Best Practice: Managing ROI-Driven Growth
By Dr. F. Barry Lawrence
Texas A&M University
So far, so good, most markets are on the mend and wholesaler-distributors are seeing improvements across the board. A clear message came out of the recession: Managing working capital is the short-term goal; managing return-on-investment (ROI) is the long-term one. To do so, distributors must grow profitably. The concept is deceptively simple, however.
Many business people are trying to understand what is being called the “new normal.” The concept is that business conditions will not be the same after the “Great Recession.” They believe that a new model is emerging, and that those who understand and respond to it will flourish. Those who do not will perish. Okay, we’ve heard that before, and anyone who has been in business since the 1990s is probably somewhat sick of such forecasts. They are nearly always wrong.
The trouble is the people making the claim are not just consultants trying to sell their services this time. They are smart business people at best practice firms. They are not publishing their opinions to gain notoriety. They are changing their business models, however.
The new normal is not yet clearly defined, but a couple of common themes are coming from top business thinkers. They involve growing profitably and sustainability.
Growing profitably or, more accurately, with a solid ROI, is a function of four financial inputs:
The first three constitute the ROI equation; the last one determines the right outcome.
• The first step is to determine your risk tolerance.
• The second is to determine your potential opportunities.
• The third is to select the opportunities that match your profile of an acceptable risk/return ratio and rank order them to determine which fit within your resource capabilities.
• Fourth, determine what best practices will apply to the venture.
• Fifth, use those projections to govern the project through to a successful and sustainable part of your firm’s portfolio.
Sustainability means the process will continue to operate efficiently. It also means the firm will continuously introduce new innovation to the process to maintain its appeal to customers. These dual objectives require a corporate culture that embraces change, encourages innovation, documents and standardizes processes, and whose human resources are trained and motivated for the task.
The current No. 1 best-selling 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 have introduced a best practice and how it can improve earnings and/or ROI under current economic conditions. We encourage you as you participate in this blog to ask questions, debate results, and offer your 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 (SOURCE, STOCK, STORE, SELL, SHIP, SUPPLY CHAIN PLANNING and SUPPORT SERVICES) based on various distributor asset categories. This month, we focus on SUPPLY CHAIN PLANNING as shown in exhibit 1.
Best Practice: Managing ROI-Driven Growth
ROI-driven growth involves identifying opportunities, determining their value, sizing the necessary investment (human as well as financial resources), assessing the risk, and selecting the right options.
The practice levels for ROI-driven growth are as follows:
COMMON practice: (1) Sales force identifies a new application or customer set, (2) Expert (sales) opinion is applied to determine risk and reward, and (3) Selection is made based on biased opinion and force of personality.
GOOD practice: (1) An opportunity assessment is conducted to forecast sales potential, (2) Expenses to support the new opportunity are calculated for varying levels of the forecast, (3) Necessary investments are calculated, (4) ROI is calculated and compared to corporate hurdle rate, and (5) Those activities clearing the hurdle rate are prioritized on perceived risk/return ratio and compared to available resources.
BEST practice: (1) GOOD practice analysis is enhanced with strategy/structure match where the selection is evaluated on its consistency with long-term corporate goals and with existing processes, (2) Sustainability is created by first establishing a measurement system to govern both the implementation and continued process operations and second documenting the process and training to establish a culture of quality and innovation.
The New Normal?
One of the characteristics of the new normal may be shorter, more frequent recessions. JIT (just in time) has reduced supply chain inventories to the point that booms are harder to sustain and recessions cannot last as long. We are still struggling with forecasting this process, but the current recession holds some lessons.
The 2002 recession came as a major shock to most distributors, but they had been working on their inventory processes for quite awhile. Retailers and manufacturers were already running lean on inventory (mostly using the distributor’s inventory), but distributors were still carrying too much. Since they had new inventory processes in place, they adjusted quickly to the downturn. Electronics distributors saw inventory turns drop from 7 to 1 in a matter of months. They stopped ordering and right-sized their inventories quickly, but the impact to manufacturing was horrendous.
2009 brought challenges on a scale not seen since the Great Depression. Distributors were now more agile and manufacturers wasted no time in shutting down operations to control costs in the supply chain. The result was inventory shortages by the summer of 2009, which caused a turn in the economy sooner than most had predicted. Predictions that the economy would have a double dip or a slow climb out were further confounded by the lean distribution inventories. As it sells, it gets ordered, as it gets ordered, it must be produced. When there are any sign that things will soften, manufacturers shut down and distributors stop buying.
Becoming more agile with inventory is a lot easier than closing and opening manufacturing processes, but we should expect manufacturers to make their processes more agile as well. The result could be a new normal of more frequent, shorter, shallower recessions, and less extreme booms. The wild card in this equation is government actions. Programs to overcome the 2002 recession superheated the economy and caused an unwarranted increase in capacity that no doubt contributed to the current recession. Still, whatever the new normal may be, these new, more agile processes make sense.
An interesting outcome of this new normal is that well-run distributors can capitalize on recessions to grow. One distributor described it this way: “When a downturn hits, we reduce inventory and accounts receivables, which increase our available capital. We then use that capital to acquire competitors or launch into new markets when the cost of doing so is very low. Recessions have now become a good thing for us.”
ROI and Growth
A virtuous ROI cycle is illustrated in exhibit 2. A new market opportunity is capitalized on by an acquisition, new product introduction, green field startup, new service model, etc. Sales increase faster than expenses leading to an increase in net margins. If net margins increase at a higher ROI than the firm’s current business processes provide, investors are encouraged to invest more into the new venture.
Another possible model is to improve processes and drive down expenses or assets. The increased ROI allows the firm to decrease pricing or simply capture higher margins. The increase in ROI again encourages investors to put more money into the firm’s improvement efforts.
Exhibit 2: A virtuous ROI cycle.
A Case Study
A small distributor had implemented inventory and accounts receivables management best practices when the recession hit. The distributor continued to manage its assets well and the decrease in inventory together with decreased accounts receivables caused an influx of cash. The firm was very liquid at a time when its competitors were not.
The firm was interested in expanding its territory or service offering. It was not clear which model would work best, so a detailed analysis was conducted using ROI as the driver. The firm was privately owned with a highly competent management team. A new acquisition would be closely supervised, and the firm was experienced in acquisitions. This experience, together with a highly reliable management chain and thorough understanding of the market (the acquisitions would be within 150 miles of their territory), demonstrated a low risk, so the firm set its minimum hurdle rate for ROI at 18%.
Three acquisitions were identified:
• The first was a distributor with an identical business model.
• The second was in a related and complementary product line.
• The third was a service firm that would complement the firm’s existing processes.
Each firm’s sales were tracked and corrected for the recession, and a conservative forecast was put in place for future growth. The forecast was then linked through the income statement of each to determine what their respective expenses would be.
Best practices were compared between the purchasing firm and each acquisition to determine how the merged operation would operate and how any reductions in costs would be captured. This analysis led to estimated net earnings for each of the next five years. The required investment was calculated by a 3X multiple of each firm’s current earnings, plus 75% of accounts receivables and 50% of inventory and adjustments for debt and other assets. The result was a 4- to 5-year payback on each acquisition or an ROI of 20% to 25%.
The firm then assessed the strategy/structure match. The services distributor was determined to be most outside of the firm’s core competency and its low margins were a concern. Service firms have few assets, so while the ROI looked good, the margin for error was small. The distributor with the related product line was less risky, but had a poor record on accounts receivables. The final distributor from the same product/service offering had the overall best ROI, but a large inventory compared to the acquiring firm. The structure was a good match and the proximity of territory meant that assets could be shared, promising opportunities to reduce inventory and other assets (for example, one warehouse was perceived as redundant).
After making the selection, the next step was sustainability. The best practice states that integrating acquisitions should happen as quickly as possible from a human resources standpoint. Delays in eliminating redundancies and creating career advancement opportunities for valued new employees will result in productivity decreases for some and the potential loss of high performers if anxieties are not relieved quickly. High-performing employees are embedded in the actual value of the firm and their loss decreases the value of the acquisition.
The firm treated each asset and new employee as a valued resource and an implementation plan was made to capture the planned ROI with the involvement of key personnel from the acquisition. Training, career path, and involvement were preplanned especially for high-value employees. Transitioning best practices from one firm to the next were planned with metrics to ensure ROI and create sustainability.
Capturing best practices and ROI in standard operations has gone on for some time and is well represented in the Optimizing Distributor Profitability book (http://www.naw.org/optimizdistprof).
Doing the same for growth implies new best practices and new perspectives. If the new normal is as we propose in this blog post, there is a need to manage growth very tightly to maintain the necessary flexibility and capture the opportunities associated with the new business environment. The upcoming Council for Research on Distributor Best Practices (CRDBP) consortium title, “Optimizing Distributor Growth and Market Share” will treat this need as its core mission. The consortium brings together many best-practice companies thereby combining the wisdom of many as opposed to the thoughts of a few. To learn more and to join this consortium, go to http://www.naw.org/crdbp/growth.php.
About this Blog
“Managing in an Uncertain Economy” is a blog created by the Council for Research on Distributor Best Practices (CRDBP). The mission of the CRDBP, created by the NAW Institute for Distribution Excellence and the Supply Chain Systems Laboratory at Texas A&M University, is to create competitive advantage for wholesaler-distributors through development of research, tools, and education. CRDBP encourages readers of this blog to send in comments and e-mail this blog to other interested parties.