Are you really managing gross margin?
by Frank Hurtte
Last week, I was called on to explain distribution to a young manufacturer salesperson: sales dollars don’t pay the bills. These supplier sales types fail to understand that, for distributors, top-line sales dollars are only an interesting number, maybe something to brag about. Gross margin is what pays the bills. Distributors create annual budgets based on gross margin, they plan their business around GM dollars and they talk constantly on the topic. But the question rattling around my mind is what are they really doing to manage gross margin?
Back in the ’90s, many distributors discovered activity-based costing. They compared the gross margin produced by individual customers against the cost of activities performed for the customers. For many, the results were eye opening. While comparing customers against the cost of delivering the services consumed, many were not profitable. Some refocused their sales efforts on the most profitable customers. Others made conscious efforts to throttle the services available to the less profitable or look for lower cost mechanisms for providing services in general. Unfortunately, many read the data, gave it some lip service at a meeting or two and then returned to business as usual.
Gross margin is on everyone’s mind. For instance, the website of this publication has over 179 pages containing a reference to gross margin. Any short conversation with distributors includes the topics of gross margin: dollars, percentages, thoughts on GM pressure and the issues with competitors who drive gross margin downwards. But very few actively manage the gross margin of their organizations, with actively being the key word.
Most distributors approach managing gross margin as if they can only indirectly affect the value. They understand sales growth as a driver, so they manage sales. They comprehend lower cost of goods sold as a tool, so they push suppliers to give them special deals. Cerebrally, they understand increases in gross margin percentage radically impact profits, but few go further than cheerleading sessions to push their sales teams to increase GM performance.
The time has come to apply some of the same principles of active management to gross margin performance. Let’s explore some techniques for managing gross margin.
Avoid giving away gains from special supplier deals
It is not uncommon for supply partners to reward distributor activity, performance or other work with some type of pricing advantage. The premise of the idea is simple: the distributor gets an extra discount which creates greater revenue via improved gross margin. But systemic breakdowns within the distributor operation are legendary. One of the well-deserved supply partner criticisms of distributors lies in their inability to control passing the price along to the customer. Extra margins designed to allow the distributor to make more money are simply passed on to the customer. The market price erodes and everybody loses.
This loss of margin building potential is so rampant that many manufacturers have resorted to passing additional gross margin along via end-of-year rebates. The arguments for and against this procedure have been debated for the past decade. But, there are simple steps to avoid the margin giveaway in the first place.
Generally, the problem stems from rampant cost-plus pricing. We call the practice “magic number” pricing. It works this way: Customer price is determined using the formula of cost plus some favorite percentage (AKA The magic number). Eliminating the magic number generally requires a great deal of cultural training. I believe it is worth the effort to address the problem head on. But without solid system prices loaded into your ERP system, it requires massive oversight. However, the gross margin can be captured by using a technique called puffing.
Puffing comes when the new cost levels are not shown in your system. For example, the supply partner gives you an extra five percent discount. Instead of dropping your system price of goods sold to match the five percent discount, the system price is only lowered by one percent (if anything at all).
Another method would be to enforce a margin increase freeze on all sales of the product. While this requires more effort, the work will move you forward in building discipline into your price process. Why not take the time to establish a rock solid system sell price on all of the products effected by the additional margin? Once established, all sellers would require management approval to deviate downward from the set price. Most ERP systems allow for management reports of price changes. Follow up each price change with a meaningful discussion with the seller who gives away the additional margin.
Review pricing for abnormalities
Who in your organization is responsible for reviewing pricing abnormalities and deviations? Back before the recession, a lot of distributors assigned someone to review invoices before they were officially entered into the system. Sometimes it was the sales manager, a senior inside sales person or another person with clout in the organization. They reviewed pricing levels for abnormalities; typically prices set too low for the situation. Somewhere between 2008 and today, this activity has largely been discontinued. Now is a good time to re-visit and re-launch the practice.
Here are points I believe must be reviewed and, considering the advanced capabilities of some ERP systems, in as close to real time as possible.
- Any gross margin which carries less than 12 percent gross margin. The list should be short and the power of watching for extremely low order prices is amazing.
- Any order carrying a gross margin ending in a five or a zero. My experience is the “magic numbers” discussed previously generally follow this pattern. Think, why 15 percent instead of 16.7 percent? Why 20 percent over 23? You get the picture.
If you want to get advanced in your review of pricing abnormalities, a good point might be to assign minimum gross margin percentages by product line. Here’s an example. One of my clients took on a new product line from just outside the norm of his current product offering. The technology was new and required a great deal of support. Further, the margins typically generated by this line were about 50 percent higher than the tradition products sold by the distributor; running about 45 percent in a 25 percent industry.
When Barry in inside sales got a request for quote on the new product, he priced it using his magic number of 25 percent. In a quick flick of his typing fingers, he gave away nearly half of the potential gross margin.
Why not set a minimum gross margin per product line or technology offering?
Segment your supply partners
The concept of segmenting customers has been with us for years, but why not segment suppliers? The issue with Barry is a good reason. Further, there are other issues that must be taken into consideration.
If you enjoy an exclusive on any line, there may be excellent opportunities for pushing gross margin forward. If any of these product lines requires spare parts, why would you consider selling them for anything besides list? A review of your customer list may uncover customers who only purchase this product line from you. Looking at the situation objectively, they probably only buy this product from you because they have no choice. Why would you offer special prices?
Another area to explore and manage in the “exclusive line” offering comes via sales to competitive distributors or resellers. Strangely, many distributor managers leave the price level of these sales to their customer service group. Again, I ask you why discount?
Digging further into supply partner segmentation, are there products you carry as a courtesy to your customer? Here’s how these show up. A customer asks you to carry a line on their behalf. In most cases, they did this to drive down their administrative costs. Most times the product line is not big enough to garner much gross margin. Yet, you invest manpower, inventory space and shipping costs to make things convenient for the customer. I believe these lines deserve much greater gross margin for the distributor (perhaps as much as 8-10 full points more) than commonly handled product groups.
Product groups with high incoming freight costs deserve higher gross margin. So, too, do those which are not particularly distributor friendly or require massive sales time to handle orders, shipments and tracking.
Review customer segmentations for errors
If you have a “pricing matrix” in your computer system and it has been a while since the information was scrubbed, I “betcha dollars to donuts” you have segmentation errors. I have not found a distributor yet that did not suffer from segmentation slide. Over the years, customers slowly migrate to the best pricing class. We’ve discovered two guys with a service truck listed in the “large contractor” class, companies with 18 employees listed as “large users,” and a rash of other errors.
A distributor managing their gross margin should investigate and fine tune their matrix at least once a year. Failure to do so will ultimately find customers sliding into lower gross margin categories.
If you have the ERP system capabilities, customer segmentation should be based on individual product types. Here’s an example: An OEM purchasing hundreds of thousands of dollars’ worth of automation products is an end-user when it comes to purchasing ladders, lightbulbs and other equipment used to maintain their facility.
Taking margin management to the bank
Gross margin improvements impact distribution like no other business. A couple of points in margin improvement typically increases the distributor’s bottom line profits before interest and taxes (EBITA) by 50 percent. And, since distributors are typically valued based on a multiple of earnings, that 50 percent increase to the bottom line increases the shareholder equity by a gigantic amount. Let me toss out an example. A distributor with $20 million in sales might produce an EBITA of 4 percent, or $800,000. If the distributor was valued at eight times earnings (number for illustrative purposes but realistic), this places the company’s value at $6.4 million. Increasing gross margin by two points raises the EBITA to 6 percent or $1.2 million. The new value of the same company with $20 million in sales would now be worth $9.6 million. Many times companies with higher EBITAs are valued at a higher multiple of earnings, further illustrating the need to make margin management a priority.
With payback like this, we can only ask the question, is this really possible or just a theoretical tale spun by a consultant? I know it is both practical and possible to do. It requires some special tools (which I don’t sell, so I have no reason to lie), and some processes which best come from pricing experts like David Bauders and his Strategic Pricing Associates. But, I have witnessed the results at dozens of distributors. The results are game changers.
Contact Frank Hurtte of River Heights Consulting via email at firstname.lastname@example.org or via phone at (563) 514-1104.
This article originally appeared in the Sept./Oct. 2015 issue of Industrial Supply magazine. Copyright 2015, Direct Business Media.