DISTRIBUTION: A GAME OF INCHES
Distributors don’t make as much money as they should. The distribution business is too risky for owners to settle for less than a 20% pretax return on investment.
A distributor earning $2 million on a $10 million equity is making a 20% return before taxes. That’s the kind of number to shoot for.
Now that “big data” analytics are becoming widely available to distributors, CPA is no longer an extravagance.
The purpose of the “customer profit” metric is to identify the profitability of individual customers. Companies commonly look at their performance in aggregate. A common phrase within a company is something like: “We had a good year, and the business units delivered $400,000 in profits.” When customers are considered, it is often using an average such as “We made a profit of $2.50 a customer.” Although these can be useful metrics, they sometimes disguise an important fact that not all customers are equal and, worse yet, some are unprofitable. Simply put, rather than measuring the “average customer,” we can learn a lot by finding out what each customer contributes to our bottom line.
Quite often a very small percentage of the firm’s best customers will account for a large portion of firm profit. Although this is a natural consequence of variability in profitability across customers, firms benefit from knowing exactly who the best customers are and how much they contribute to firm profit.
At the other end of the distribution, firms sometimes find that their worst customers actually cost more to serve than the revenue they deliver. These unprofitable customers actually detract from overall firm profitability. The firm would be better off if they had never acquired these customers in the first place.
DISTRIBUTOR customers are created equal, they just don’t stay that way
Customer profitability analysis (CPA), as used by high-profit distributors, is a top-down process of allocating and assigning costs to customers. Activity-based costing, used by manufacturers, is a bottom-up process of allocating costs to products. CPA is consistent, reliable, inexpensive and critical for decision making about pricing.
EFFECT OF PRICING ON DISTRIBUTOR ROI
Weak pricing decreases profits by over 25%, according to a worldwide study by Simon-Kucher & Partners of pricing in all industries. Weak pricing is even more pernicious to profits in distribution due to the loss return on sales – hence, a “game of inches”.
STRATEGIC PROFIT MODEL
The strategic profit modeL proves this point. For a distributor who turns assets over four times per year, with a 1:1 debt to equity ratio, increasing return on sales from 1% to 2% increases pretax return on investment (ROI) from 8% to 16%. Increasing ROS to 3% elevates ROI to 24%.
THE POWER OF “8”
Thus, The Power Of “8”: A one percentage point increase in your gross margin increases your return on investment by at least eight percentage points. Our experience with SMARTPricing projects for hundreds of distributor operations is an improvement of overall company margin of one to two percentage points, sometimes more.
DISTRIBUTOR PRICING STRATEGY
Is your pricing strategy to optimize margins, maximize sales or getting more profit from existing accounts? Do you have a pricing strategy?
According to the Simon-Kucher research, nearly 50% of companies think they are in pricing war. Over 80% of those companies believe someone else started it.
Evergreen Consulting’s work, exclusively with distributors, proves a powerful positive correlation between management influence over pricing and profits. Whale curves from our clients’ data illustrate that optimizing profits from existing accounts is a shorter and more reliable path to profits than chasing new business.
Although distributors care very much about their sales reps and suppliers, our data shows that – except in rare cases – money-losing transactions and customers are not a viable result, even when they help a rep (or supplier) make their numbers.
How do the research findings compare to your company’s approach to pricing? Where are you in terms of distributor pricing maturity?
PRICING OPTIMIZATION FOR DISTRIBUTORS
Now that pricing analytics are becoming universally available to distributors, price optimization is no longer a profit effectiveness luxury. It is a must-have no matter what legacy ERP system you use. Market-driven pricing and healthy profits benefit all: customers, sales reps, support staff, managers, suppliers and of course owners.
The pricing optimization techniques that create sometimes mystifying differences in the cost of hotels and airline tickets are being used by distributors to redefine their profit results. In the distributor environment, the vast array of products and variations in cost to serve require the price optimization on an enterprise scale.
After undertaking pricing optimization and customer profitability projects for hundreds of distributor operations, Evergreen Consulting has a distinct perspective about why some distributors are reluctant to pull the trigger on pricing optimization. Our viewpoint is unique because Evergreen is the lone consulting firm that performs both of these analyses for distributors. We have found that there are two reasons why, in spite of the obvious need and proven results, distributors postpone pricing optimization projects:
- Distributors don’t know where to find dependable competitive pricing information about their specific products, customers and competitors in the markets they serve. They may not even believe that this data exists.
- Distributors don’t know how to change the way their pricing process, the way their organization does pricing. They may not even believe that it is possible to do so.
Your sales reps how much your products cost but they have only anecdotal information about market prices. Most of what they know about competitive pricing is sketchy data provided by customers trying to work out a better deal.