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.

Best Practice: Inventory Stratification

Best Practice: Inventory Stratification

By Dr. Barry Lawrence, Texas A&M University





The current economic environment is frustrating to say the least. Many have adjusted to lower volume and reduced their capacity (inventory, human resources, value added services, and even facilities) to reflect a lower business volume. Manufacturers have dramatically scaled back with some cutting capacity by as much as 80%. Demand has not decreased as much so most believe that soon (end of the year or sooner) production will be needed again (albeit at a lower level) and the economy should start grinding slowly forward. Issues with the banks, excess real estate inventories, and consumer debt will linger, however, and are expected to make the recovery a slow one.

Aggressive firms are already thinking about the recovery and seizing market share from weakened rivals. Those still gasping for air are trying to make it through the end of the year and praying for relief. Others want to sell out as soon as the markets recover. Still others are fighting off bankruptcy. In the midst of this chaos and with so many different priorities among distributors, how does one come up with a common set of strategies we can all discuss and share for the betterment of the distribution community?

The new NAW Institute for Distribution Excellence book Optimizing Distributor Profitability: Best Practices to a Stronger Bottom Line 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 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 (the 7S process group includes SOURCE, STOCK, STORE, SELL, SHIP, SUPPLY CHAIN PLANNING and SUPPORT SERVICES) based on various distributor asset categories. This month, we focus on the STOCK group. The STOCK group has seven processes and we’ll discuss inventory stratification here.




STOCK: Inventory Stratification

Inventory stratification prioritizes investments in inventory based on customer service or shareholder value. Customer service often drives large, inefficient inventories in an attempt to be all things to all people. Shareholder value seeks to carry only profitable products, at reasonable levels (asset efficiency), producing maximum sales (cash flow), while also increasing market share (growth).

Inventory stratification techniques are well known but often not applied correctly. The practice levels for inventory stratification are as follows:

COMMON practice: 1) No inventory stratification (2) Product line grouping (3) Not connected to purchasing

GOOD practice: (1) Volume (sales $) based (2) Logistics (hits) driven

Revenue driven models, like sales in units or dollars, emphasize fast movers often at the expense of more profitable products. Customer service driven models, like hits, emphasize always having what the customer wants, when they want it, often at the expense of ROI.

BEST practice: (1) Profitability (GMROII) based (2) Multiple criteria based (3) Combination method

Profitability driven models, like Gross Margin Return on Inventory Investment (GMROII) or Turn and Earn, emphasize profitability often at the expense of economies of scale created by higher sales. The best approach will be some sort of combination model tied to the purchasing process.

A properly executed inventory stratification will ensure shareholder value and direct all purchasing decisions towards the firm’s financial strategy. An example purchasing scheme might be to carry “A” items with a solid safety stock, carry “B” items with a limited safety stock, “C” items with no safety stock, and eliminate “D” items.

Upon hearing such a strategy many will ask “How am I supposed to eliminate ‘D’ items when important customers require us to carry them?” The question demonstrates a fixation with sales as a stratification method. No matter how many times you explain that a ‘D’ item has no profits, almost never gets picked, and generates almost no sales, people will get concerned. The stratification needs to combine techniques and all parties must be educated on how it works.

So What’s the Impact?

Even with a combination technique, the average distributor has about 20 to 40% of their inventory in ‘A’ and ‘B’ items (great contribution to shareholder value) and 60 to 80% in ‘C’ and ‘D’ (negative contribution to shareholder value). Firms that execute inventory stratification connected to purchasing processes are able reduce or redeploy 20 to 50% of inventory in cases we have observed. The following exhibit describes the link between stratification and shareholder value.



When “cash is king” as it is now, inventory reduction takes center stage. One distributor faced a crisis last year when their sales were flat and inventories were expanding due to canceled customer orders with the onset of the recession (numbers have been simplified and somewhat disguised for confidentiality). Inventories ballooned from $8 million to $10 million in a few months. The expansion led to an increased financing need of nearly $2 million since supplier funds were maxed out.

A further problem was Accounts Receivable. As the economy worsened, customer Days Sales Outstanding increased from 30 to 40 days resulting in a need for another $1 million in credit just to stay afloat. So with no change in sales, the firm suddenly had to come up with an extra $3 million in credit.

Then the loan covenants kicked in. The distributor had been granted a line of credit up to 50% on good quality inventory. The economic slowdown and pressure on banks caused them to decrease it to 45% and disallow more inventory as potentially obsolete. The net effect was that even with a $2 million increase in inventory, there was effectively no increase in the line of credit.

The bank also gave 90% on Accounts Receivable (A/R) of less than 90 days. Due to reevaluating the distributor as more risky, they reduced the covenant to 80%. In addition, a greater percentage of customers went beyond 90 days as the economy trended downward. The net effect was almost no increase in credit to cover the increase in A/R. So the company found itself with nearly a $3 million shortfall, a potential death sentence for an otherwise profitable firm.

The firm was fortunate to have started an inventory stratification process before the storm hit. After analysis, they had $2 million in ‘A’ items, $2 million in ‘B’ items, $4 million in ‘C’, and $2 million in ‘D’. They set out to reduce ‘A’ and ‘B’ by $500,000 each(relatively easy to do), ‘C’ by $2 million (discounting would bring a 5% loss in value), and ‘D’ by $1 million (discounting 30%).

The firm freed up $3.6 million in cash to help get them through the crisis. They also “righted” the ship by improving their inventory quality and bringing it down to a manageable financing level. Loan covenants on inventory were restored to the previous 50% level by the bank.

What If Cash Flow Wasn’t the Problem?

The firm could have gone after the other shareholder objectives if they weren’t facing a cash crisis. Instead of only reducing inventory, they could have redeployed it to fast movers or into new products or markets spurring growth. The impact would have been higher profitability on increased sales with greater asset efficiency since the investment would be in ‘A’ and ‘B’ items.


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 email this blog to other interested parties.

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