Among the time-honored truths of electrical distribution lie some powerful misconceptions that can have a devastating effect on what you're trying to do — assuming what you're trying to do is survive and thrive and grow your business profitably. In an economic environment that feels like part-recovery, part-recession, it's even more important to have a grip on the profit drivers in your business because it becomes harder to make up lost ground. This is a good time to stop and take a look at your company and dig into the details because getting it right now can pay dividends — literally — for generations to come.

Not only does it become harder to make up lost ground in a sluggish market, but some of the most widely recognized fallacies about making money in the notoriously low-margin distribution business begin to sound more reasonable. You'll hear more of your people making a case for choices that will come back to bite you, whether it's cutting prices, inventory or people, or investing in costly expansions of product lines and territories. And you'll be more disposed to listen.

It's time to check your assumptions and seek new insights about what drives profitability in distribution and what destroys it, and to teach your people what you learn. To help you out, we've gathered insights from a few of the wholesale distribution business's more interesting consultants on the subject of profitability and invited them to blow up widespread misconceptions about how profits are made.

“Most profit pursuit in wholesaling destroys rather than creating profit,” says Scott Benfield of Benfield Consulting, Naperville, Ill.

Here are some of the misconceptions that can lead you to destroy value in an attempt to build it.

“All we have to do is survive until the economy rebounds.”

Don't bet on that. Looking out across the year ahead, electrical distributors' forecasts, aggregated nationwide, are predicting industry growth on the order of 5% (see “2012 Market Planning Guide” in EW November 2011, p. 14, or ewweb.com/market_planning/guide/2012/). Given that electrical distributors historically have proven to be an optimistic bunch when forecasting their sales, and given the broader concerns about potential large-scale negative shocks to the economy from lingering unemployment, debt deflation and instability in European markets and Middle East oil-producing states, among other things, waiting for the economy to float your boat doesn't really count as a profitability strategy.

The growth of the overall market doesn't account for changes in local market share, of course, and most distributors will be looking for sales to grow more than the market. But you have to keep in mind there's a point of diminishing returns, depending on how that growth is won. Trying to capture share using the time-honored techniques of the business can lead you to continue pursuing the mistaken assumptions that hurt your profitability in the first place.

“We have to say at present, ‘I can't wait for the economy to make my life better. I have to go make it better on my own,’” says Albert Bates, chairman of Profit Planning Group, Boulder, Colo. “You've got to sell more to the existing customers you already have. When a guy comes into will-call counter, if you can add one more crummy item on that order, you can change the economics of your business a lot.”

“Our accountant can tell us what's profitable and what's not.”

Most of the standard financial reports show your company's activity during a snapshot in time. What they don't show you is the true value of the return on your expenses - which of your expenses really contributed to producing your margin dollars and which just took a chunk out of your hide.

For Bates, gross margin is the single most important driver of profitability for distributors. He cautions against using gross margin return on investment (GMROI) because it places too much emphasis on inventory turns, suggesting you can boost profitability by increasing turnover when in reality the effect of turns is more limited. He gives a detailed discussion of the hazards of GMROI in his 2008 book Profit Myths in Wholesale Distribution put out by the National Association of Wholesaler-Distributors (NAW). His new follow-up, Triple Your Profits!, takes his thinking further.

Scott Benfield has boiled down his theories about distributor profitability to what he considers the fundamental unit of the distribution business: transactions. Most models for understanding profitability in distribution assign an average cost to all transactions, when in fact the cost of different kinds of transactions vary wildly. To get a handle on which transactions are making money and which are costing more than they're worth, distribution execs need to capture information about how the transaction took place and how much labor capacity (i.e., human time and effort) the transactions required. (Benfield covers this subject more depth in a group of whitepapers available from his site, www.benfieldconsulting.com.)

“We don't understand how (profits) are made, and we do not consider our expenses as investments,” Benfield says of distributors. “Because of this mindset, distribution is perennially a low-profit business. Unless distributors move from accounting to measuring in a way that takes into consideration their use of labor capacity, many of them will continue in their death spiral.”

Many distributors assume that modern enterprise resource planning (ERP) systems have the necessary reports for tracking profitability built-in. ERP systems have improved remarkably over time, Bates says, but they're based on traditional ways of looking at distribution, so getting outside that mindset will require figuring out how to generate more timely and relevant reports.

“Our customers will leave us if we don't match our (idiot) competitor's price.”

Pricing is one of the big keys to profitability. Many distributors still rely on a simple cost-plus pricing scheme where they apply a standard percentage mark-up to what they pay their suppliers.

Allen Ray, principal of Growth Wizards, Kennedale, Texas, a consulting practice that works most with smaller distributors, is known for a nuts-and-bolts, facts-on-the-ground focus. He sees not only price competition, but slack internal processes for updating prices as a serious, widespread problem.

“A lot of distributors will look at the invoice (from their supplier) and say, ‘This is what we paid,’ and put a markup on it. This is cost-up,” Ray says. “A lot of distributors do this with conduit and wire, and most distributors get good at it because they know to call. But items they don't sell very often is where they get burned.” He mentions a couple of situations where distributors lost hundreds of thousands of dollars in a year because they didn't update their pricing.

“A lot of those guys are disappearing,” Ray adds. “It's a real slow death. They don't realize what they've done to themselves until it's too late.”

A greater problem is salespeople's inability to justify higher prices due to a lack of selling skill or a sense that pricing above a certain mark-up is morally wrong.

The better approach is to evaluate all product lines on their margin contribution and use slower-moving but critical items to offset razor-thin margins on the highest velocity products, Bates says. “They've just got to go back and look at the profit they're generating across every item. What we continually find is I'm probably very price-competitive on fast-moving stuff, but don't make it up as much as I should on the lower volume stuff. Even in a slow market, that opportunity is still there, but requires somebody going out and looking at it. It's a lot of effort, but that effort tends to pay off.

“Let's go find the slower selling items we have, and ask why. If people only buy them once a year because that's when they need them, they may not care what the price is. All they care is, do you have that item in stock? It's a tremendous opportunity,” says Bates. “It might move slowly because the price is too high, but that's fairly rare. More often it's just a slow-selling item. If you raise the price, you will sell the same volume but at a higher profit. That's the whole challenge in the pricing arena. If it were easy, everybody would do it tomorrow. If you do it right, you get the results every time you sell in the future.”

“We can make it up in volume.”

You knew this one would be in here, didn't you? Everyone in the industry knows this is hooey. If you're not making money on a sale, higher volume means you're not making even more. But the belief that a large order can make up for insufficient margins continues to sound seductive, especially when cash flow is tight and your company's survival is in question.

“This is probably the most widespread misconception right now,” says Bates. “We're still slogging our way out of an absolute beating we took at the hands of this recession. People assume you can make it up with volume. That's the number-one thing you cannot do, and everybody knows you can't do it, but when things get tough you go back and say, ‘I need sales volume.’ So there's a tendency to try to do that, and it absolutely kills us.”

Some distributors go after the big game, national accounts. For distributors who aren't in on the negotiations, who just service the account because they're part of some consortium or buying-group effort, national account contracts can hurt because of the increased level of service expense combined with lowered margins.

“If you're out in Timbuktu and you've got a national account set up by an outside party at 16 percent, you're going to lose your ass,” says Benfield. “Just because you're a member of a buying group that has a national accounts group doesn't mean anything.”

“We need to cut inventory.”

One of the first places many distributors look when trying to reduce their costs is in the warehouse. Be very careful. This is a cut that can hurt more than it helps. The temptations of inventory reduction can hide a trap, says Bates. The impact on customer service and therefore sales can quickly swallow up the money you saved in inventory investment and carrying costs.

“If you have too much inventory, and you're paying interest on it, it's there and you can see it. If you don't have enough inventory and you're losing sales, you don't see that,” Bates says. “There's nothing on the income statement showing ‘here's what you could have sold if you had it.’”

Bates points out that survey after survey of distributors' customers shows that the best way to make them happier is to have the products they need in stock.

What's more important than overall investment in inventory is what's on those shelves. All distributors have some dead stock, and need to get rid of it. The puzzle is in determining what stock is really dead.

“We don't know as much as we ought to know (about dead stock). How much of our inventory really is dead? I've seen figures as high as 20 percent, which is a choking number!” Bates says. “If a good hunk of that really is dead, that means your good inventory has got to really be trucking to support sales because your dead inventory is supporting zero sales. But instead of cleaning it up, distributors tend to say, ‘We're high on inventory, let's cut everything.’”

“A sale is a sale.”

When the numbers are down and cash is tight, any sale brings a sense of relief, but it's critically important to distinguish good sales from bad. Bates in his Profit Myths book lays out a simple binary that keeps the focus on how much additional cost a given sale incurs:

Good sales: These include sales growth that is achieved without a commensurate increase in expenses. The most notable examples are sales due to product-line inflation, increased penetration of existing accounts, and increasing a firm's fill rate (even if more inventory is required).

Bad sales: These include sales growth that incurs significant expenses, including targeting new customers, expansion of the product line, or opening new branches.

From the perspective of transactions, Benfield's research and field studies for customers have determined that of the six prevalent transaction types used in distribution, only three of them consistently make money: stock original orders, direct shipments and stock transfers.

“The other transaction types, in aggregate, lose money and from our field data do so consistently,” he says.

“Just-in-time inventory is the new normal.”

Despite the intuitive sense behind reducing the amount of product sitting in the supply chain, and the fact that a whole generation of managers has had the ideal of just-in-time pounded into them from their earliest days, relying on smaller, more frequent transactions comes at a cost. The example of the automotive industry's disruption in parts supply after last year's earthquakes and tsunami in Japan drove home the risks inherent in relying on a JIT platform.

Even leaving that fragility aside, the transaction costs will eat you alive, says Benfield. “Just in time supply means instead of making one large order and holding it, you've got a whole bunch of little $200 orders, so the transaction costs go through the roof and guess what? You've just crapped all over your profitability.”

“If we don't stock it, we can get it.”

Non-stock orders are a common killer of profits, and sometimes whole businesses, says Ray of Growth Wizards, particularly when the customer cancels and the goods end up on your shelf.

Shipping in non-stock items also opens the door to unbilled freight costs, another common drag on distributor profitability, he says. “They don't tend to think about it until the end of the year when their accountant says, ‘What's this big pile of money you aren't making any money on?’ It's a big problem. They should be assigning it to and collecting it from their customer. Most ERP systems will tell you when you have an orphaned non-stock item. They won't tell you what's the freight and how do you go back and get it.”

“If we compensate salespeople on margin dollars, they'll protect our margins.”

Scott Benfield points to research showing that none of the many variations in sales-force compensation makes a significant difference in profitability. Focusing on gross margin without accounting for variations in the associated expenses can distort what look like good results.

“All these plans are predicated on margin dollars alone,” Benfield says. “You can't do that and make any judgment whether those dollars give us a positive return on investment. The metric's a bust. You have to reward on all four components — sales, margin, cost to serve and return on invested capital.”

“Electrical distribution is a simple business.”

Setting up and managing to grow profitably in a tight economy in what's already a low-margin business is extremely difficult, but focusing on item-by-item margins and transaction costs can take your company beyond the traditional expectations of the industry.

“A reasonable portion of what they (distribution owners and executives) know about profitability is simply wrong,” says Bates. “Twenty percent or so are things they've been told at conventions when a guy gets up and makes a presentation, shoots from the hip, and they say, ‘Boy this guy was smart, he must know what he's talking about.’ Over time a lot of this becomes the ingrained knowledge in the industry, and it's that last segment that I think keeps us from doing as well as we might.”

More Mainstream Misconceptions

This article only scratches the surface of a long, heavy conversation the electrical wholesaling industry needs to have about profitability. Here are a few more quick things to think about as you're digging into the numbers:

  • Providing “value-added” (free) services can wreck profitability

    The assumption is that you'll make it back in customer loyalty. Will you? Or will you just cultivate a taste for unpaid expensive services among your marginal customers?

  • Expansion of niches or branches will cost before they earn

    Over time, if you're good and lucky, it turns out to be true that new branches will bring you new money. But when you're fighting for every margin dollar, adding fixed expenses in facilities and personnel while trying to establish your brand in a new market will suck up a lot of cash.

  • If your counter sales are growing, it's probably destroying value

    Your counter area is a nest of small orders and typically staffed by people unaccustomed to up-selling and suggesting add-ons.

  • Small orders don't deserve field sales calls

    If you have a lot of small customer orders, under $200-$250, and you're delivering to them and have it assigned to a sales guy, try to raise price, take it inside or let it go, says Scott Benfield.

  • Increase your use of drop shipments

    Drop shipments are some the least expensive, highest value transactions you can do.