Distributors are in a rut. Although numbers appear to be going up, profit has plateaued. The ratio of costs versus return on assets has hovered at a steady 7%-8% for the past 30 years.
In this interview, Dr. Al Bates explains the three myths surrounding profitability, key margin drains, his point of view on firing unprofitable customers and the steps distributors can take to climb out of their rut.
Bates has worked in distribution for more than 30 years. For the first portion of his career, he ran The Profit Planning Group, the largest benchmarking business in distribution, which was benchmarking nearly 2,000 companies a year through associations and buying groups. After selling the business, Bates started a think tank called The Distribution Performance Project. He and his colleagues analyze what causes some distributors to succeed and others to stagnate.
Distribution Strategy Group: Why do you say distributors are in a profit rut?
Al Bates: If I can use an overused term today – I follow the data. I’ve been tracking performance in distribution for 30 years, and every year I try to look at what is causing companies to be successful and unsuccessful. What I find is that over time, they have the same numbers. There are great, terrible and okay years, but if you take all three and put them together, you have the same profit results as 30 years ago.
I like to look at return on assets (ROA), which allows me to compare profit pre-tax in relationship to total investment. When I look at the numbers, I see that they are 7%-8%. The numbers were also 7%-8% 10, 20 and even 30 years ago. I think that’s a rut.
I also like to look at how some companies get out of this rut. We used to do surveys in every industry, and about 10% of companies were consistent every year. So, I started analyzing what causes some companies to be profitable long-term, what causes some to be successful episodically, and what causes some to be in this profit rut of 7%-8%.
DSG: Can you give a simple definition of ROA?
Bates: It is simply pre-tax profits as a percent of total assets, or total investment in the business if you will. We look at pre-tax because I can’t compare somebody in New York with somebody in Florida on an after-tax basis. So, I think it’s the cleanest measure.
On the investment side I like to look at total investment. This includes all of the current assets such as cash, inventory and accounts receivable. It also must include all of the fixed assets such as physical facilities and equipment.
A lot of people like to look at the return on net assets, but that number could go up and down and still be in its own rut.
DSG: The criticism of ROA we often hear is that you can shrink a company and increase the number. Growth is not required to improve ROA, at least in the short term. What are your thoughts on that?
Bates: I’ve got to be growing the business to be successful long-term. If not, I’m throwing the world’s biggest going-out-of-business sale. Year over year, you might build some efficiencies and shrink the company to build ROA, but it’s not going to happen over five years. ROA makes sense as a long-term measurement since it forces growth anyways.
DSG: If I’m the CEO of a company and decide to focus on ROA, how does that translate into action throughout different parts of the organization?
Bates: You have to do things that cause ROA to go up as opposed to going down. That leads me to what I think are the three drivers of ROA. I want to phrase this judiciously because I think companies should avoid what I like to call urban myths. In profitability, the three big urban myths are:
- “Sales solve all problems.”
- “We can make it up with volume.”
- “Cash is king.”
The companies that we see staying at a high ROA have avoided these urban myths and run their businesses a little bit differently.
Of all the profit drivers, gross margin is the most important. If you say, “I added 5% more margin dollars,” or “I took 5% off expenses and added 5% to sales,” margin would be the biggest driver of ROA.
Having said that, it is hard to translate that to salespeople as they are in a serious price bind. Forces are working against them in trying to improve gross margin.
In my presentations, I like to find older salespeople and ask how many calls they’ve made. Often, the numbers end up being around 20,000 sales calls. Then, I ask them how many times during those 20,000 sales calls a customer told them their prices were too low and they ought to raise them. The answer is never. On the other hand, they’re constantly told that prices are too high. Salespeople say, “if I could just cut that price a little bit, I could get more volume.”
Generally, that’s not well believed beyond the sales force, but I think margin pressures are. The pressures are subtle, but there is a desire to keep from having sales eroded by B2B distributors on the internet. Nowhere does management say cut prices, but they do suggest holding the line on volume.
DSG: What are some other margin drains you see?
Bates: I see two big margin drains. One is a reluctance to raise prices, and the second is dealing with price increases. If I’ve got a business with 20,000 SKUs, we can use the old 80/20 rule to say 20% of my SKUs give me 80% of my volume. Down at the bottom are those “D” items that we all kind of hate. They are incredibly non-price sensitive.
People think if they raise their prices on items customers only buy every 10 years, their business will die. Everybody is afraid of being overpriced in today’s environment – it’s a kiss of death. But I keep saying, “if they buy it every 10 years, they don’t know what the price is, and they don’t care.”
The second thing is price increases. The problem is when I have a 5% price increase one month and a 10% increase next month, etc. Then, customers begin to get a little nasty out there. If my competitors don’t pass those increases along, that begins to put pressure on me, particularly on A and B items. You’ve got to pass along price increases dollar per dollar. That’s the absolute minimum. But when nobody else is going along with it, you begin to have a tough market.
DSG: Customer-facing people are very concerned with price increases. They want to avoid pushback on sales or conflict with the customer, so they’ll proactively discount, even if the customer hasn’t asked for it. Do you see that a lot?
Bates: I’ve seen it a ton – particularly if salespeople have access to cost data and know the gross margin of different items. They think, “we sell A and B items for a 20% margin all day. So how can we possibly charge 40% on a D item?”
I think we could use artificial intelligence to find where we can raise prices. I put together a list a long time ago of which items someone could raise prices on. They tend to be things with a small sales volume that are not bought frequently. You could build a matrix to determine which prices to pass along without anyone complaining.
DSG: If a distributor gives their services away for free, there is no disincentive for sales reps to give them to everyone, which drives costs in the organization. So, pricing services isn’t just about increasing profits; it also helps keep down extra costs.
Bates: Right. It’s hard for a product-oriented company to build a service-oriented sector successfully since they’re two different businesses. For example, I may have a service I charge for, but when working with a large customer, I might say, “Well, he’s a large customer, so he should get a lower price on that service set.” I may think that when in fact, he may be more expensive to serve.
Once you’ve given some services away, it’s awfully hard to come back and say, “Just kidding! These new services are going to be charged.” It’s hard to do, even though they may be more expensive to provide and have a good justification for being priced. So, I think you’re better off trying to charge from the beginning.
DSG: Should you have a pricing expert on the inside? Or should you outsource to a consultant? Would it be possible for an internal expert to be tactical and an external expert to give strategic advice?
Bates: That’s not a bad solution. I think I might want to use an outside specialist at the beginning. Then, once I’ve got the framework, pass along the baton to the internal specialist to implement it. I would strongly prefer an internal person if I could. The value of an outside specialist is that they’re an expert, but I think I could do better with an internal resource who had the power to make changes and make them stick.
DSG: Are you anti-sales?
Bates: I once wrote an article entitled, “Not Sales, Profitable Sales.” What I want to do is tie together sales volume with expenses. Gross margin is the single most important driver, and expense is the second most important driver. Your expenses are actually more important than your sales. The problem is if you have a meeting and say, “We’re going to sell more,” everybody yells and jumps up and down. But, if you have a meeting and say, “We’re going to cut expenses,” they’re going to throw things at you.
I have to be pro sales, but a lot of things we do in the sales arena look at the cost of servicing this sales model.
One of the key drivers of profitability in cost of service is whether you can get more items or a bigger line on an order. So, we need to monitor and measure how many lines are on each order. What is the average line extension inside and outside? If you raise the average line, ideally by raising the price, the customer doesn’t have to pick anything extra. I place a lot of emphasis on lines per item and even more on average line extension.
DSG: Many cost-to-serve experts recommend firing unprofitable customers. What are your thoughts on that?
Bates: About 2% of your customers are problematic. They tie up your salespeople all the time, are constantly hounding on price and have lots of errors that are always your fault. According to some analysis, about a third of customers are unprofitable. If you take away the 2% of troublesome customers from 35%, you still have 33% left. This tells me that we need to begin working with customers one at a time to change their buying relationships.
DSG: How transparent should you be with unprofitable customers?
Bates: I would go about it as gingerly as possible. Only as a last resort would I fire a customer. I think I would say, “I love you like my brother, but I’m losing money on you. We would like to change the relationship.”
Going back to what I said earlier, 2% of customers know they’re unprofitable and glad about it. The other 33% don’t want to be unprofitable for you.