Best Practice: Sales Growth through Inventory Reinvestment

By Dr. Barry Lawrence, Texas A&M University




and Dr. Ismail Capar, Texas A&M University



One step forward and two steps back is what it seems at times with this economy. Still, most are starting to look at growth as the next objective. Distributor growth will, in fact, be the next consortium for the Council for Research on Distributor Competitiveness (CRDC), the joint research effort of the NAW Institute for Distribution Excellence and Texas A&M’s Supply Chain Systems Laboratory. The NAW Institute Board of Directors selected the topic even before the recovery began, and the concept is now gaining momentum in the industry.

In last month’s blog, we addressed growing sales from a customer stratification and sales force redeployment perspective. This month we will discuss another growth perspective: Inventory Reinvestment. Distributor growth can be thought of as moving along in three dimensions: organic, vertical and horizontal integration, and expansion.

Organic refers to growing business with existing customers or new ones coming to us through our standard business practices. Strategies surround creating a more effective sales effort and marketing tools.

Vertical integration involves moving up or down the supply chain by taking on manufacturing or retail processes. Horizontal integration refers to taking on new functions like repair or consulting services. Strategies include acquisitions or developing new service capabilities.

Expansion takes on two forms: geographic and product driven. Geographic expansion refers to growing within new territories. Strategies include opening new operations and acquisitions. Product-driven expansion involves new product offerings. Strategies include taking on new product lines from existing suppliers or adding new suppliers. Each of the foregoing expansion strategies requires some sort of investment. Since most firms have limited resources, the strategies require an understanding of how return-on-investment (ROI) will be affected by each strategy. Those growth strategies with the highest ROI should get the scarcest resources. An even more difficult decision requires comparing existing investments to new strategies to potentially stop doing one thing in favor of a new higher ROI opportunity.


The new NAW Institute for Distribution Excellence book, Optimizing Distributor Profitability: Best Practices to a Stronger Bottom Line (available at http://www.naw.org/optimizdistprof), details best practices, their implementation, and ROI. These practices are valid in any economy, but the significance of one best practice versus another may change under different market conditions. Each month in this blog, we are introducing a best practice and how it can improve earnings and/or ROI under current economic conditions. Through this blog, we encourage readers to ask questions, debate results, and offer their own experiences with such practices so that we may further the knowledge of the community and the understanding of the science of distribution.





Best Practice: Sales Growth through Inventory Reinvestment

In our August blog entry, we addressed inventory reduction through best practices like inventory stratification. One approach is to reduce inventory, which eases cash flow problems and improves ROI through reducing the denominator (assets) in the equation. The strategy does not, however, grow sales. Pursued too aggressively, in fact, inventory stratification will reduce sales on C and D inventory and not add any back. Inventory stratification can be performed at branch level—or local ABC—and company level—or global ABC—and combined in a single matrix to determine inventory deployment strategies and business decisions at the company level. Common strategies are:

• Increase service levels. If items are A and B at both branch and company level
• Review/eliminate. If items are C and D at both branch and company level
• Evaluate. If items are A or B at branch level and C or D at company level
• Redeploy. If items are C or D at branch level and A or C at company level

World-class distributors receive a 300% or better ROI on their A and B item inventory (based on gross margin contribution). No other investment can give a greater return, so a reduction in inventory to invest in other forms of business does not make sense. The most powerful approach would be to reinvest in A and B inventory. The strategy is organic in nature and requires that the opportunity to reinvest be available.

Reinvestment can take the form of increasing inventory on A and B items to improve their fill rates. A higher fill rate on the most important items will lead to an increase in sales, since fewer stock outs mean fewer lost sales and the resultant higher customer satisfaction level will lead to a greater share of the customer’s business. The process is doubly effective since the high turn rate on A and B items means that the small changes in inventory (lower holding costs) will have a big impact on service levels (lower stock out costs). Properly applied, you can have your cake (lower inventory) and eat it too (increased sales) by significantly decreasing C and D items and marginally increasing A and B items. Best practice purchasing policies are shown in the following figure.

In an interesting example, a distributor for grocery stores was trying to decrease C and D inventory. The company decided to implement a rule that when the purchasing department placed an order, they could not use C and D items to make truckload quantity. Purchasing would have extra space on the truck and would buy larger quantities to make truckload freight rates. Since volume levels on A and B items guaranteed the highest discount possible, purchasing logically took on more C and D items to get discounts there as well. The practice had created large slow-move inventories.

Purchasing, therefore, was forced to use A and B items to make truckload. The company reduced C and D inventory significantly, but was surprised when overall fill rates rose and sales increased as stock outs on A and B items dropped.

An Expansion Example

A number of distributors have used a technique called “storefronts.” The process consists of opening more locations with “A” item inventory only and serving other items from regional distribution centers. Contractor-serving distributors will commonly use this method to combat the “big boxes” (retailers). The distributor’s advantage comes from more locations closer to the customer coupled with a professional sales force. Retailers follow a similar strategy of “A” item inventory only, but they do not field as strong a sales force.

The inventory requirements are minimal since the storefronts can be replenished from a central warehouse on almost a daily basis along with slow-move items not carried by the storefront. As a result, facilities can be kept very small. The process allows for high sales with fewer assets (high ROI). The decreased need for inventory assets frees up resources to open more storefronts (geographic expansion).

An Integration Example

Integration has failed many times when manufacturers have purchased distributors. Distributors have a slightly better record when they add light manufacturing. Common examples have included building materials distributors who take on paint mixing lines (vertical integration). Fluid power distributors often will carry out systems integration responsibilities by building larger, more complex or specialized, power units from products they already carry (horizontal integration).

Integration takes advantage of assets already in place to add a new function or service. It often fails when the new process is performed poorly (not a core competency) and ROI requirements are not achieved.

Home Depot attempted horizontal integration when it purchased Hughes Supply. When the firm added distribution as a function, it found that the new division, HD Supply, could not meet the firm’s ROI requirements, and so they were forced to sell it.

Reinvesting

Inventory strategies allow for many reinvestment opportunities. If nothing more can be done with existing A and B items and no new products can be added, other forms of expanding inventory impacts, like storefronts or integration, can be employed. Whatever the choice, ROI is king and failure to optimize it guarantees failure. The following exhibit describes the link between stratification and shareholder value.

Best Practice: Customer Stratification

By Dr. Barry Lawrence, Texas A&M University




and Dr. Malini Natarajarathinam, Texas A&M University











Well, the indicators are turning green. Experts say we’ll look back on July and August as the beginning of the recovery. Still doesn’t feel like it though. One distributor related a familiar story about how his suppliers and customers are coming together to paint a rosy picture. Competitors have folded up, and customers are seeing new orders. Suppliers are making deals for consignment inventories and transferring new territories to the distributor as well. The problem is banks are about to call their notes, and they may not make it through the month much less capitalize on the opportunities.

Even those strong enough to weather the remaining few months of the storm face challenges. Competitors have been beaten down; customers are anxious to get back into the game, but few have money for even the basics. Consumers have to clear higher hurdles to get mortgages, and contractors are having a difficult time borrowing money to start jobs even when homeowners have the mortgage. Consumers are cutting corners and tucking money away so all the old rules about who has money and who is spending are out. Still, as one distributor put it, one thing is clear: Increasing sales is the order of the day.

The new NAW Institute for Distribution Excellence book, Optimizing Distributor Profitability: Best Practices to a Stronger Bottom Line (available at http://www.naw.org/optimizdistprof), details best practices, their implementation, and return-on-investment (ROI). These practices are valid in any economy, but the significance of one best practice versus another may change under different market conditions. Each month in this blog, we will introduce a best practice and how it can improve earnings and/or ROI under current economic conditions. We encourage readers to ask questions, debate results, and offer their own experiences with such practices so that we may further the knowledge of the community and the understanding of the science of distribution.

The book breaks business processes into seven groups based on various distributor asset categories. The 7S process group includes SOURCE, STOCK, STORE, SELL, SHIP, SUPPLY CHAIN PLANNING, and SUPPORT SERVICES as seen in Exhibit 1. This month, we focus on the SELL group. The SELL group has eleven processes and we’ll discuss customer stratification here.



Best Practice: Customer Stratification

Customer stratification may sound like an odd idea in a climate where any paying customer is a good customer. Still, the sales force has two issues to deal with: First, who do I call on that has a chance of giving me an order and paying for it? Second, who should I be calling on, and how do I secure relationships that will still be worthwhile when the economy takes off?

Customer stratification answers these questions and many other, perhaps more important, ones. Customer stratification measures how much business a customer does with us (sales), how profitable they are in gross margins, how loyal they are, and how costly they are to serve (to protect net margins). Each of these dimensions has a bearing on the sales force’s questions.

Customer stratification techniques are gaining popularity, but they often are not applied correctly. The practice levels for customer stratification are as follows:

COMMON practice: 1) No defined customer stratification (2) Customer groups based on market type or product line (3) Top customers based on revenue

GOOD practice: Based on a single factor (1) Volume [sales $] based (2) Gross margin (3) Business potential

Volume (sales) is critical to achieve economies of scale. The fact that gross margin customers are willing to pay in down times says a great deal about what they’ll do in up markets. Beggars can’t be choosers, but given the choice of calling on high- margin versus low-margin customers is a no-brainer.

BEST practice: Based on multiple factors (1) Cost to serve, customer loyalty, business potential, profitability, and relationship (2) Combination method

Loyalty is important since replacing customers and chasing customers who come and go is expensive. Finally, cost-to-serve will overwhelm the gross margin if the customer drives services through the roof. In a down market, the sales force may give away services easily just to capture short-term sales. There are long-term consequences for these decisions.

Customer stratification can be used in conjunction with other best practices. Pricing is an obvious one. Sales force redeployment is another. Pricing decisions include many factors but essentially they start with the customer and the nature of the relationship. Sales force redeployment determines not only which customers the sales force will call on, but how much time they will spend with each and the nature of that discussion.


Pricing

One distributor set up a pricing methodology to increase its margins. A key part of the strategy was customer stratification. When quoting, the salesperson would open a screen that gave a recommended price based on customer stratification, item stratification, unit cost, previous margins, and customer-item visibility. The last four items came from the system’s data and were undeniable. The key issue was the customer’s status.

The distributor’s screen listed the customers according to the stratification as Core, Opportunistic, Service Drain, and Marginal. These terms come from Pricing Optimization research at Texas A&M University (see Optimizing Distributor Profitability at http://www.naw.org/optimizdistprof for a complete description of the Customer Stratification technique and how to implement it). The customer stratification model is shown in Exhibit 2. The distributor chose a different set of names for its application.


The salesperson would open the screen, see the recommended price, and then examine the customer’s status. Even though the system had already factored in the customer stratification, the sales force needed the additional comfort of knowing that core customers were properly identified. The strategy worked like this: If the salesperson was planning to ask for a 22% margin and the system came back with a 28% margin recommendation, maybe the salesperson would split the difference. In a pricing environment, a 1% increase in gross margin can easily mean a 20% increase in net margin.

The process worked better than expected with gross margins growing by more than 6 points (6% or going from 22% to 28% gross margin in our example). The key component was and is the customer stratification. The salesperson split the difference on the low side in the beginning but, as they gained confidence, moved closer and closer to the system’s recommendation.


Sales Force Redeployment

The sales force makes a sincere effort to call on the right customers and spend the right amount of time with those customers. Still, the salesperson may or may not understand whether the customer is in fact a Core customer or an opportunistic one worthy of pursuing. Without the right analysis, the sales force makes decisions about who to spend time with and give services to based on their perspective of the customer relationship. Sometimes they’re right, but often they give away services to Service Drain customers or discounts to Marginal customers thinking they are, in fact, Core or Opportunistic customers. Exhibit 3 describes the link between customer stratification and shareholder value.



A powerful example of working with Core customers comes from an oil field services firm. The sales representative worked with the operations manager for the customer on taking control of the warehouse. Up to that point, the distributor was the largest but not the only supplier for the operation. The operations manager had instituted a significant measurement system and was disappointed with the performance of the warehouse.

Contractors working for the customer ordered far more material than they needed since they did not trust the warehouse to have the material on time. The result was excessive, obsolete materials when the contractors did not use everything they ordered. The warehouse was awash in inventory.

The distributor’s sales rep worked up a strategy based on the customer’s measurements (which were driven by return-on-net-assets or RONA). He got the customer to agree to share improvement in RONA in exchange for the distributor managing the warehouse. The sales rep then worked closely with the contractors to build confidence, disperse the dead inventory through their own network, and improve picking and tracking procedures.

Since the distributor’s network was far larger than the customer’s, the distributor was able to reduce a significant amount of inventory through redeployment. By winning the contractor’s confidence, the distributor was able to significantly reduce excess orders. Finally, through demonstrating value add directly in RONA, the distributor won a larger portion of the customer’s business at that location and rolled the program out worldwide for an even greater gain.

The distributor did not take ownership of the inventory. The investment came in the form of the sales rep’s time to set up and run such a program and additional human resources in onsite management. The decision to redeploy these resources was made rationally based upon the customer’s status (Core). The additional services were directly compensated for through the RONA split. If additional resources are not compensated for, the distributor’s cost-to-serve rises without higher compensation and turns the customer into a Service Drain.



Only Scratching the Service

These examples only start to demonstrate the benefits of customer stratification. Future blogs will explore blending it with other best practices as well.