The contracting business revolves around three things: customers, trained workers, and a dependable source of materials. Take any of these away, and the business is doomed to fail. Each of these requires ongoing care and attention. A quick search of this publication’s website points to literally thousands of articles associated with finding and acquiring customers. Similarly, the important subject of employee training and retention gets the coverage it deserves. However, there is only a modest amount about the “care and feeding” of the supply side of the business.
Many may shake their heads and assume the attitude that suppliers are a dime a dozen, and if one goes away, there are plenty more pushing for our business. But the truth is, unplanned supply interruption can cost your business. Further, if supply should become tight due to regu- issues or some national parts shortage (it happens), maintaining a strong supply base is doubly important.
As with the customer and worker sides of our three-sided equation, the more you under-stand your supply partner, the better. Furthermore, the more we know about our employees, customers, and suppliers, the greater our ability to facilitate constructive communications. And, communications drive value to our organization’s ability to create a solid bottom line. In this article, we will explore some of the things you should know about your supply partner.
Distribution is a low−margin business
Don’t let the size of a distributor’s building or top-line sales numbers impress you. Distributors aren’t rolling in dollars. In fact, the average profit margin before taxes and interest (lots of them are leveraged) is below 4 percent. That means for every dollar they bring in, they get to keep less than 4 cents. You can contrast this against the 25-35 percent average of the typical North American (non-automotive) manufacturing company.
Unlike car dealerships and a few other businesses that play strange games with their invoicing and profit picture to give the appearance of low profit margin, the sub 4 percent number includes all of the rebates and incentives. The intent of this article is not hocus-pocus propaganda. Profitability is a big issue for distribution.
Distributor revenue is under major pressure
The old school rule of distribution is: Buy low, sell high. Distributors refer to the difference between the buy and sell as gross margin. And, for the past two decades, gross margin as a percentage has been trending downward.
There are a number of reasons why this revenue squeeze is occurring. First, geography no longer protects distributors. It’s easier to travel from West Overshoe to the next town down the road today than it was in the 1970s, so distributors face more competition. Second, the industry is in a state of consolidation and change. Bigger distributors are buying up small independent ones and using price as a tool to break into the market. Finally, internet-based competition has set new pricing pressure. While most distributors don’t lose significant business to internet rivals, their prices are contrasted and judged against online pricing.
In my mind, many distributors have an irrational fear of internet-based sellers. While many contractors shop the inter-net, very few have moved major pieces of critical supplies to these companies. Typically, the reasons for contractors not moving business over to internet delivery lie in two areas. First, entering orders requires time and effort to manually select products, quantities, and enter other information.
And perhaps more importantly, the better known brands are unavailable. Many experts also point to online sales of HVACR equipment as enabling untrained handy-man types to insert them-selves into the contracting busi-ness and encouraging dangerous do-it-yourself attitudes with homeowners and small commercial firms. Local distributors pro-vide a number of services above and beyond just the delivery of parts. And the service thing involves people.
People represent the largest single piece of the distributor’s business costs
Distributors in the HVACR industry participate in an operational benchmarking process called “The Profit Report.” The report’s design allows distributors to understand how their business performs compared with the rest of the industry. Here’s one of the results: People costs consume more than 60 percent of the typical distributor’s revenue (the gross margin we discussed earlier).
The costs associated with the right people continue to increase. Health care costs are going up approximately 18 percent per year, according to news reports. The cost of qualified people is escalating. That new person you talk to on the phone could be costing the distributor $60,000 to $75,000 a year in burdened cost if he or she is a college graduate.
With people-related costs rising, distributors are looking for ways to increase the personal productivity of their teams. All have invested in business systems to assist with inventory tracking, billing, and other back-office tasks. Many are reviewing their processes tied to order entry and customer interactions. Some are modernizing their warehouse and logistics operations with bar-coding, computer-assisted parts picking, and advanced shipping and receiving procedures.
A small vanguard of progressive distributors have begun identifying the right customer mix for improved productivity of their teams and the resulting profitability. For instance, some distributors have identified very small contractors as unable to produce the amount of revenue required to offset the cost of serving them. Small orders, typically under $150, don’t cover the distributor’s operational cost. Speaking in broad generalities, small contractors place lots of small orders one job at a time with individual products rather than case lots. The economics of the two businesses (small contractor and distributor) just aren’t compatible. I believe the trend of segmenting and studying customer profitability will only grow as internal labor becomes increasingly costly.
All this is interesting, but what should a contractor do?
We started off with the premise that it pays to understand the three legs of the contracting business: customers, trained workers, and a dependable source of materials. At this point, you know more about the distributor channel than you did when we started, but allow me to connect a few of the dots on this distribution thing. Here are six ideas that could benefit your business.
Beware of Bait-and-Switch Pricing Tactics
The expense and pricing models described above apply to not only the HVACR wholesale industry but to other similar models, such as the electrical, plumbing, and industrial supply businesses. There are no silver bullets. No one has yet developed a business model capable of providing the same products and services for significantly less money. Yet, we regularly see pricing extended to contractors for much less.
Many companies use bait-and-switch pricing tactics to pull in new customers. The idea is to establish a buying relationship and then gradually increase the price over the next few years to get back to a sustainable level. A few contractors have seen fit to use this approach in driving up their own profits. Professionally, I wonder if they have considered all the costs of switching businesses?
Think About “Tri-Lateral” Negotiations on Price
The operating profitability of manufacturers can be as much as 10 times that of distributors. If a contractor uses significant quantities of a product or has an application for a new product fighting for market acceptance, the best place for a price concession comes from the manufacturer. Because distributors serve as the emissaries of manufacturers, it pays to keep distributors involved and to ask for coaching as you move your price negotiations up the supply chain.
Improved Buying Habits can Change Your Value to Distributors
Can you anticipate purchases to create larger sized orders? Do you have solid commitments for work in the next construction cycle? Distributors benefit from your business practice. It’s completely reasonable for them to share some of the value provided by your actions.
Your People Costs are High too. How can Contractors and Distributors Work Together to Maximize Productivity?
Distributors and contractors are both paying more for qualified people. However, there are areas where distributors have an advantage based on technology, training, or unused capacity. In some locales, unions or government regulations put upward pressure on the contractors’ costs of burdened labor. I wrote an article in the Sept. 25th edition of this publication on how contractors should work with their partners to devise plans for determining who might do various shared processes more efficiently.
Understand Distributor Logistics
Twice this week, I received calls from distributors complaining about the headaches of products returned from contractors. As distributors go through the profit squeeze, they are studying costs more closely. Returns from customers are costly. Studies indicate the logistics of accepting and restocking something from a customer costs eight- to 10-times more than the cost of shipping it out. Most of this comes by way of additional personnel involved. When a contractor ships product back that needs cleaning and testing before the next sale, the cost goes to the 20- to 25-times range, yet returns are required. Being a good partner means holding returns to a minimum.
A Final Thought on Payment Terms
The vast majority of HVACR distributors advertise 30-day terms for their contractors. In reality, the typical payment rate is closer to 62-55 days. The distributor’s suppliers strictly enforce 30-day payment. If they miss a couple of days, the supplier shuts them down. This means distributors are acting as banks for a good many of their contractors. Nobody talks about it, and while interest rates are low, the impact to the distribution business is small. However, interest rates are creeping up. Soon, people will start paying more attention. If you pay “like clockwork,” I recommend you discuss the value of your great business practice with your distributor.
There is value in a steady and reliable source of products. Distributors view contractors not only as customers but as part of their own channels to market; many flatly refuse to sell products to do-it-yourself guys; most actively try to push business to their contracting partners. Alternative forms of supply are a threat not only to distributors but to the contractors and dealers who make up their customer bases. It pays to understand one another.