As we move into the fourth quarter of 2008, we've heard from some distributors and noted some trends concerning declining margins. The following quotes are typical:

“What have I done wrong? My margins are shrinking and I am pushing through all the price increases! I am following-up on my DSOs (days' sales outstanding) and if it is a project of any size, we get protected with liens.”

“We file for most of our SPAs (special price authorizations) and claim-backs,” says another. “We know we leave some money on the table, but sometimes don't know where. We've come to the conclusion that we basically are paying too much for the product to begin with and we are either saddled with the ‘cost of carry’ at the bank or we don't have use of the money. Sometimes the claim-back period can be 120-plus days, even when filing electronically.”

Some distributors report that their overall net has now slipped to 3.125 percent of sales, down from an industry average 3.7 percent two years ago.

The question arises: Are you doing something else within your operations to cause a decrease in your profitability?

Historically, distribution has worked on the premise of buying in bulk, selling in smaller quantities and offering credit to customers. Some distributors negotiated dating terms with their manufacturers, but not necessarily on all products or all orders. Along came SPAs. Many high-profit distributors understood the value of quickly claiming their money and some automated the process. Others didn't. The group that didn't learn how to handle claim-backs quickly saw the manufacturer as selling product to the distributor for too much money, whereas those who claimed quickly recognized that the manufacturers were seeking to improve their profitability based upon distributors' not claiming their funds (this is called breakage). This group of distributors recognized that it was their money and profit.

Many distributors desire net-into-stock pricing because this method eliminates the cost of the SPA/claim-back process, and ensures that the distributor is charged the appropriate amount for the product without having to do a claim-back (hence no breakage). The distributor retains the use of their cash flow by not having to reclaim their funds from the manufacturer. Inevitably, this improves distributor profitability.

The knee-jerk reaction of some distributors faced with reduced profitability has been to tighten credit and in some cases threaten, or file, liens. In a slow economy this becomes a challenge as it can have an adverse effect on sales. While the practice may be distasteful to the distributors and their customers, each understands that the material bills and liens are valid protection. Hence the conundrum … get sales or get paid.

Over the years, it has been interesting to note that distributors go through phases where their salespeople vacillate between sales revenue and order profitability or customer profitability. In a slowing economy, many focus on market share and use price as their point of differentiation. Sometimes the attitude is “anything to get an order — especially before the end of the month.” This type of mentality frequently results in net order margins of less than 3 percent.

If a project is involved, most distributors recognize that lower margins are quoted and agreed to. Distributors should look at draw schedules, at whether or not the general contractor is reasonable and in some cases at whether a completion bond is required by the owner. But both sides understand that in the end, the distributor will be paid regardless of the cost to collect.

Many contractors operate using lines of bank credit secured by assets and sometimes by projects. This requires the contractor to have good credit so that at review time, the note can be extended or enlarged based on past history.

Within the past two years, we've witnessed a lending phenomenon where banks were, to a certain extent, de-regulated, sub-prime loans became a way of life and Wall Street packaged sub-prime loans and sold them worldwide. Along the way, credit card debt rose to unprecedented heights. Instead of people paying off loans, they borrowed more. Home foreclosures were but a tip of the iceberg for electrical distributors. Many thought, “I'll just pursue other markets like institutional or commercial or industrial.” This leads to reduced margins for everyone as inexperienced distributors seek to take market share in those new markets.

Back at the distributor's place of business, many thought they were protected on their DSOs: even though some of their “friends” were a little slow paying, the distributor thought he was safe. But the real question is now coming to light: Just how safe are you with a 3 percent net profit and 60 to 90 days out with extended terms?

When banks tighten credit and ask for more liquidity, shorten review times from a year to more frequently, are forced to move off-book transactions onto their books and securitize their loans, this can hurt contractors. Contractors begin to understand that they may not bill correctly, or timely enough, on change orders, which typically have a higher margin than the overall project. Many do not have a project budget to get paid on time. In addition, they may not have enough net working capital. Cash is king to most contractors that recognize they should take discounts.

Contractors may be slow to recognize that they have uncollected change orders, thus increasing their orders with distributors before they have paid down previous billings. At some point the distributor should be saying, “Pay me for some of the old invoices!”

Uncollected change orders and project billings force contractors to look elsewhere for cash, hence the need for additional credit. They think they have a viable project, but can't get at the money in a timely fashion. That's when contractors begin to convert outstanding invoices to credit card debt. It's not necessarily about “miles.” They have to operate and need credit from you for new projects. Banks that are tightening certain loans and liquidity requirements may further force a sub-contractor to resort to a credit card. Additionally, if a contractor needs to sign off on a mechanic's lien (which is designed to protect the sub-contractor from the general contractor/owner) then they may be compelled to pay the invoice via a credit card. They live another day. The GC is happy.

Meanwhile, the distributor who thought he was secure with a 3 percent net profit has suddenly developed financial problems. Not only are margins down, but cash flow has slowed.

Most credit card companies charge 2 percent to 3 percent, depending on the credit card. These charges are the first problem for many distributors, especially with credit card sales growing to 10 to 15 percent for many distributors (one distributor reported that credit card sales represented 32 percent of their business). On top of that, the distributor is then denied the use of the same money that has been shipped out as product and booked as profit.

With this in mind, have you re-thought your pricing lately? Is a 3 percent net margin enough? Probably not! Many distributors will basically put off looking at their true margins in favor of performing a marketing function. This neglect of margin management will eventually catch up with them at some point.

But the real questions you need to ask are:

  1. Do I know what percentage of my business is conducted via credit card and what types of customers are using credit cards?

  2. Do I have enough margin built into my prices to support credit card sales at the counter?

  3. Do I have enough margin on a drop-ship order to cover a credit-card conversion after my customer has ridden my credit for 60 to 90 days?

  4. When is the last time I checked the margin levels of my “A” and “B” items? Many distributors tell us it's good enough to check margin levels annually. Is it? With margins declining for many for reasons not related to the competition, it may pay to bring in someone to change the way you think about your pricing and the value your organization places upon itself. Normally a day's discussion will identify a number of potential areas where there may be problems.

When distributors are asked about the cost of carrying their inventory, many revert to turns as a way of saying they are doing well. The real answer should be the amount of money you have invested in your inventory and how much profit it made you. Very few distributors understand that once they sell a product on credit, there is a period of time when they don't have use of their money.

If you expect to make 3 percent to 6 percent and you collect it at 60 or 90 days and then you unexpectedly have to pay a credit card company 2.5 percent to 3 percent to get your money, where is the profit?

Here's where you can start to get a handle on this:

  • Review your receivables to determine how much is credit versus credit card.

  • Identify customer payment trends.

  • Consider margin adjustments to compensate for the added expanse of credit cards.

  • Develop strategies to encourage the payment option you prefer — these can include cash and non-cash options.

  • Attack habitual profit-leakage areas.

While it is nice to have finally collected the money, if you are doing all the work, shouldn't you get some compensation? The only way to ensure that you do is to proactively manage margins and collections, and then correlate the two.

Allen Ray is principal of Allen Ray Associates, www.allenray.com. Allen Ray Associates helps companies improve profitability through effective pricing strategies to increase profits, revenue and streamlining business processes through effective e-business utilization. Allen can be reached at 817-704-0068 or allen@allenray.com.

David Gordon is a principal of Channel Marketing Group. Channel Marketing Group develops growth strategies for manufacturers and distributors. He can be reached at 919-488-8635 or dgordon@channelmkt.com. Register for monthly newsletter at www.channelmkt.com.