In the previous installment in Electrical Wholesaling's June issue (page 40), we reviewed the costing logic for transactions. Differential costing uses transaction types and common operations to develop costs for discrete transactions of stock, stock transfer, drop-shipment, non-stock, counter sales and backorders. The costs per transaction can be used to understand where profit is made or lost.
As a point of review, the need for a new understanding of profit rests on the idea that traditional financial accounting and PAR reports come up short in helping drive operating profit. Traditional accounting is time-period based and encased in definitions such as assets and liabilities. It doesn't amend itself well to marketing- and sales-based definitions of segments, customers and transactions. Also, the distribution industry is a thin-margin, aggressive step-cost business where operating costs rise in step with sales volume. Managing by gross margin percent and margin dollars means little unless costs are included with these metrics.
- Using differential costs and their implications
In Exhibit 1 on page 36, differential costs have been calculated for five transaction types for Big Time Electric. For instance, looking at the row for Stock (original order) transactions, we see that the average sale is $300; margin is 26 percent; cost is $63; and profit per transaction is $15. When the total transaction profits for stock orders are taken as a percent of sales ($3,661,665/($244,111 × 300)) the resulting product is that they are approximately five percent of sales. However, looking at the Transaction Profits column, 32.67 percent of total transaction profits ($3,661,665/$11,207,688) of Big Time Electric are in stock orders. Transaction profits are similar to operating profits but don't include fixed costs such as branch overhead and officers' salaries. From the exhibit, several things are evident including:
Stock (original orders) and drop shipments comprise approximately 130 percent of the profit of the firm.
Stock transfers, non-stock, and counter sales destroy approximately 30 percent of the firm's operating profit.
If carrying more inventory at satellite branches costs less than $23, Big City should consider increasing stock at these locations.
Shifting transactions to other modes (from non-stock to stock or stock transfer to drop shipment) can improve profit significantly.
These actions can help tremendously in the long-run profit of the firm. It's important to understand that the proposed actions will work best in the long run. For instance, if it shifts transactions from stock transfer to stock or drop shipments, the firm will make more profits in the long run as the firm grows and costs to perform operations will come down as less work is involved from processing less costly transactions.
The firm will eventually transfer some of these savings to customers and will be rewarded with greater share of market. If Big Time Electric's management can reduce the excess capacity resulting from shifting to less work intensive transactions, then immediate increases in operating profit will result. But reduction of capacity is difficult to do as many functions are interconnected. Nonetheless, if the firm has properly flow charted operations and knows their capacity constraints, headcount reduction can be done once less labor intensive transactions are adopted.
The exercise of developing differential costs and analyzing transactions has a significant effect on the understanding of how to grow profits in distribution. Management is no longer dependent on managing margin dollars or margin percent and left guessing if their transactions, sellers, branches or other operations are contributing to operating profit. From my firm's work in differential costing and transaction management, I have developed a concept on profitability called the “Three Pillars of Transaction Profit.” The concept illustrated on page 36 says that to drive operating profits in the step cost-intensive business of distribution, the firm must measure and manage three variables including:
The size of the transaction in margin dollars
Simplistically, the larger the transaction size in margin dollars, the better off the firm is.
Transaction type and cost are keys to profitability
We've seen highly profitable firms that have a high percentage of direct shipments and low profit firms with loads of counter sales and non-stock transactions. Managing the processes and pricing of transaction types can pay off handsomely.
The mix of transactions can change the profit picture significantly
Most wholesalers have five or six basic transaction types. Changing the mix on these transactions greatly enhances long-term profitability.
Many wholesalers don't see how to make practical use of the Three Pillars of Transaction Profit concept. Since the concept is new, it will take some time for the thought processes to develop and become accepted knowledge. To help in making the concept tangible, we've included Exhibit 2 on page 36. Looking at the exhibit, we can see the Three Pillars listed in the far left column followed by “Activity” and “Description” columns. For example, in driving transaction size in margin dollars, three options exist, including using quantity-sized pricing to drive transaction size to a minimum transaction size, and selling product bundles based on applications, kitting, etc.
The Activity column is not exhaustive. There are numerous ways to drive transaction profits. However, the activities listed are those we have found many wholesalers acknowledge and, to some extent, use.
The next installment will review the implications from differential costing as it relates to the sales force and account management. When transaction costs are applied to accounts and sales territories, much changes and wholesalers will be introduced to new knowledge that can greatly alter their fortunes for the better.
Scott Benfield is a consultant for industrial distributors and manufacturers in the areas of sales, marketing, channel management and operations. His is the author of five books, numerous Research papers and articles in industrial channels. His firm, Benfield Consulting is located In Chicago and its work can be seen at www.benfieldconsulting.com. Scott can be reached at (630) 428-9311 or [email protected].