- Substitute functionally equivalent products that are more efficient to fulfill for those that are inefficient
- Raise minimum order quantities or encourage more efficient order aggregation, specifically on orders with costly fulfillment requirements
- Lower the costs of drop-ship products (automation and other efficiencies)
- Request vendor cost support for customer-specific products purchased into stock
- Implement handling fees or raise prices for purchase-into-stock products
5. Reduce Credit Risk
Customers who pay slowly or default on credit can be a significant cost to the business. Maintaining active reports on customer payment performance and credit risk is critical to managing interest expense and write-offs.
Tiering customers into quintiles of days receivable outstanding (DRO) and/or credit risk, can provide visibility that helps branch personnel to apply one of a few approaches to the lowest quintile(s):
- Require prompt payment
- Raise the pricing standard
- Require cash on delivery (in extreme cases)
Although borrowing costs are currently at historic lows, credit risk has risen substantially and needs to be managed aggressively to protect liquidity and profitability.
6. Address Frequency and Magnitude of Product Returns
Two customers each purchase $75,000 worth of net sales. One has returns of 2 percent of sales, while the other has returns equal to 15 percent of sales. Again, as you may have guessed, common customer sales and margin reports won’t capture this critical difference.
With broken box quantities, damages, handling costs, inventory and logistics costs, returns can be very costly to serve. In fact, returns average 2.5 percent of invoice lines for a typical distributor. And, like each of the other areas we’ve covered in this article, there is a wide variance among similar customers. Bottom-quintile customers in terms of material returns generate 6.3 times more return transactions than top-quintile customers, controlling for customer type and size.
To address this issue, branches need to build remediation plans to do some combination of the following:
- Incent customers to behave more efficiently
- Request vendor support (if the root cause is apparently product-based)
- Build in returns/restocking fees
- Raise the pricing standard for such customer/product combinations
Work with Branches to Move in the Right Direction
The key in each of these Cost-to-Serve levers is to implement a continuous improvement plan, supported by visibility and accountability. Give your team clear and attainable performance improvement goals and tightly integrate branch management and the customer-facing or vendor-facing teams who implement the remediation plan. Of course, be sure to account for the sensitivities and competitive dynamics in place.
In a thin-margin business such as distribution, where average EBIT is four percent of sales, cost-to-serve factors are always critical to managing profitability. Today, with many companies’ revenues stagnant or shrinking and prices under pressure, mastering the cost-to-serve lever is a critical backstop for distributor profitability and cash flow. Mastering this process can raise profitability by 50 to 200 percent or more.
Need additional help? The SPARXiQ team has a lot of experience helping companies make the small adjustments that can yield significant results. If you’d like to explore how you can master the cost-to-serve playbook, feel free to contact us.
Explore our pricing and profitability resources to see how you can unlock the visibility needed to get the most out of your profit improvement initiative.
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