More than half of the customers the average distributor serves are not profitable, according to research conducted by Dr. Al Bates, founder and director of research of the Distribution Performance Project. Dr. Bates also provides evidence that your best customers produce close to 150% of your bottom line. Based on this analysis, about half of your customer base consumes more services than their gross margins pay out. Simply stated, half of your customers are subsidized by your best customers.
Over the years, this topic has been visited and revisited. At each iteration, there seems to be a knee-jerk reaction within the distribution community. Most of the time, the discussion turns to the need for growing unprofitable accounts and instructing salespeople to pay more attention to top/target accounts. The shock and dismay of the whole situation is then simply forgotten over the next month and we return to the status quo. However, on occasion, some brave soul decides to take action.
Years ago, after a round of activity-based costing (ABC), a young distributor manager came up with the idea of “firing” customers who didn’t produce a profit for his organization. This plucky move netted unfavorable results. Even with the help of my firm, it took him a couple of years to get everything back in order. Trust me, there is a better and more subtle approach.
Let’s explore why some customers are not profitable and what you can do to ease them into the black ink.
Gross margin isn’t the only indicator of profit vampires
Very few distributors have accurate ABC measures in place. The ABC process was discussed a lot at the turn of the last century, but the practice lost momentum because, quite frankly, it was time consuming and difficult. If you have ABC metrics in place, identifying the right list of “wrong” customers is pretty easy. If you don’t, here are some things to think about.
Do you have customers who “cherry pick” your product line and only buy repair parts for existing equipment, resulting in numerous small and special orders? The cost of dealing with these customers may exceed the gross margin they produce. In cases like this, raise the prices of these items. Chances are, the orders will continue to flow but the gross margins will be higher.
Do you have customers who provide you with long lists of products for quotation but rarely purchase more than a few items? Creating quotes is time consuming. What’s more, the time invested in quotes generally takes someone away from the real work of providing value to existing customers. Why not set a limit? When customers purchase less than 25% of the items quoted, place them on probation and review their purchasing trends and buying patterns. After a frank discussion, these customers may change their purchasing habits or only ask for the prices of products they really need.
Some customers are really poor at paying. If their business is not significant, consider asking for cash on demand (COD). Distributors operate in an environment with short margins (just north of 3%), which means it takes $3,300 in good sales to offset a single deadbeat loss of $100 in bad credit. Chances are, these customers will continue to place orders, but the risk will be eliminated.
Average order size is important
Segmenting customers by typical order size will provide insight into profitability. Here’s a tale of two customers. Both customers purchase $10,000 worth of products annually from their local distributor at roughly the same margin. The first customer purchases the same products twice each year. The second customer places small orders almost weekly. At first glance, both appear to be low-volume customers with similar profitability. However, when service consumption is taken into consideration, the first customer is extremely profitable while the second is marginable.
With most credible ERP systems, you can calculate the number of orders placed by each customer. This allows for some additional calculations tied to the cost of receiving and processing an order. Surprisingly, most distributors fail to take this into consideration with customers.
According to a calculation my firm conducted some years ago, the average cost of processing an order for an industrial/electrical distributor is more than $50. We can assume that the cost has gone up significantly over the past seven years. However, if we stick with the $50 figure and apply a generous 25% gross margin to any incoming order, every order needs to exceed $200 for the gross margin to cover the breakeven cost of service.
If a customer provides you with a healthy string of orders less than $200, they are likely sucking dollars from your bottom line.
Segment your customers based on services available
It’s important for management to identify and categorize sub-profitable customers. Sales and customer service teams are hardwired to provide service and most believe every customer and every sale is important. While this attitude of service is admirable, providing a level of service commensurate with the customer’s contribution is critically important to long-term profitability.
One distributor my firm counseled segmented customer groups into gold, silver and bronze levels, with terms of service laid out for each level. The plan looked like this:
Gold Level
Services available:
- Unlimited pre-sale service
- Credit terms with options for extended payment terms
- Trilateral negotiations with manufacturers to get pricing advantage
- Free shipping
- Return privileges
- Special orders with no added fee
- Unlimited expediting
- Access to product support teams and specialists
- Service stock at no charge
- Complete warranty support
- Special waivers for training (on some products)
Silver Level
Services available:
- Credit terms with options for extended payment terms with management approval
- Trilateral negotiations on large projects
- Shipping available on orders more than $1,000
- Return privileges with a restocking fee
- Expediting on larger orders
- Access to product support teams and specialists on projects
- Service stock with management approval
- Complete warranty support on select lines
Bronze Level
Services available:
- COD payment
- No salesperson assigned to the account
- Special orders available with prepayment
- Shipping charges added on incoming and outgoing freight
- No returns (unless triggered by distributor error)
- Access to product support with a fee
The distributor implementing this plan intends to migrate all bronze level customers to a webstore where they will receive the same price for web orders and to raise the prices of products purchased in the more traditional way.
Fee-based services come into play
Distributors provide many necessary services, ranging from logistical in nature to highly technical. They serve as the first line of support on many programmable products. The best distributors provide ongoing training to their customers. In the past, these services were largely supported by the gross margin produced through product sales. However, the combination of margin pressure, rapid advancements in technology and rising employee costs create an environment where this is no longer sustainable.
In our book, The Distributor’s Fee-Based Service Manifesto, we reinforce the idea that at least some of your customers, actually all but the best customers, need to be migrated to fee-based services. The best place to start is by charging customers whose profit contribution is in question. It simply makes sense. Why would you provide free services to customers who don’t contribute to your bottom line? Why would you pull resources from your best customers to subsidize the worst?
The dark figure on the horizon
Hopefully, you’ve found yourself nodding along with the observations and suggestions laid out in this article. But alas, a dark figure looms in the distance ready to shoot down the best of your plans. Expect pushback. Some of these points cut straight to the very core of time-honored distributor culture. Here is a short list:
- There is no such thing as a bad customer. Wrong. A customer who does not contribute profit is not a good customer. Either deal with these customers or accept the fact that business will not be as profitable as it could when we provide free services to society.
- A few customers may decide to take their business elsewhere. Maybe. At the same time, why should this be a concern?
- Some small customers could grow into the next General Motors. True. As customers grow or change their methods of conducting business, reward them with increased services, better terms and a full package of value; the kind of things you provide to your best customers.
- Our supply partners will see this as a turndown in distributor service. Maybe. At the same time, the service to the most important customers will remain the same and definitely improve.
- Sales teams view the small no-profit accounts as a source of leads for future growth. Really? Our experience indicates very few salespeople, apart from those new in territories, spend significant time prospecting for growth accounts. When they do, why not allow them to temporarily extend higher service levels for a year? We call this process auditioning customers.
- Salespeople will miss commission dollars generated by the no-profit accounts. True. Generally, these no-profit accounts are quite small. We recommend removing them from commission plans and, if need be, adjusting things upward.
Tying this all together
Half of our customers consume important bottom-line dollars. Most of us can afford it now. Will we be able to extend the practice for a year, five years or even a decade? I don’t think so.