Merrifield Consulting Group

February 26, 2003 - Distribution Channel Commentary (DCC) # 13

Greetings:

�� If you know what these commentaries are about, go to �TOPICS� below; otherwise, read on.

�

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THIS WEEK�S TOPICS

1. WHAT�S WRONG WITH A �MARGIN ENHANCEMENT� PROGRAM?

2. THE WISDOM OF 10 X 10 SELLING; FOUR LEVELS OF RESULTS

3. WHAT AM I PERSONALLY INVESTING IN? (AND ECONOMICALLY FORECASTING)

1. WHAT�S WRONG WITH A �MARGIN ENHANCEMENT� PROGRAM?

In DCC #12.3 I covered a case study on a �RONA trend ranking report� about which we got a few good comments and a somewhat concerned one. The email note with the concern follows with my response plus some more comments. BELOW IS THE EMAIL NOTE FROM A REGIONAL DISTRIBUTION CHAIN CEO:

Bruce,

Did I detect a bit of a slam at �margin enhancement programs (sell higher) at the branch level� in your �RONA Trend� commentary in your latest DCC (#12.3)? We are working on just such a program at all of our branches. What are the pitfalls? I distinctly remember your describing some sort of similar buy-low, sell-high improvement program that you did for some branches in one of your association convention speeches in the �80�s under the topic of �sensitivity analysis.� Have you changed your view in some sort of way? What should we do to increase the odds of succeeding with our current program?

�� SellHigh Smith

Dear SellHigh,

Wow! Maybe I�ve done too many speeches and too many articles over the past 20+ years in the world of independent distribution channels to get away with anything. You are right about the �sensitivity analysis� speaking topic that still holds true.

For readers unfamiliar with sensitivity analysis, the analytical approach assumes that if you focus creatively on any aspect of your business, you could probably improve it to the good by 1%. So, the most sensitive profitability factors in your business have two characteristics. 1) They are the biggest numbers, because 1% of a big number is more interesting than 1% of a small number. And, 2) the improvement amount will have a high flow-through percent to the operating income line (or profit before interest and taxes, PBIT).

To explain big numbers with big flow through, here are some examples. Inventory investment is a big number. But a 1% reduction doesn�t flow to the PBIT line year after year. It gives you, instead, a one-time source of cash to pay down debt which then reduces interest payments that flows through to the profit line before taxes every year. This isn�t as significant as increasing the biggest number of all, sales, by raising prices 1%. You could also increase sales by selling 1% more volume at the same mark-up, but the flow-through to PBIT is much less. Because incremental costs starting with cost of goods sold and then other variable transactional costs increase, the flow through impact to PBIT is about one fifth of what you would get if you could simply raise prices.�

Buying lower would seem to come close to selling higher, because cost of goods sold is a big number and 100% of any savings would hit the PBIT line. But, in the real world there are usually hidden, bigger negative tradeoffs to buying lower. I would recommend ideally focusing on first maximizing fill-rates, then turn-earn of inventory and total procurement cost minimization as best you can measure it. Then, if nothing else changes, you can pursue lower prices, better terms and other miscellaneous marketing subsidies that you might get from a supplier. But, don�t bother with suppliers with whom you don�t think you have a growing, improving future and for whom you are not willing to do some extra work in return for what ever you are asking. Free lunches don�t last.

So, SellHigh, you are right to focus on �margin enhancement; there are no two levers with greater impact than buying lower and selling higher. But, just the phrasing can lead you down sub-optimal pathways; try �selling better and buying better� which is not just semantics. Let�s look deeper into these objectives.

Why haven�t these programs worked in the past? Several reasons:

WILL THE OTHER PARTY GO ALONG WITH IT?

To sell high or buy low, your customer or supplier �partner� has to go along with it. They do this as often as one spouse in a marriage concedes to give more and get less on the biggest problem in the marriage with no other expectations. And, in the absence of a compelling reason for the concession, it is more likely to start up the same old argument of �by the way I (the other party) am not getting what I should on this issue.� Is it any wonder that sales reps and buyers would be reluctant to address this issue? Even buyers have run out of viable alternative suppliers (due to consolidation) to shop prices and terms against.

As a side note on the increasing counter-power that sellers have with concession demanding buyers due to consolidation realities, two interesting case studies:

1. On Feb 6^th AK Steel of Middletown, Ohio threatened to cut off GM over contract terms. This has turned into a legal battle. GM tried to get AK to swallow some extra charges, but, AK knows that GM can�t get enough of the right steel fast enough to feed 15 plants told GM to pay up. I don�t think GM is historically used to this type of treatment from its suppliers.

2. The Donald (Trump), always looking for any free publicity and negotiating angle, announced on Feb. 21^st that he is likely to dump his long-term real estate insurance provider, AIG, because their prices are too high and there are too many other carriers that want his business. Of course, the other side of the story from AIG is that: Donald wanted them to buy his junk bonds with his premium payments but, his premiums weren�t even covering the average costs of covering his real estate. They would rather be smaller in premium volume and make more money than be bigger and make less. Maybe the Donald won�t find as many lower bidders in the insurance world as he thinks.

An acid test for whether our average sales reps could sell higher would be to pose this moment of truth scenario. A big, important customer shops the field and offers us a last look to meet a competitor�s price. Can all of our reps look the customer in the eye and request last look plus a premium for both their own past value-added actions on behalf of the customer and a bit more for the company�s service brilliance? Can they explain to the customer that although we will continue to charge a premium price, our service is actually giving his company a lower total procurement cost and a fatter PBIT line? Until our sales force and our service actually deliver superior value, we probably can�t expect to sell higher in a straight-forward way. By telling some customers that we are going to unilaterally raise their prices we will trigger a reflex for them to start shopping the market.

HOW TO REINVENT VALUE BEFORE GETTING PAID FOR IT

To start the sales force on a transformational journey towards getting last look plus a premium for their individual value-added work try these steps:

1. Assume that 10% or less of all sales reps are actually worth seeing in a business, bottom-line improvement sense. Being a nice person is necessary too, but not sufficient for last-look+. Review the factory reps that call on the company as a group. Who are in the top 10%? Specifically why? Who was the best, most valuable of all time? Collect all the valuable attributes, �the do�s�, on a flip chart. From a different angle, without necessarily mentioning names, who were the worst reps of all time and why? Summarize �the don�ts� too.

2. Point out that a key to organizational learning technique is for many heads to look at an opportunity in different ways, to gather information, share it and then see if they can discover new success assumptions, guidelines and methods out of the findings.

3. Once the sales force has practiced defining both what a �10� and a �1� are for factory reps whom they have known, what�s the next exercise? Try to identify one particular type of buying influence within one niche segment of customers that the sales force could survey? Asking these people for their definitions of both a �10� and a �1.� Because different buying influences at different types of accounts will value what reps do or don�t do differently, it may be best to try this in the simplest, least threatening and most focused way. Develop a simple survey that each rep can use to poll 3 to 5 of their most friendly accounts on these topics.

4. A guiding assumption should be that: a good rep., by focusing more time and creativity on the right customers, should be able to help that customer do their job better and add money to the customer�s bottom line. This incremental PBIT action will in turn support last-look plus �a fraction of that incremental PBIT action� back to the rep for their distinctive value-added efforts.

5. Once you get a sales force to start thinking about all of these issues, they have a chance of slowly starting to transition towards the vision of asking for last-look+ and getting it.

REGARDING DISTINCTIVE BASIC SERVICE, FILL-RATES AND BUYING-LOW TRAPS

Statistically speaking, there have to be at least 90%+ of all distribution locations that don�t have distinctive, guaranteed-in-your-face, basic service brilliance for which a customer would pay last-look+. Just like escaping from prison by digging a tunnel with a spoon, such service can be achieved. For a faster, more enjoyable solution kit for improving service than the spoon metaphor, I recommend our video �High Performance Distribution Ideas for All.�

The cornerstone of basic service excellence value is having the highest, quickest (local) fill rates for a customer�s one-stop-shop set of inventory needs. If we try to buy low, we will most likely incur a bigger, negative trade-off hit on fill-rate service and transactional productivity economics. For more on this trade-off see DCC 8.3, 9.1 and 10.3.

WHY GM% DOESN�T CORRELATE WITH BRANCH RONA AND PROFITABILITY

In past DCCs I have commented on the fact that in most distribution channels, especially ones with higher delivery costs, there is no correlation between GM% and branch profitability. (See DCC 2.3, 10.2 and 12.3 as well as the articles and case studies in our �e-booklet�(EB) dealing with small order management numbered 11-14. We will email the EB upon request).

PUTTING IT ALL TOGETHER: CASE STUDIES AND TARGET ACCOUNTS

Because every account is different, case study discussions with both reps and buyers on selling and buying better can be very effective. The net result will be to identify a few target customers per rep and a few key suppliers for each buyer for which positive intervention will make a big difference. For a complete how-to on doing this type of an exercise, I refer you to the �High Performance..� video modules #ed 4.10 through 4.14 that cover the topics of �getting paid for and partnering with service excellence.�

CONCLUSIONS

So, Sellhigh, I will admit that I dis�d �margin enhancement� programs at the branch level, because they are so perennial and so ineffective. For such programs to work, you really have to dig down to change and improve the root causes that ultimately support better selling and buying total economics. I wish that I could offer a short-cut way to achieving sustainable, high performance results but it doesn�t exist. I believe, however, that 50% of solving a problem like not getting paid for what you are doing is just being able to identify the right root causes and have some viable maps for how to address them. Hope this commentary was helpful.�

2. THE WISDOM OF 10 X 10 SELLING

I recently had a client ask me for a refresher on �10 x 10 selling� and my first commentary above reminded me of the hidden levels of opportunity within this technique. If you would like to get the highest flow-through to the PBIT line for a given sales promotion effort, then read on.

THE SUPERFICIAL APPROACH

Marketing studies have tried to measure the relative degrees of difficulty for selling the four combinations of selling old and new products to old and new customers. One study in one industry, for example, found that for a constant selling effort the increased sales results were from best to worst: old products to old customers generated 15x the incremental volume; new products to old customers � 10x; old products to new customers � 3x; and new products to new customers - x .

A few key conclusions from these types of studies are:

1. It is more difficult for sales people to crack new accounts than it is for them to master and sell new products.

2. Most companies and sales forces get bored with selling old products and look for new ones long before they have finished thoroughly selling the old to old opportunities.

3. We always think the expected potential for new products (and new customers) are going to be a lot greater and more easily achieved than they actually are. Most distributor warehouses have plenty of new products that have been added in the last five years that are now collecting dust.

4. Although we may think we have sold all of the old products to all of the old customers, when we systematically, measurably check it out, we are always amazed at how many old-to-old oversights there really are.

Here are the steps to a 10 x 10 exercise with the sales force:

1. Each sales rep creates (with help) a grid with their top 10 customers (more or less is OK) across the top and the firm�s top 10 �products� down the side (more or less here too). �Products� could be: segments of product lines; unbundled services or service concept selling; i.e., not necessarily the top 10 most popular SKUs by sales volume or picks. An item ranking report is, however, a great tool to use for picking the top 10 opportunities.

2. The rep then systematically fills in �yes� (we already sell them this), �no� (we don�t, but theoretically they should be buying this from someone else) or not applicable (NA) (this account wouldn�t buy this at all.).�

3. A lot of boxes on the grid will, not surprisingly, have Y�s in them because otherwise how could top items and top customers be what and who they are. For the N�s, the reps should then split them into three sub-categories: easy, maybe, probably not. They will find some N�s for which the incremental business is there for the asking (easy). They will find others where they will recall that at one time they did ask for the business, but were turned down. Perhaps the customer buys that item along with others from a viable #2 supplier (fair share rule), or they prefer a brand solution that we don�t carry. These N�s might be tough. Then there are the N�s in the middle.

4. Send them out with vigor to get the easy ones and pitch the rest to get better final results than if you pursued one of the other old to new combinations.

SECOND OR NEXT LEVEL THINKING

Thinking back to �sensitivity analysis� in the commentary above. The flow-through of incremental old to old selling is EXCELLENT. If a distributor is making, for example, a 3% profit before interest and tax (PBIT) margin, old to old might have a 6% plus PBIT for a number of reasons. The company will not have to stock any more inventory, the old items will just turn a bit better. Because best items are well stocked with highest fill rates, this incremental business will have a low incident of stock outs, split orders, buy outs and substitution activity. The sales force will not need any incremental training or product support. The customers will often, although far from always, order the incremental items with other regular items so that the average order size increases without any incremental paper work or delivery costs.

THIRD LEVEL THINKING

If we work with our best customers to have a re-ordering system that allows someone, maybe our personnel, to systematically review and order inventory on a periodic basis that generates larger average order sizes, with more lines per invoice. If so, our flow through PBIT might hit 10% + of sales or 50%+ of the incremental gross margin. At the other extreme, imagine customers that have re-order points of zero and I need it right away. They are killing both themselves and us with small order transactional costs.

FOURTH LEVEL THINKING

If we looked at all of the top customers that populate are 10 x 10 grids, can we identify a sub-group that are very homogenous and that would order a high number of the same items? If so, add another 10 rows for �new products� that we find through surveys that they all have been buying in the past from other types of vendors. Could we add those products not just to inventory, but to the re-ordering systems that we are proactively setting up due to our level three thinking above? If a core group of customers immediately started to order a new group of items because it dramatically lowered their total procurement cost, while it decreased our cost of servicing as a percent of an increased sales total, wouldn�t that be cool? How do you think drug wholesalers make good money on 5%+ margins out of the warehouse when selling to drug-stores? Their entire channel does business on a marry-one-vendor, enter huge, system generated orders electronically. Imagine what a durable goods distributor could flow through to the PBIT line with an average order size that was 2 to 4 times the industry average in both dollars and lines on fast moving items?

For more on selling old to old via systems, see DCC�s 1.1, 7.3, 8.3, 9.2 and 10.3

3. WHAT AM I PERSONALLY INVESTING IN?

One of our �High Performance..� video users, sent me the following question in an email to which I have added my response. THE EMAIL QUESTION:

��

Bruce,��

I�ve read all of your stuff (the E-Booklet, all of the DCCs), and I�ve gone to some of your recommended post-bubble, doom and gloom net sources. I have been watching my stock investments and retirement funds shrink for three years because I wanted to believe what all of the �expert� forecasts and �cheerleaders from Wall Street have been telling me. But, your (DCC 11.1) discussion that touched on your personal investment process from Dec. �99 on made me sell out of all stocks into cash. I�m even subscribing to Richard Russell�s service, what great stuff for really a cheap price. I have read hours of his past stuff that is on his site.

�� So, what should I invest in next? I realize that you aren�t an investment advisor, but you do seem to bet on your economic beliefs in your personal investment strategy. I realize that this is a personal question, so don�t hesitate to pass on it. I do find, incidentally, that lots of business execs have strong economic opinions or convictions, but when it gets down to betting their own money on those opinions they don�t. They will only mumble about �not having time�. mutual funds�buy-and-hold for the long-run� Any further advice?��

Joe Distributor

Here was my response( with additions):

Dear Joe,

The short answer is that I�m currently in gold and gold stocks(80%); natural gas (San Juan Basin Royalty Trust �SJT- only in my IRA-10%) and cash(10%). I sold off my zero coupon bonds in my IRA last week and refinanced my home mortgage from an ARM to a fixed 30 year rate of 5.625%.� This is because I think that when the bombs drop in Iraq, long-term interest rates will start to rise and there won�t be anything that the Fed will be able to do about it. This will, in turn, lance the monthly payment mentality housing bubble and housing values will go into a long-term, slow, steady decline. As long as you can make your monthly payments, I think a chunk of fixed debt in US dollars will be paid back in depreciated dollars.

On the gold stocks, it is a total job to figure out which ones to invest in, but there are some good, still small gold stock mutual funds that the average investor should consider.

(For those of you who haven�t read DCC 11.1, please do so; it�s at www.merrifield.com under �articles� and dated 2-12-03. If you don�t read my �personal assumptions, you may think I�m a loonie.)