“Distribution is simple: a distributor is like a hamburger,” the CEO of a major public distributor said to me over dinner. He continued, “Customers are the top of the bun; operations are in the middle; and suppliers are at the bottom. The key to success is doing three things well: increase sales, control operations costs and reduce supplier cost – it’s as simple as that.”
For years, this was the rule of thumb for distributor success, embedded in every company’s core key performance indicators (KPIs). It provided a guiding light for virtually every distributor. It was simple and seemingly obvious. Today, it is completely wrong.
Today, these age-old KPIs lead all too many distribution company managers to create enormous amounts of unprofitability within their companies and expose them to rapid sales and profit losses to aggressive digital companies and other highly focused competitors. Conversely, insightful managers using the right KPIs produce 10-30% year-on-year sustained profitable growth.
Today’s Effective KPIs
What has changed that has made these universally used KPIs obsolete? The answer stems from the transition we have been going through from one business era to another.
In the prior Age of Mass Markets, which occurred throughout most of the twentieth century, revenue maximization was the win strategy. Companies had relatively uniform pricing, cost to serve was relatively uniform as the products were just dropped at the customer’s receiving dock, economies of scale meant that large sales volumes led to diminishing unit costs and diminishing unit costs meant more profits.
In this situation, management’s primary goal was to maximize revenue while minimizing cost. The traditional KPIs were aligned with this objective. Importantly, the information needed to produce them was available in this era before computers and data capabilities became widespread.
Over the past 25 years, however, our business system has changed enormously. We have entered what I call the Age of Diverse Markets. In this new era, companies have instituted complex pricing varying from customer to customer, and even product to product within customers. Cost to serve varies again by customer, and even by product within a customer. Products have proliferated into all ecological niches, and flexible manufacturing and outsourcing have enabled many niche products to achieve minimum efficient scale.
Enterprise Profit Management (EPM) – which creates a full, all-in P&L on literally every transaction (every invoice line, based on precise information pulled directly from a company’s general ledger) – can be configured in a few weeks and provides the financial information that managers vitally need today. Over years of experience with EPM, we have found that virtually all companies have a characteristic pattern of profit segmentation:
- Profit peak customers are typically about 15% of the customers generate 150% of a company’s profits.
- Profit drain customers are typically about 20% of the customers erode about 50% of these profits.
- Profit desert customers typically are the remainder of the customers who produce minimal profit but consume about 50% of a company’s resources.
The same profit pattern characterizes every dimension of a company: products, suppliers, sales reps and order lines.
Because EPM shows the all-in P&L details of literally every customer and product, it is easy to see where the company is making money, where it is losing money and why. Moreover, it provides the correct KPIs essential to success in today’s complex, rapidly changing business world:
- Grow your profit peaks. This is your highest priority. It gives you a direct, rapid profit boost, and importantly, ensures that your critical high-performing business segment does not erode.
- Reverse your profit drains. Surprisingly, in most cases these large, money-losing customers are unprofitable not because they have under-market pricing, but rather because they have excessive operating costs. This is a result most often due to unmeasured, unmanaged costs like overly frequent ordering and excessive expediting, which are costly for both your customer and for you.
- Reduce your profit desert cost to serve. A few of your profit desert customers are important development accounts that warrant extra time and cost, but most are small, marginal customers with low profit potential. The key objective is to reduce your cost to serve through measures like portals, standardized menus and strict management of “extras.”
These are the correct KPIs essential for success in today’s rapidly changing business world.
Why Yesterday’s KPIs are Obsolete
Simply increasing revenues, reducing operating costs, and dropping supplier costs across the board – the old hamburger strategy – completely misses the mark.
To succeed in today’s business world, managers need to target the right customer segments with the right combinations of account selection and management, operating costs and capabilities, and supplier costs and activities. The essential point is that each of your profit segments – profit peaks, profit drains and profit deserts – needs a distinctive and different profit growth game plan.
Grow your profit peaks
These are your large, high-profit customers, in most companies the 15% of the customers that contribute 150% or more of your company’s profits. All too many sales reps view these customers as already “good customers,” because they have high revenues, and shift their focus to finding more large customers. This is a huge mistake.
Instead, the winning strategy is to clearly make growing your relationships with your critical, high-profit customers your company’s highest priority. It is your fastest, surest path to strong, low-risk profit growth and your most effective way to prevent profit erosion.
These customers typically are very service-sensitive, open to win-win innovations, and less cost-sensitive. However, they often require higher-cost service, which is a great investment; and in return, they reward you with more high-profit business. Simply reducing your service to these customers in an across-the-board cost reduction program is extremely counterproductive.
For example, several years ago, Baxter’s hospital supply business faced chronic price wars on its largely commodity products. In response, it developed one of the first vendor-managed inventory systems, doing the counting and delivering supplies directly to the patient-care area and clinic shelves in its major hospital customers. This created three huge gains: (1) hospital costs dropped by over 20%, which locked in the company’s highest-profit business; (2) Baxter’s own costs dropped by an amazing 30%, as Baxter now controlled the hospital’s inventory and order pattern (its main supply chain cost drivers), and (3) Baxter’s sales skyrocketed by 35% or more in its highest-penetrated customers. This was a monumental win-win for both Baxter and its best customers.
Three key building blocks enable you to grow your profit peak customers. First, use EPM to identify, analyze and track your profit peaks. Second, form a dedicated tiger team that is expert in developing and deploying innovative ways to deepen your relationship with your profit peak customers. Third, use your EPM system to monitor your ROI on any increased service cost required to grow these high-profit relationships to clearly justify the extra expenditures.
Reverse your profit drains
These are your large, money-losing customers. In most cases, they have market-level prices but excessively high operating costs. Three steps enable you to reverse many of these customers’ losses, converting them into profit peaks.
- First, use your EPM system to identify these customers, and analyze which costs are excessive relative to a peer group of similar customers. Typically, these costs can be clustered into a few common, easily fixable issues like overly frequent ordering, failure to offer higher net profit substitutes and excessive expediting.
- Second, develop and deploy an expert tiger team, different from your profit peak customer tiger team, focused solely on working with your profit drain customers to reduce their excessive costs.
- Third, carefully track your progress in each profit drain customer. Such as, where you are not able to reverse the excessive operating cost, reprice your contracts to at least break even, even if it means losing the customer, or better, reducing your presence in a customer to retain the relationship.
For example, one distributor developed a standing order system to stabilize the order pattern for its high-volume products in its major accounts. The company’s managers were sure to include provisions for occasionally expediting extra product if an unexpected demand surge occurred. Total channel costs dropped by over 30% for both the distributor and the customer, leading to substantial new sales and profit growth.
Reduce your profit desert cost to serve
While some small customers are development accounts which must be protected, most typically are low-potential accounts that contribute little or no profits, but often consume a surprising 50% or more of your resources.
Because this segment often comprises well over half of your customer base, it is costly and complex to serve. The key to success is to standardize and automate your sales and customer service process for these customers using proven measures like portals and menus, as well as strictly limiting the “extras” that they can request.
For example, in one major distributor, the company’s EPM system showed that its profit desert customer segment accounted for an astonishing 70% of its sales and supply chain costs. While the company’s managers could make a strong business case for investing in automation to reduce their cost to serve these customers, they determined that Amazon and other digital giants were investing so heavily in developing innovations to serve this segment that the distributor simply could not keep up. The distributor’s top managers quickly concluded that they would be much better off investing these funds in growing their profit peak customers and reversing their profit drains, segments that were defensible and offered strong long-term growth.
Manage your Profit Rivers
Today, distributors are like rivers. They have three profit rivers flowing through their business: profit peaks, profit drains and profit deserts. Each river has very different characteristics and requires a very different management game plan. As each flows through the company, it generates a specific set of revenues and incurs a particular set of operating and supplier costs.
Profit peaks generate high revenues, but often incur high operating costs. This is a terrific investment, but it requires the essential ROI information that an EPM system provides.
Profit drains typically require specific interventions to reduce their excessive operating costs. The benefit/cost ratio for successful interventions can be very high, converting these large customers to long-term profit peaks. Again, your EPM system shows you the ROI for this investment and enables you to track the customer’s long-term profit growth.
Profit deserts generally need extensive investments in relationship automation to become profitable. This is a risky, low-payoff proposition, given that these customers are the primary targets of giant, focused digital competitors.
The Bottom Line
The bottom line is that continuing to manage a distributor with yesterday’s obsolete KPIs – more sales, lower operating costs and reduced supplier costs across the board – is a losing proposition.
Instead, successful managers in today’s hyper-competitive, diverse business environment deploy a powerful new set of KPIs, grow your profit peaks, reverse your profit drains and reduce your cost to serve your profit deserts. With these as your guiding light, you can create strong, defensible profit growth for years to come.
Jonathan Byrnes is a senior lecturer at MIT and founder and chairman of Profit Isle, a SaaS Enterprise Profit Management company. Jonathan is coauthor of the recently published book, Choose Your Customer: How to Compete Against the Digital Giants and Thrive. He can be reached at firstname.lastname@example.org