Between inflation, supply chain disruption and online marketplaces like Amazon, distributors have a lot to contend with to maintain and grow profitability.
Jonathan Byrnes is a profitability expert and senior lecturer at MIT with doctoral degrees in both supply chain management and strategy. He has consulted for many leading brands in finance, healthcare and distribution on how to enhance profitability and improve customer interactions. He is the author of “Islands of Profit in a Sea of Red Ink” and “Choose Your Customer: How to Compete Against the Digital Giants and Thrive.”
We spoke with Byrnes about how distributors can take back control in this unpredictable market, slow their profit drain and bolster their bottom line with Enterprise Profit Management.
Distribution Strategy Group: You have dedicated your career to profitability. Can you share how you got to where you are today?
Jonathan Byrnes: I was involved in a series of projects in the hospital supply industry and was very active in telecommunications during the breakup of AT&T. At the time, I noticed that when I tried to dig into either a telephone company or hospital supply company and understand why they were profitable, as opposed to whether they were profitable, I couldn’t really get past the P&L statements. I found it really puzzling. As an academic, if I can’t understand something deeply, I’m not comfortable.
So, I thought and thought about it and realized the issue was that in traditional accounting, revenues and costs are piled up together. Then, you subtract one from the other, and hopefully, the numbers are black and not red. I learned that there are two types of accounting: financial reporting and management control. When you look into what goes on within these systems, particularly with vendor-managed inventory, there are various relationships companies can form with their customers. All of those different relationships had varying costs and revenues. I realized that the uniform cost and revenue paradigm from the old mass-market area era was breaking down, so I developed a way to do a P&L on every single transaction.
What we always see are three categories of profitability. All suppliers basically have about 15% to 20% of customers that provide 150% to 200% of the profits. We call those customers “peaks.” Then, about 15% to 20% of customers on the other end of the spectrum take away profits. We call those “profit drains.” Then, the other 60% or so are basically what we call “profit deserts.” They consume about half of the available resources but produce nothing in return.
Our economy has gone through three very different eras. In the 1800s, everything was local. Then, around 1900, we developed more roads and transcontinental railroads. Eventually, we saw the rise of the era of mass communication and mass markets. To succeed in the era of mass markets, you had to do one thing and do it well – the more units you sold, the lower each unit cost. So the winning strategy was to get all the revenues you could from everywhere and make sure your costs were low. That created the basic paradigm that people use in business today.
This began to break up around the year 2000 or so with the rise of the internet and Amazon. Basically, what Amazon did was an inventory play. They looked at books, which were hard to predict which ones would be popular, and they thought, “why don’t we centralize this inventory?” Local bookstores couldn’t carry much inventory, so their offerings were always a hit or miss. Amazon centralized its inventory and then used the internet for marketing.
It’s very interesting because if you think about those three profit segments in most companies, the peaks, which are high-profit customers, the drains, which are losing customers and the deserts, which do nothing but have a large demographic, Amazon goes after the deserts. They’ve made a science of going after them.
What they did was essentially break up these unitary mass markets. When Amazon and other internet players came in at the low end and ate up profits from desert revenues, companies panicked. You can’t beat Amazon at their own game, but that leaves the whole higher-end of the market as an open playing field. So companies that were smart began to move up the market.
DSG: How can distributors start to take back control of their profitability?
Byrnes: As a general rule, you have to go upmarket. That also means you need an enterprise profit management view that helps you understand where you are making money, where you are losing it, and where you are doing nothing but consuming resources.
The most important thing is “How do I make money?” Most people will dive right into where they are losing it. I’m here to tell you that’s the wrong thing to do. Instead of focusing on loss, make money by doubling your profit peaks. For instance, if I say that 15% of your customers are profit peaks and you double your business among a third of them, that’s only 5% of your customers. But, by doubling your business among that 5%, your profits will go up by 60 or 70%. It’s really that simple.
DSG: So, you’re saying that rather than starting with the profit drains and trying to reform them in some way, you start with the high-profit/high-volume customers and do more business with them?
Byrnes: Absolutely. And you do things like supply chain integration. Supply chain integration drives more sales than sales does. It’s an astonishing thing. If you know who your peak customers are, you can start integrating your supply chain with them through a variety of measures. It may be with product categories, whole management or technical development. It drives enormous sales increases. But, if you try to do that with a profit-drain customer who’s not willing to give you more sales and not willing to lower the cost, you’re going to lose your shirt.
What that means is that you need a relationship hierarchy. So, let’s say there are four different kinds of relationships we can offer: highly integrated, somewhat integrated, steady standing order, occasional and so on. You know, fill in the blanks of your own company. Then, the salesperson and the supply chain people need to mix and match customers to relationships based on their available margin, size, operating fit and willingness and ability to partner. Then you sell the connection, and the sale and supply chain costs take care of themselves.
That’s how you link these profit segments to business development. It’s one thing to have a report that says you made this much money on this and that much money on that. Having a systematic roadmap to increase your profits is something else entirely. In the companies we work with, we’re sustainably increasing profitability by 10% to 30% annually.
DSG: How do you recommend dealing with inflation?
Byrnes: Inflation pricing is a really big issue. For example, if you’re dealing with inflation, most people will want to do a general price increase, but it’s wrong to do that to your peak customers. Say you’re hit with trans-specific freight-rate increases. See whether that has hit your customer’s products and if it hasn’t, don’t increase your prices. Instead, say, “Hey, you’re a good customer. We’re going to forego raising prices here, but let’s talk about vendor-managed inventory. Let’s get closer and drive sales that way.”
If you do have products that are hit by rate increases, then you can figure out how to play it. For instance, if you’re hit with a cost increase, you can say, “Well, we can keep your costs here, but you’ve got to lower your operating costs.” That’s the trade.
This all also ties in with other major issues of our day, such as supply chain shortages. With profit peaks, you need to give them first priority on everything. Tell them that you’ll give them 100% of their historical demand if you can do it. If not, offer substitutions to your peak customers first. Tell them that if they can lower their cost to serve, you’ll give them a higher percentage of demand. Then, you can use the shortage to upgrade your relationship.
Now, the most important piece of this is that if you choose to try this strategy, your service level must be 100%. Service is measured by whether you keep your promise or not. You don’t have to make the same promise to all customers, but if you promise 100% to your peaks, you give them 100%. If you promise 70% to your drains, you give them 70% 100% of the time, and so forth.
DSG: We talk a lot about the Distributor Relative Value Model, which is the idea that as you add complexity to a transaction, your value to the customer rises. So if you think about a company that’s configuring a drive for automation, that’s a very high value-add. But conversely, if you look at Amazon, it deals with very simple logistics and has low added value. What are your thoughts on that?
Byrnes: Well, the value-add from Amazon has two dimensions that I can think of. You know, can they come in and configure my drive? No. But, they have 10,000 recommendations and an information-rich environment. So for certain easy-to-buy products, it’s a good fit.
This goes back to the idea that the higher your service value, the further you’ll want to move up the market. The corollary is that the higher your service, the higher your cost will be. But, it’s still a great investment. You can look at your ROI if you don’t know what the return on your higher investment is for a customer or service.
DSG: One blind spot you and I have talked about is what happens between the gross profit line and the operating profit, right? Distributors run on gross margin. But it turns out that gross margin can be very misleading. You can have customers that are high gross margin. You can have segments that are high gross margin. But they are low operating margin, so what happens is that gross margin ends up being fool’s gold.
This is a hard thing for distributors to hear because the variability of what happens between the gross profit line and the operating profit line is greater than the variability of what happens within the cost of goods sold. So the key – and this is a plug for what your company does – is making sure you have a way to get the visibility of what happens between that gross profit line and operating profit line, not just at a branch or even at a customer, but at the transaction or line-item level.
Byrnes: That’s right. … It’s very powerful. I’ve worked with companies that have 20% EBITDA in distribution. I mean, those companies are rare, but it is possible to achieve those kind of returns once you start to get the visibility into what’s happening.
DSG: The differences in profitability for certain segments of distributors’ businesses are often radical. We reviewed profitability data for a PVF distributor who had contractor customers, mechanical customers and industrial customers. The industrial customers were five times more profitable as the mechanical contractor customers.
Byrnes: Yes. You can take this concept of identifying profit peaks into any part of a business. I remember visiting a branch of a HVAC and plumbing supply company and talking to a rep who said they waste all their time bidding jobs they don’t get. When I asked how they knew who they’d get, they didn’t know. They just respond when the bid requests come in.
With the right information, you can profile your profit peaks. And go hunt them down. And when they come in, you give them white-glove service. When you get a drain, you put escalators in the contract. It they don’t want escalators, you don’t get the contract. All revenues are not good. All costs are not bad.
DSG: We’ve gone down this brilliant path. I asked you to describe your career. And we got into the thread that goes through your career, which is supply chain and profitability, and how you think about profitability and what distributors need to be doing today not just for profitability, but for profitability in an extraordinary time.