Predicting profitability of an order by measuring average margin is ineffective. Averages are susceptible to outliers and rarely represent the true value of any individual measure within the set. In this article, the authors examine flaws in conventional thinking about margin and provide practical ways to better manage small orders.
Distributors and wholesalers have been dealing with the “small order problem” for decades. Now, more than ever, mastering the policies and procedures that are a near-complete solution to this issue is a necessary and fundamental skill for every distribution organization.
Examination of distribution company transaction data provides deep insight into distribution profit production, and clear guidance on how every company can quickly and directly address this very real challenge.
Nearly a decade of this work shows that every company has a small account component to its business, and the profit dynamics are pretty much universal. It reveals significant adverse impact on profitability where this component hasn’t been managed, and significant profit contribution where it has.
Addressing this effectively can be one of the most important things a company can do because it can lead directly to immediate and sustained profit gains of 25 percent or more. There’s no delay because there’s no requirement to develop new business; it’s already there.
How’d We Get Here?
Every distribution company, at its genesis, is a very small player and for the most part, can attract and retain only very small accounts. In this phase, the company will have a naturally low operating cost as it has not yet invested in the personnel and infrastructure that will later be needed to service larger accounts and larger deals.
As the years pass and the company grows, it is able to attract and service larger accounts, which produce larger gross profit numbers that cover the service costs of larger deals. The company invests in capabilities and infrastructure to support a service model geared to a more sophisticated relationship with its larger accounts. This “improved” service model is a mismatch for small accounts, with increased infrastructure costs they don’t need, don’t want and won’t pay for. The gross profit production is just too small to support the additional cost-to-serve.
The issue occurs at the order level: larger accounts will have more orders that produce gross profit to cover the service costs; small accounts will have a larger proportion of orders that do not.
To enhance the profit viability of small orders, companies don’t have to invent a new infrastructure or skill set, they can just reconstitute an old one.
How Profit is Actually Made
In our profit analytics work, a core discovery provides guidance to reliable strategies for profit production. It also refutes much of the conventional wisdom that thwarts companies’ attempts to drive profit gains.
Paradoxically, it’s the pursuit of analytics that has led to the biggest roadblock to distribution profitability.
At one point or another, every manager has gone through an exercise of determining the average profit on an order or the average size of a profitable order to establish a “rule of thumb” guideline to assist with identifying good or poor performance. It also led to the conclusion that every order above this average would make some small contribution to the bottom line. In practice, the average is most commonly expressed as a gross margin rate.
The data shows this methodology – and the resulting decision-making – is just flat wrong.
The profitability of an order cannot be predicted by its margin. That would be like trying to predict the height of the next person to walk by a building using the U.S. national average male height of 5’ 10½”, which will result in an incorrect prediction in all but the rarest of cases. Correspondingly, the next order likely will generate a profit that will be lower than (or, potentially, much higher than) expected regardless of the gross margin rate.
Every order generates a specific number of gross profit dollars and carries with it a specific cost structure directly related to the consumption of infrastructure. Direct orders, for example, don’t involve the warehouse, and therefore are less expensive and can support lower pricing. The profitability of any particular order is driven by the spread between the gross profit dollars and
the specific cost structure associated with the order.
Mathematically, margin rates stay within a very narrow band, roughly 15 to 30 percent. The cost structure rates cover the whole range, from near-zero to more than 100 percent of the order’s revenue. The important discovery is that, because of its much broader range, the cost rate is a much bigger factor in determining order profitability than gross margin ever can be.
This leads to another epiphany in profit generation: a company’s bottom line is the net of all money-making orders, less all money-losing orders. For most distributors, between 60 percent and 80 percent of all orders lose money. This means that the money-making orders produce extraordinary profit rates, enough to cover the losses on the majority of orders and leave some small amount that is the company’s bottom line.
It’s not only a strong indictment of the industry’s rule-of-thumb gross-margin management, it also suggests a pathway to extraordinary profits. This knowledge can be used to directly exploit the opportunity in small accounts.
Addressing the Small Account Challenge
Since every order generates a specific number of gross profit dollars – the operating budget for servicing the order – and has a specific cost structure determined by the associated logistical elements, the real trick is to keep the service costs within the gross profit operating budget of each and every order.
To make sure this happens, increase gross profit amount on the order and/or reduce the service costs for the order.
The company can decide to either give up the small accounts or reestablish the kind of infrastructure that is an ideal match for accounts of this size. This is what Bruce Merrifield refers to as the “wholetail” model:
- Increasing gross profit can be achieved by establishing differentiated (higher) pricing for the small account group and for wholetail sales. Add-ons, such as delivery charges, small order charges and other service fees, also contribute to higher gross profit production, helping make small orders viable.
- Decreasing associated infrastructure costs also contributes to the viability of small orders. There are commonly five logistical elements that make up the cost structure of any order: order entry, warehousing, delivery, A/R & administration and sales compensation. In the wholetail model, the goal is to reduce or eliminate as many of these as possible.
- Attack order entry costs by selling only vendor-bundled and barcoded items at the counter. Stop selling singles of 50-cent parts that need manual processing at the register.
- Reduce warehousing costs by moving the most popular products in front of the counter and let the customers do the picking.
- Make sure delivery is a gross profit generator by charging more for it than it costs to buy or produce.
- Eliminate account receivable and administrative expenses by making all small accounts, and all small counter sales, credit card only. Fully half of A/R tracking and collection structure is driven by tiny orders from tiny accounts.
- Helping customers combine orders contributes positively to all of these areas.
- Finally, eliminate sales commissions on counter sales, small orders and small accounts. Reps need a narrower focus to service and obtain significant accounts. Paying them on accounts they never call on – accounts they don’t influence – is both a distraction to the reps and an unnecessary drain on your bottom line.
Making It Work
Moves like these usually trigger a little noise and smoke, but rarely an actual fire. Meanwhile, they get the company on a path to increased profitability and remind everyone the relationship between gross profit and logistics costs.
There can be amazing results when company leaders realize how the math works and how to use these techniques to get control and mastery over their small account/small order business. Some companies have realized permanent triple-digit profit gains.