Distributors must learn what drives cost in order to avoid giving away the store.

by Richard Vurva

Many distributors cause themselves undue hardship when they design compensation systems that pay off of top-line revenues or gross margin dollars. Why? Because behaviors and incentive plans aren’t always in sync with the cost nature of their firms, according to Scott Benfield, a Chicago-based consultant.

A common method to reward distributor salespeople is to give greater pay for greater gross margin, rather than rewarding increased top-line sales. Benfield believes paying on margin dollars is only a marginally better incentive.

“Consider the marketing variables available to a distributor,” he says. “There’s the product itself, the channels of distribution, price, sales promotion and service. Few of these variables are controlled by sales. Yet many distributors have open pricing systems in which salespeople have considerable leeway to reduce price.”

In order to get the sale, salespeople often reduce price and hope to ramp up volume.

“In mature commodity markets, price reductions can build quick volume but cause havoc on profits,” Benfield says. “Total gross margin dollars go up, but so does volume. As volume increases, activity costs influenced by volume also rise and are translated into increased operating costs.”

In other words, a reduced price drives more dollars to the bottom line but not at a rate that outpaces expenses.

When volume rises, costs do too
An essential part of understanding the effect of pricing on profits is understanding the behaviors of cost. Many distributors don’t understand the nature of their cost structures and what drives cost. Wholesale distribution is a step variable or a variable cost business. Costs rise, more or less, directly with volume.

Distributors often discover that when volume increases, pre-tax dollars decrease because price-induced volume increases drive expenses to rise faster than sales. Three publicly traded distributors that belong to I.D.A. recently released earnings reports that showed sales increases between 3 percent and 40 percent, yet net income was down 11 percent to 93 percent.

“Part of the problem in a variable cost business is that large sales gains are followed by larger expense increases,” Benfield says.

It takes additional trucks, new services, overtime, bricks and mortar and above average inventory to support new customers. These expenses move at a faster rate than revenues and the result is substantially lower income.

Most distributors hope costs will level out over time and net income will return to previous levels.

“My experience, however, is that net income as a percent of sales is often harder to maintain as top-line revenue rises,” he says.

One reason is because companies reward price-cutting behavior by paying salespeople on margin dollars and not income, so they take orders at a lower margin percent. A second reason is because as the business grows, it becomes more complex and more difficult to manage costs.

Benfield believes the first problem can be alleviated by rewarding salespeople on gross margin percent and gross margin dollars. Or, better still, distributors should tie compensation to activity-based costing profits.

“The other important thing to remember is that as you add services, you probably add costs,” he says.

These costs are reflected in operating expenses and influence operating profit, not gross margin profit. Adding services without getting a higher price compromises gross margin and reduces profit.