Which would you say is the most critical factor in predicting if your customers are profitable for you to deal with?
- Sales volume! Big customers are where we make real money.
- Margin percentage. The higher the margin the more profit we generate.
- Order size. We make the most on the largest orders.
My seventh book about distributor profitability was published in November. I feel that In Search of the Perfect Customer: Customer To Serve for Distributors may be my best one to date (apparently readers agree as it is selling very well). The new book takes up where More to the Bottom Line: Customer Profitability Analysis for Distributors, written a few years ago, left off. Measuring customer profitability and ranking customers by profit is the launching pad for management action. Distributors need to use the “CPA” information to segment their customers based on profit and growth potential before deploying their people and other resources. Focusing the organization on profits, not just sales and gross margin dollars, helps push profit results into the top quartile of ROI performance.
Cost to serve dissects the elements of why it costs more (or less) to meet the widely varied needs and demands of various customers. By customers I mean individual large accounts not necessarily groups of customers (customer segments).
Customer profitability is a delicate balance of order size, margin percentage and cost to serve. If one of the three is out of whack the other two must compensate for it. If one is too far off, the others won’t be able to offset enough. If two are off balance the third cannot fix the problem.
I will focus in this letter on the three legs of the customer profitability stool: order size, gross margin percentage and cost to serve.
Order size
Our research, testing and actual use of customer profitability analysis (CPA) by distributors we work with has demonstrated the critical importance of order size to distributor profitability:
- Warehouse order size is the most profound predictor of customer profitability for distributors.
- Most distributors no longer use quantity price breaks to encourage larger order size. Pricing is more commonly based on the customer-distributor relationship; the customer expects the best price on each order regardless of quantity purchased.
- Incentive sales compensation, usually commissions, is often not subject to a minimum gross margin dollar threshold. In other words, many distributors fail to encourage selling behavior that would build order size.
- Most distributors overestimate their median order size by measuring only average order size. The average is seriously distorted by very large orders. The vast majority of orders are fairly close to the median, not the average.
- Distributor sales reps are sometimes not very effective at cross-selling and account penetration to build order size. The average number of line items per order is only around 2.5 in many trade lines.
Many distributors fare little better than break even on their median size order. Distributors need to examine their order size trend, especially for warehouse orders, and put order-building tactics to work.
Margin percentage
The struggle for higher margins is a seemingly endless quest. Debates about prices are a source of tension between distributor sales reps and their customers, sales reps and their managers, etc. Despite the sturm und drang, margin percentages have drifted downward in recent years for a large proportion of distributors in many trade lines.
- Incentive sales compensation plans for distributor sales reps are designed to encourage the reps to persuade their customers to place orders with higher margins. In most cases however the sellers can maximize their incomes by spending their time going after more volume instead of squeezing out more margin and risking alienating their accounts.
- Sales reps have very limited true market pricing information available. What little pricing data they do have is not broken out by customer segment and size, product line, and customer price sensitivity.
- Routine pricing decisions, especially for smaller customers, is not the highest and best use of precious selling time.
- Sales rep negotiations with larger accounts are most successful when based on customer value received, not the cost of the product.
- Most distributors do not designate a strong manager as company pricing coordinator.
Many wholesale distributors have already discovered that pricing consistency and other margin improvements can be achieved rapidly, and sustained, using strategic pricing.
Cost to serve
The third leg of the customer profitability stool is the wide variation in expenses incurred by distributors in meeting the demands and needs of individual customers, especially large accounts.
- The seven major expense categories for warehouse transactions are selling, sales support, office, administration, handling, delivery and storage.
- The greatest variation is usually in the sales cost category, which happens to be the largest one. More distributors are providing different types of sales coverage for various customer groups.
- The sales support category has become more important as a cost differentiator in recent years due to the proliferation of technical support specialists.
- Order entry method is gaining more significance as a cost variant as more customers place orders without involving distributor sales or customer service staff.
- Many distributor ERP systems can track the exact outbound freight cost incurred by each transaction. Freight cost continues to be a major differentiator.
- Customer use of credit cards is a rapidly growing and pernicious cost issue for distributors.
Distributors are learning to extract cost to serve information from their transaction data, and to use the insights to fine tune strategic pricing. Market-driven pricing must be balanced with cost to serve and order size to create both customer value and shareholder value.
Balancing order size, margins and cost to serve is a leadership challenge and opportunity for building customer profitability and ROI for your wholesale distribution business!
