What do your people believe about your company's profitability?
By Frank Hurtte
Many distributors refer to the difference in sale price and costs of goods sold as Gross Profit. I believe this is a major mistake. Here's why. When our employees here the term Gross Profit, they assume the lion's share of what I call Gross Margin goes straight to the owner.
As I crisscross distributor land talking to sales teams, I often ask this question:
"If your company buys something for $80 and sells it for $100, how much money ends up in the owner's pocket?"
The answers are mind boggling. I hear answers ranging in the $15-18 range. When I share numbers from distributor association benchmarking reports, I get blind looks of dumb disbelief. There is a big difference between the supposed 20 percent return and the actual 2-3 percent return of real distributors. The looks turn to utter amazement when I further explain that the 2 or so bucks are later taxed at rates nearing 45 percent.
For some reason most distributors have never educated their people on a critically important point. Distributors work on a razor thin margin. Lack of education creates an ongoing ignorance (not stupidity). Because the distribution model is about a whole lot of people making independent and often unsupervised business decisions, this leads to some really poor choices; especially around pricing.
As counterintuitive as it may seem, a good many distributors have left pricing decisions to customer facing employees. We discover counter salespeople with less than a years' experience negotiating and setting price levels. With this in mind, you would expect a set of detailed guidelines, rules and market price training. But most organizations focus on product feature training.
Left to fend for themselves, new employees are forced to pick up price training from wherever they can get it. Often, this means oral traditions where cost plus some percentage is the safe level. At least until the customer pushes back.
Speaking of customer pushback, I have been privy to purchasing training where buyers are trained to say, "Gee that's a little more than I expected" after every price quotation. Add this little purchasing trick to our lack of pricing and business understanding and we have a huge problem. But, it's not a problem confined to new comers to our industry.
Most customer facing people stare down a couple of dozen pricing related issues every day. Setting prices and establishing margins come up far more often than most managers realize. Every time a customer buys a product they have never purchased before, the seller must make a split second decision. New products, variations of old products create the same moment. So too, do new vendors and technologies. And without solid understanding of the business model, it's easy for the employee to make the wrong decision.
How do we break out of this situation?
The first step is actually pretty easy. Creating an awareness sets a person's mind into action. Posed with the question, how much of a discount can we give customers in a two percent business starts the process. Simply talking about it can make a difference with a few of the more astute employees. Back this information up with some other rules of thumb. For instance (and using the Profit Analysis Report of one distributor association), distributors in our industry must make an average of 24.6 percent gross margin to break even or the cost of processing a special order for a none stock item costs around 67 dollars.
Make sure your people understand the value you create for customers. Knowledge-based distributors carry out services far beyond just transactional sales. They provide technical guidance, engineering assistance, product selection and often hold special purpose inventory just to cover unique customer applications. One would expect these tasks and services cannot be provided at the lowest price on the planet. This move helps your team better react to offhand pricing challenges from customers.
The final set comes in building system-wide pricing confidence. Many distributor salespeople struggle to use their companies "recommended system pricing". Experience dictates whole technology and vendor groups where the system numbers are either questionably maintained or poorly set. When nothing reliable exists, employees tend to gravitate to one size fits all pricing. When everyone gets the same price level, opportunities for margin optimization is lost.
Let's drill into this. Should the customer buying 10 light bulbs pay the same amount as the gigantic customer down the road purchasing a full truck load? Does the lighting contractor pay the same price as the maintenance man supporting a single facility? Without the proper guidance, it's not uncommon for the tiny customers to get the same "fair shake" as the largest customer in the territory. Customer segmentation by type and size must be studied and incorporated into the pricing equation.
While many toy with the idea of customer segmentation, very few think of the ramification of pricing levels by vendor. As the middleman, distributors must weigh the cost of doing business with the customer on one hand and the supplier on the other. As an example, think of a majorly important supplier. The distributor probably does business electronically. Orders are swiftly and efficiently handled between the two companies. But what about the smaller fringe supplier? Is it a hassle to identify part numbers and place orders? Do you qualify for free freight? Without some type of segmentation, money is lost dealing with the smaller vendors.
Strategic Pricing Associates' (SPA) David Bauders often refers to impressive gains made by distributors by addressing their pricing practices with tiny and small customers alone. What's more, after dozens of interviews with SPA clients, most tell me the quickly migrate the practice to every customer.
How can they do this? It's about pricing sensitivity. Simply put even your largest customer for one set of products is probably small potatoes in some other product category. They have high sensitivity for the products they buy in massive quantity and low sensitivity on the rest. From the internal workings of your business, the effort going into processing the high quantity orders is less as a percentage of order size than the items they buy in small quantity; you "earn" a larger margin.
Looking further at the whole of the SPA process, we can return to Pearson's Law: That which is measured improves. That which is measured and reported improves exponentially.
The SPA system makes use of proprietary computer algorithms which analyze for pricing sensitivity. This not only allows management to scientifically set specific pricing/margin levels by product, vendor and customer type. On top of this, SPA's reporting tools provide measurements and coaching tools which can be used to modify the distributor team's behavior.
With all of this in mind, let's return to our original question. What do your people believe about your company's profitability? We have yet to meet a thinking person who didn't want to work for a company with a future, a company with resources to weather economic storms and the strength to provide opportunity for growth. Perhaps it's time to start the educational process.