Al Bates, founder and chairman of Profit Planning Group, Boulder, CO, wants to change how distribution executives think about their business. In this interview, he addresses dysfunctional behavior, alternatives to typical mindsets and ways that distributors can manage better in a turbulent economy. Based on his experience as a corporate financial planner and decades of data analysis, he’s not afraid to buck conventional wisdom. In fact, he enjoys it.
Bates has studied financial performance across dozens of wholesale distribution sectors for more than 25 years. His firm conducts the annual benchmarking report series, PAR reports, for more than 40 wholesale distribution associations. This interview discusses key themes from his new book, Profit Myths in Wholesale Distribution: The Truth About Sales, Margins, Inventory, and Expenses, recently published by the NAW Institute for Distribution Excellence. For the book, Bates distills extensive data analysis to help distribution managers elevate financial planning to a more strategic level.
MDM: What’s your mission with this book?
Al Bates: Simply put, the mission is to encourage distributors to forget everything they know about profitability and start over. That’s a rather dramatic statement, but I think it is realistic. Most distributors make good profits when the economy is strong, they suffer badly when the economy is weak and they don’t do a lot more than muddle through in between. I am convinced the reason they muddle through is that they don’t have a complete understanding of the financial side of the business.
The reason they don’t have a complete understanding is because financial issues are the most difficult to understand for most managers. As a result, they tend to be susceptible to bad advice. As one example, if I attend an inventory seminar and the seminar leader says that the key to better performance is to lower my inventory, I tend to believe I should lower my inventory. There is not a good mechanism to test whether lowering inventory is a great idea, a terrible idea or a completely neutral idea.
The entire purpose of the book is to give managers the ability to challenge ideas with empirical evidence and analytical models. Once managers have the capability to evaluate actions from a profit perspective, decision making should get a lot better.
MDM: In the beginning of the book, you describe distributors as unique in the degree to which decision making is dispersed throughout the organization. How so?
AB: In most distribution businesses, not all, it’s a branch model. It’s not centralized. It’s 30 guys running 30 branches, making 30 sets of decisions based on local markets. The problem is the branch managers know the nature of the local market very well. They also know their people very well. That is the benefit of a branch model. The very large downside is that they can’t see how all of the branches tie together. Different branches may be going in very different directions.
We did a comparison one time of equal-size distribution companies with one doing $50 million of volume out of one distribution center, and one doing $50 million in volume out of 10 branches. You can make a heck a lot more money when you can centralize things. The economics of consolidation are dramatic. However, the reality is that branches are a way of life in distribution. We need to get everybody on the same page. With any luck they might all be on the right page.
MDM: Is a customer focus model like that diametrically opposed to profitability?
AB: No. But it requires a more sophisticated branch manager. It implies more compensation, better education, more extensive follow-through and the like. Some companies do a very good job in this regard. They view the branch manager as a partner and share the rewards.decline moves the firm to its break-even point. A 20 percent sales decline decimates the firm.
You have to have one set of answers for a large hit, and another set for a milder impact. If it’s going to be traumatic, the answer is: “I have to shed employees.”And my recommendation is do it once. Make it large enough to get rid of the people who have not been working since 1984 anyway. If you do it in dribbles, you’re dead. If you cut some, then three months later you cut some more, people are going to say, “Who is next?”It is very dysfunctional. As traumatic as it is to cut 20 percent of the workforce, at least it’s clean and you’re not bleeding by a thousand cuts.
If it’s more a manageable sort of recession, which I happen to think it will be, excluding construction, then you be a little more strategic. Here again, branching makes things a little more difficult. Branching gives you tremendous capability to have local market coverage which you have to build on. If there are three or four employees in a branch, it is almost impossible to reduce the workforce by 10 percent.
However, if the branching model is really a hands-on, high customer contact model, you can work with customers to get them to buy better for both themselves and for the distributor. I address changing the order economics in the book. You can change the way people buy if you explain the benefit -fewer daily deliveries, for example. That’s critical in a down market. It’s a tough but important sale. It is easier to do if you have constant contact and communication with customers which branching facilitates.
Another problem or mistake that people tend to make in a recession is to cut marketing. We see it more in retail than at the distributor level. We tend to look at that marketing budget as discretionary and related to sales. The more you sell, the more you market. I argue that the more you market, the more you sell. There’s a relative savings in the short term. But when the recession ends you have lost a lot of momentum. Maybe we think how those dollars are spent, but I still want to go out and tell people, “I love you, man.”I want to avoid customers thinking we don’t care about them.
MDM: Are things different today than what you have seen in past cycles?
AB: No. We have been here before. We seem to follow this pattern of getting tough on expenses during the downturn. Then things begin to take off and we can do no wrong. So we add more employees than we should and we go through the entire cycle again. That’s human nature, incidentally, so I hold no hope of changing it. Ideally, distributors need to plan based on moderating the down cycle, but in doing that will probably moderate the upside as well. That’s hard to do. The book makes a strong case for rethinking your business along those lines, where you manage the return on assets across the entire business cycle.
MDM: What’s the biggest financial myth out there?
AB: That you can make it up on volume. The reality is the lower your margin, the less you can cut. With a low gross margin, the additional volume you have to drive just goes up astronomically (see graph).
If you have a really high gross margin, like McDonalds, in the range of 75 percent gross margin, value meals bring in incremental traffic and have an impact.
So a high-margin business should be doing specials and price cuts of the week. A low gross-margin business can’t survive that. Most distribution falls somewhere near a 25-percent gross margin model. It’s almost impossible to make up the volume. The workload becomes incrementally more difficult. The graph also assumes no increase in your fixed expenses, and at some point those become unglued.
Most people start out on the volume path with a new type of customer or just for a little while. What tends to happen is that that one-time special event gets transmitted to the existing market the next day. The one-time special price becomes the regular price.
To order the book, Profit Myths in Wholesale Distribution, go to www.nawpubs.org or call the National Association of Wholesaler-Distributors at 202-872-0885.
Unfortunately, way too many view the branch manager as simply another employee. If the manager fails, we will find another one. In the branch model, the manager is running a mini-business. They need to be educated on how to run such a business and compensated on overall performance.
MDM: What should distributors focus on in the current turbulent economy?
AB: Clearly you have to manage the loss of sales volume. For most distributors, a 10- to 15-percent sales decline wipes out profits. If sales are down five or six percent, that’s one issue. It’s tacky but we can live through it. If sales are down 20 percent, you’ve got to make dramatic changes. In that scenario, too often distributors do what I think is absolutely the wrong thing in an attempt to free up cash. They try to lower accounts receivable and reduce inventory to make up for selling less. Inevitably, that leads to sales declines getting even worse. Back orders go up. Customer service goes down and what might be a 10-percent sales decline becomes a 15-percent sales decline.
Thinking about cutting inventory and accounts receivable is a very normal reaction, though. It is compounded by the fact that most distributors don’t have much cash, even in good times. So the first thing when sales are sluggish, you tend to lower the inventory. I really think you’ve got to avoid that at all costs.
At the same time, when times are tough, my customers are going to drag another five or six days, and that’s just the way life is. You have to ride out the storm on the investment side. Having said that, I’ve got to make it up somewhere and the best way is on gross margin. Most distributors, even though they will argue they are doing a good job on gross margin, have inefficiencies they need to address.
The concern is in a down market, most people say, I can’t raise my prices.”You can’t on faster selling commodity items. But there are many slower moving items where the pricing has been adjusted down for one customer, and then it gets adjusted down for everybody. Its really a time to evaluate pricing. For most businesses, there is potentially enough gross margin to make up for the sales decline -at least two-thirds or three-quarters of the sales decline. If I manage the gross margin area properly, I wouldn’t smile through a recession, but at least I wouldn’t be frowning as much.
As far as efforts to lower accounts receivable, it’s dysfunctional. For one thing, customers don’t have the money. They will probably pay when they can. And a down-market is not the best time to hound people. The last time we had a recession in 2001, W.W. Grainger openly detailed how they felt it was a great opportunity, as their cash-strapped competitors were lowering inventory and AR, to increase their investment in those areas to grab market share.
MDM: Can you provide more detail on managing gross margin?
AB: It’s a pricing game. Distributors have to stay on top of commodity price inflation, but they can use that to pass on increases. That’s a very legitimate source of margin. For example, what we see is that when you do have continual price increases, distributors reach a point where -for whatever reason -they feel they can’t pass a full five percent on, so they only pass on three percent. That’s a real danger. The fact that the supplier is raising prices is the best reason in the world to go to my customers and say, “This was not my idea! Suppliers did this to us again.”
MDM: What about the expense side of the equation?
AB: You also have to look at the expense side, obviously, in any downturn. If you recall in 2001, particularly in the industrial sector, we not only had the recession, but we had a strong movement of factories offshore. A lot of distributors took sales hits of 20-30 percent. I mentioned earlier that a 10 percent sales