The quest for productivity

Are durable goods distributors helping or hurting?

by Scott Benfield and Jane E. Baynard

In his recent book, Managing in the Next Society¹, Peter Drucker gives a controversial but cogent argument on forces that will come to play in the next generation. Among his more disconcerting comments for distributors is the following quotation from a 2000 interview.

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“The center of power has been shifting to distribution now for 50 years. That’s accelerated by several orders of magnitude...But so far the distributor has squandered that power.”

The context of the interview was regarding the change within and subsequent decline of manufacturing as a percent of the gross domestic product (GDP). As manufacturing has declined in relative importance to GDP, distribution has risen as one of the dominant sectors. But according to Drucker, the shift in power has been largely wasted.

Our connection to distribution initially gave us umbrage at Drucker’s viewpoint. Further research in the productivity of distribution on our part, however, leaves us seriously considering that there is more than a little truth in Drucker’s assertion.

Productivity defined and its importance
An essentially non-scientific, but generally accurate, definition of productivity is: Doing more with less. For industrial markets, the concept of a demonstrable advantage is the ability of the supplier to provide a better price or cost savings on the product or service. 

In recent years, several industrial/MRO associations have adopted a “value-added” slogan to accompany justification of their cost of service. Much of this value added has been translated into education on advanced sales techniques for more expensive products that offer cost savings in spite of a higher purchase price.

Increasing productivity is one of the foundation stones for economic prosperity. From Adam Smith’s Wealth of Nations to most economic and managerial primers, increasing productivity is a fundamental concept of industrial markets and national prosperity.

For our research, we reviewed two productivity measures on distribution over the past decade. We first looked at sales per employee and then at a more recent measure called total factor productivity (TFP). Our findings for distributors vs. other sectors of the economy did not bode well for durable goods distributors and gives credibility to Drucker’s position.

Sales per employee
Sales per employee is a straightforward and telltale statistic for most distributors. As employees comprise 60 percent or more of distributor operating expenses, the increase of real sales growth per employee is a no-nonsense measure of doing more with less. Our findings, using research from the Department of Commerce and the Bureau of Labor Statistics, yield the following:

2. Electrical/electronics, plumbing and heating, and industrial (machine tool and supplies) distributors show varying real sales growth per year over the decade: electrical distributors grew 4 percent, plumbing and heating .38 percent, and industrial 1.92 percent.²

3. Electrical/electronic supplies showed significant growth from 1992 to 1997 of 7 percent (we think dot-com related) but had only nominal growth of .2 percent per year from 1998 to 2002.

4. Sales per employee for three of the more prominent vertical markets of plumbing, HVAC (heating, ventilating and air conditioning), and PVF (pipe, valve and fittings) shows sales per employee of $173,000 in 1984 and $181,000 in 2002, for an increase of .26 percent per year.

We are reasonably sure that the limited improvement in sales per employee would apply to other distributor vertical industries as well. Why? Quite simply, the distributor has not fundamentally changed the branch/sales intensive/geographic territory structure in the last 20 years.

Branches still have branch managers, a plethora of inside sellers and outside sellers with geography as the defining unit of labor. Computerization has, of course, made some operations more efficient, and purchasing and receivables/payables have moved to the home office. However, the fundamental structure and operations of the wholesaler distributor remain unchanged and the sales per employee point this out.

But, sales per employee is only a single statistic, and there are other productivity measures including asset utilization metrics. So, we move on to the other measure of productivity.

Total factor productivity
Total factor productivity (TFP) is a fairly recent measure for tracking the productivity and economic health of a firm or industry. The measure began to appear in the management literature in the late 1980s and early 1990s. The version of the formula presented here is, based on our opinion, the most straightforward and simplest to use.

Total factor productivity = Percent change in sales per employee – (.4 x percent change in assets per employee).³

TFP is important because it integrates three measures: change in sales per employee, a capital investment factor of 40 percent for technology investment and change in assets per employee. In short, TFP is a more balanced measure of productivity improvement than simple sales per employee.

We plugged the data for durable goods wholesalers into the TFP formula and came up with the following results.

Nominal sales per employee for durable goods distributors was $245,000 in 1992 and $325,000 in 2002 (projected). The change was approximately 25 percent including inflation.

Average monthly inventory per employee⁴ was $33,627 in 1992 and $44,050 (est.) in 2002. The change was approximately 23.6 percent including inflation.

Plugging the data into the TFP formula gives the following: A 25 percent change in sales per employee: (.4 X 23.6 percent change in assets per employee) or a TFP of 1.55 percent per year
(15.5 percent/10 years.)

Comparing this to other industries finds that the total factor productivity of the U.S. economy has been hovering around 3 percent for most of the 1990s.⁵  Again, pursuant to the TFP measure, durable goods distributors appear to lag other industries, and this matches our conclusion from the sales per employee measure.

Our research, while certainly not exhaustive, does point to a productivity issue in the durable goods sector for merchant wholesalers. Why this exists is a matter of much discussion and concern. We will spend the rest of this piece trying to explain some of the more telltale issues behind the lagging productivity.

Probable cause and experience
Earlier in this article, we mentioned that wholesaler distributors were operating from a model that has remained unchanged for much of its history. The basic geographic branch, serving numerous segments with sellers setting strategy, is common to most durable goods distributors. Over time, certain functions such as payables, collections and purchasing have been consolidated at the home office, but the basic branch has remained the same.  

A big part of the productivity challenge is that outside sellers set strategy based on the accounts on which they call. Since most territories are geographic in nature, sellers will sell most any customer who buys within their territory. Over time, this can create an undifferentiated marketing strategy where the local branch is forced to offer many specialized services to differing customer groups. The result is that the branch has trouble matching services to a defined market segment and has to perform numerous services equally well. This drives up complexity and expenses and creates an environment where excess capacity is needed. The result is a model of business that is difficult to scale and leverage since the beginning sales strategy was more or less unfocused.

Another problem with sales-driven strategy is that sellers are paid on margin dollars. Again, this drives sellers to sign up most any account for a margin dollar gain over the prior period. Sellers are literally being driven by management to sign up business that may not fit within the firm’s service expertise. And, since sellers are not charged with the operating expenses of their customer base, they often sign up accounts that cost more to serve than they deliver in margin dollars.  

The sales-driven strategy, while appropriate in the early years of an industry, needs to change as the industry matures. The sales function moves from being product-driven to providing other services and, in some instances, the market won’t support the cost of an outside seller. Sellers with geographic territories paid on margin dollars are largely, by design, not prepared or paid to consider the cost to serve.

Without a careful targeting of served customers and matching of services to the defined segment, distributors have difficulty maximizing capacity. In short, they are trying to be all things to all people. Or, as one of our clients puts it, “We are trying to be too many things to people who we’re not sure we want to sell.” 

It is difficult to leverage service capacity (operating expenses) when many services are offered. The result is a rather large level of service over capacity because of the lack of differentiation and poor controls on service promises.

The cost of service will also come into play in the quest for productivity. Currently, there are far too many wholesaler distributors that don’t have adequate measurements for service costs. Most are content to use accounting ratios for management, but accounting is a 500-year-old discipline that found its best application in the manufacturing economy. Costing services requires activity costing or process documentation and time estimates. Until wholesaler distributors have an adequate understanding of costs to serve for customer groups, they will be handicapped in efforts to do more with less.

Our own experience with distributors on service-value definition and the resulting productivity issues leads us to believe that many are content to wait and see. Recent research on Home Depot⁷, for electrical products, found that the company has a lower cost of procurement and greater sales than some of the industry’s largest distributors. The price paid for many electrical products was less not only because of volume but also because of Home Depot’s supply chain cost savings.

We mentioned the research to several electrical distributors and were basically told that customers value services of the local distributor more than a lower price at Home Depot. The problem with this stance, as we see it, is that not all customers value service in the same way and some are willing to spend more time in the ordering process for a lower price.

Wholesaler distributors should take lessons from Southwest Air and the airline industry. Southwest offers considerably lower-priced tickets than the incumbent airlines including United, American and Delta. The argument from the incumbents, in the early days, was that passengers valued their services and would not defect. Their logic was that Southwest flew from older, out-of-the-way airports, offered peanuts instead of hot meals, didn’t assign seats and adopted a first-come, first-served attitude for boarding. Ergo, according to the incumbents, the low cost of Southwest fares wouldn’t make that much of a difference, since customers valued the full-service package.

The position of the incumbent airlines is well known today. The nation’s second largest airline, Chicago-based United, recently filed bankruptcy and disclosed it was losing as much as
$22 million a day. American Airlines has touted a cost-savings goal in the billions to stanch its losses.

The key lesson is not to take your past service/price platform for granted. Unbundle the services and offer the customer choices on different price and service combinations. And, if possible, experiment with new models of business that leverage the cost structure and appeal to the cost-sensitive buyer. Simple dismissal of low-cost providers or stripped-down service providers may prove to be regrettable.

The reader should understand that this thinking and work is in its infancy. The identification of wholesalers that have perfected these processes is quite short. And, many who have worked through these issues for increased profits are silent, as they find little redeeming value in tipping off the competition. 

We have found that the more profitable and productive wholesaler distributors exhibit the following traits.
• They do not have always have traditional geographic sales forces. They utilize a variety of solicitation methods to lower the cost of sales.⁶
• They understand costs to serve and are brutish on costs.
• They generally target a handful of segments with well-defined services.
• They stock inventory that is specific to their target audience.
• They are savvy on pricing strategy, have segmented pricing and charge for out-of-the ordinary services.
• They realize some customers are negative profit producers and either delete them from the portfolio or minimize the loss; and
• They tend to pay out bonuses on earnings more than margin dollars.

Finally, many distributors are inundated with traditional education for outside sales, hyper-educating branch managers and marketing slogans on value added.  While this knowledge may help in the short run, it is not, in our opinion, critical to the larger problems at hand.

Many of the industry’s educational bodies trumpet value added but few, if any, can measure its cost, unbundle and reconstruct it, move beyond manufactured product value to service value and align it with a sustainable market strategy. Hence, they do not lead with the new knowledge and feed their memberships popular but dated fare.

In closing, our warning is that service value, found in the distributors’ operating expenses, needs work, and costs will come out of this area. Service value is determined by the customer, and not everyone wants full service at a full price. Change is the responsibility of distributor executives. Those who lead an open quest for new knowledge do a service to themselves and their industry peers.

With lagging productivity and sagging profits, however, we are assured that the prevailing logic, knowledge and product-driven sloganeering of value added won’t last forever. Durable goods wholesaling went from approximately 13.5 percent of the GDP in 1992 to 11.5 percent (est.) in 2002. The gap was likely filled by outside players that are more productive and targeted in their efforts. Wholesaler distributors and their educators who ignore the signs and don’t begin to move away from the undifferentiated sales and service philosophy and yesterday’s knowledge will suffer.

1 Managing in the Next Society, Peter Drucker, 2002 St. Martin’s Press.

2 In determining sales per employee for vertical markets, we were dealing with two data sets.  Industry sales are compiled by NAICS code and labor statistics are compiled by SIC code.  We matched the codes as best we could per U.S. government cross references and determined sales per employee for each vertical market.  We then went to the latest PAR reports for each vertical and reviewed their sales per employee.  In all instances, the government figures and PAR calculations matched, with little difference, on the sales per employee measure.

3 Total Factor Productivity formula based on work of S. Maital , Technion Institute of Management.

4 We used inventory value per employee as a proxy for assets per employee.  While the measure is not as accurate as assets per employee, the majority of assets held in distribution (75 percent of current) is in the inventory on hand.  As most distribution is private, a historically accurate number of assets per employee is not available, as the financial statements are closely held.

5 TFP has been calculated by any number of research firms and uses several methodologies.  Most calculations have the U.S. economy’s TFP at 3 percent or more per year for the last decade.

6 See Facing the Forces of Change: Outlook 2003, New Models of Sales Allocation, NAW/DREF, www.nawpubs.org.

7 See feature story on Home Depot vs. electrical wholesalers.  TED, The Electrical Distributor Magazine, November/December 2002, Bethany Sullivan, author.

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