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Big changes for industrial distributors
Why you won’t be able to sell yourself out of trouble.
by Scott Benfield and Jane E. Baynard
The latest profit figures from the Industrial Distribution Association (I.D.A.) show that its member distributors report profit of 0.4 percent of sales or a return on net worth of 2 percent.
Part of the slide is due to the dismal economy and the recession, now in its second year. However, the decline is not only symptomatic of the lousy economy, it is indicative of structural changes that have been brewing in industrial markets for some time.
Distributors serving the MRO and OEM manufacturing base1 are advised to carefully consider our diagnosis of the problem and prepare accordingly. One more year of the dismal economy at a 0.4 percent pre-tax level and the audience for our work will substantially decrease.
When did the slide begin?
The slide for industrial markets began long before the current malaise. Starting in the early part of the last decade, industrial distributors began an earnings decrease. Pre-tax earnings, as a percent of sales, drifted downward from 1.9 percent in the late 1980s to 1.6 percent by the mid 90s.
Of course, anyone familiar with this period knows that there was a slight recession in 1990 and 1991, but the economy roared back until the last half of 2000.
So, why were industrial distributors’ profits decreasing in the boom economy of the 1990s?
Get a pricing grip on your integrated supply agreements
As early as 19982, we were arguing against the cost-plus pricing model used in most integrated supply agreements.
Our view of these agreements, supported by activity-based costing, was that the mechanism of placing a margin on the cost of goods was the wrong thing to do. The risk in integrated supply or managed inventory agreements is the operating cost needed to support them.
When a major customer signs over a large portion of its MRO or OEM inventory to the local distributor, the customer becomes largely dependent on the supplier for supporting services. In the early years of integrated supply or managed inventory agreements, many sellers were literally pricing them in the sub-two-digit margin range.
To support our claim, a quick glance at the 2002 I.D.A. profit report finds that high-profit I.D.A. firms sell integrated supply contracts at the highest gross margin. Our suggestions and suspicions from 1998 still hold true and they are:
• Price these agreements on the incremental cost of service. If you don’t know or can’t forecast incremental service costs, then use standard operating expenses as a percent of sales for similar-sized customers.
• Build a pro-forma model of each agreement and discount it by the cost of capital (see your accountant). Run sensitivity analyses on the agreement to understand the different net present values and how they vary by gross margin and operating expense fluctuation.
• Let a committee price these agreements and include accountants, operations personnel and marketers. Most salespeople simply don’t have the skill sets to develop realistic models of these agreements and price them.
• Get an activity-based costing model or take a course on activity costing. It helps in understanding how to allocate operating expenses to these agreements.
Beyond this, beware of taking managed contracts for old-line mature industries. Why? Simply put, mature manufacturing industry in the U.S. is moving offshore. They often try managed agreements as a last experiment to lower operating cost structure before they pull the plug and put the plant in Asia or Eastern Europe.
We recently found a pipe, valves and fitting distributor trying to justify taking a large contract for 7 percent gross margin with full knowledge that the customer -- a steel manufacturer -- was on the ropes and quietly moving plants. If the prospective integrated supply customer is in trouble or in an industry where the plants are moving, think twice about taking the deal and have the courage to walk away.
Learn how to develop fee-based services
Fee-basing services is not as difficult as it seems. There has been a heightened interest in understanding how to fee-base services in industrial markets in the recent past.3
The knowledge for developing services that can fetch fees is available4 and, from most reports, works. The idea that the distributor can keep adding increasing value to commodity products without commoditizing or negating the service value needs rethinking.
Unbundling the service from the product and pricing it separately works with new or higher-valued services. Why? Consider the following reasons and advantages in separating services for fee income:
• Rolling services into the product price conditions the customer to expect services for free.
• Services are the value that distributors manufacture. Understanding them and marketing them aligns your company with the controllable value.
• It is nearly impossible to measure if new services create new product sales unless you unbundle them. Throwing a new service on top of a mature product doesn’t give the detail needed to fairly evaluate the service. And, the seller keeps repeating the same mistake if they give away a costly service.
• Services that are real winners, that are not fee-based, can create a stampede of demand from all customers. This, in turn, can overrun the distributor’s ability to supply a quality service, whereupon the service quality falls and the customer leaves because of a service that wasn’t priced to begin with. In short, fee-based services separates customers that really value it from those that will take it because it’s offered.
Fee-based services won’t totally turn the tide against the market changes in industrial manufacturing, but it can pull in desperately needed incremental dollars.
Reduce the overcapacity in outside sales
Our research5 has chronicled a severe overcapacity in outside sellers in industrial markets. There are approximately 30 percent to 50 percent too many sellers based on the research.
If these sellers can’t be deployed for greater productivity, then the only recourse is to thin their ranks. If thinning the outside sales ranks is unconscionable, then refer again to the I.D.A. 2002 PAR Report.
High-profit distributors had 3.7 percent of expenses in outside sales and 3 percent in inside sales/counter personnel. The net difference of 0.7 percent was one of the smaller gaps in these expense categories. Our sales research found that inside sales were as valued to customers as outside sales and high-profit distributors seem to be getting the message.
There may be hope in alternative models of sales productivity. Currently, most distributors allocate salespeople by geography. Geographic allocation, however, does not allow for a market- based focus on any plane other than common geography.
Alternate models of sales allocation are too complex to discuss in this article, but we encourage readers to follow readings on segment, functional, consultative, enterprise, transactional and hybrid/queuing.6 New models of deploying sales personnel have been shown to be three times more effective than simply adding more feet to the street.
Many distributors are hard pressed to reduce or change the sales effort. Our feeling is that time has essentially run out on a complement of just-in-case sellers. Customers aren’t willing to pay for them and many will seek the distributor with low operating expenses, a low price and reliable service.
There will be an increasing use of catalogs, e-commerce and alternative forms of solicitation. The planned solicitation of the customer contact effort will become much more sophisticated with distributors alternating catalogs, e-commerce and alternative models of deployment.
This process, called hybrid marketing, is just now being explored. How hybrid marketing will be used in distributed markets, and what the results will be, are too early to tell. But all signs point to big changes in the sales effort and time has run out on procrastination and wishful thinking.
Segment and diversify your markets
We have been talking about meaningful segmentation since our first article (July 1994). Segmentation should set the stage for pricing, service allocation, customer solicitation methods and where to invest for growth.
Many industrial distributors are serving the old line manufacturing markets and hoping that their sales will turn around with the next recovery. Our advice is to research the future of manufacturing as a percent of the gross domestic product (GDP).
The goods-producing portion of our economy is continuing to fall as a percent of GDP. The current percent of manufacturing to our GDP is somewhere around 18 percent to 20 percent. It has fallen significantly as a contributor to the overall goods and services produced.
Manufacturing, however, has shown significant productivity gains, and manufacturing output is significantly higher than it was 10 years ago. The real problem is that the service portion of the economy is growing much faster than the goods producing portion.
What manufacturing is left will increasingly be in the high-tech industries7 and, while we are not forecasters of industrial product demand, our guess is that high-tech manufacturing uses far less of the abrasives and cutting tools common to old line manufacturing.
One can rightly ask what does segmenting markets have to do with all this? Our answer is that if distributors were reading up on the growth trends of their segments, they would begin to deploy their salespeople to parts of the economy that are growing, including the service institutions in health care and education.
There will still be a powerful manufacturing base in the U.S., but don’t expect the mature industries to stay stateside when lower labor costs and foreign markets begin to industrialize. Segment your markets and move your salespeople into areas of the economy that offer better growth opportunities.
If you can’t beat ’em, sell out
If you are not willing to commit to some major changes, our advice is to consider selling. In fact, your business may be worth more to someone else than it is to you for the simple reason that another management team can leverage the returns to a greater extent than you can in the current environment.
Our series, Selling a Distributorship8 chronicles the process of divesting a wholesaler, from the decision to sell to closing the transaction. We deal with key issues such as valuation, tax effects, structuring the transaction and even viable alternatives to an outright sale.
It is a must-read for any owner or stockholder interested in learning how to extract a nest egg without cracking the shell. Our advice is to plan the sale and move forward. There is a definite overcapacity in distributors in U.S. markets. The overall number of firms in wholesale distribution has declined approximately 30 percent in the last 15 years.
We believe the market for industrial distributors and those serving industrial manufacturing won’t bounce back as they have in past business cycles. The structural changes of mature industries moving offshore, overcapacity in distribution (especially sales forces), the risks of managed inventory agreements and the literal poverty of pre-tax returns point to a tough environment for distributors in the coming decade.
New ways of management and thinking about distribution will be required. Sales deployment will become more complex, the need for market-driven growth will surface and cost management will be increasingly more important.
Those who try to sell their way out of the current malaise will find themselves pushing the square wheel of stone up a 45-degree slope. In short, it’s time for a new set of skills to right the business and the clock is ticking.
Scott Benfield and Jane E. Baynard are consultants in finance, marketing, and operations for distribution and industrial manufacturers. They can be reached, respectively, at and .
1. Our definition of industrial distribution includes any distributor serving the MRO, OEM, and capital projects for the U.S. manufacturing base.
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2. Pricing the Managed Inventory Agreement, Supply House Times, First Quarter 1998.
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3. Our seminar to the I.D.A. on the subject, November 2001.
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4. See Services That Sell, NAW Publications, nawpubs.org, 1999, Benfield and Baynard-Authors.
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5. See “Valuing the Outside Sales Effort,” Progressive Distributor, Jan./Feb. 2002.
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6. See Facing the Forces of Change, NAWPubs.org, 2003 Edition, Benfield Consulting submission.
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7. OECD, The Economy in Perspective, Sept. 1999
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8. A Progressive Distributor online exclusive series by Scott Benfield and Jane E. Baynard, www.progressivedistributor.com
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