Productivity and Profit Issues in Durable Goods Distribution and Industrial Channels, and Channel Restructuring from the Convergence Effects of Service Unbundling, Foreign Manufacturing and Transaction Technology

Portent for Distributors and Manufacturers

Introduction
Wholesale Distribution is a vast industry in the U.S. Economy. The Durable Goods Sector of Wholesale Trade, representing goods with a life of 3 years or more, passes approximately 2.35 trillion dollars of merchandise through its doors.1 Much of the Wholesale Trade is private and financial performance numbers are difficult to procure. Many industry associations issue annual financial performance reports (PAR) and these are the important forms of information for discrete vertical markets of distribution. Benfield Consulting's work in the Durable Goods Wholesale Sector (NAICS 421) has questioned the productivity of the sector as a whole and especially those firms known as Merchant Wholesalers.2 New data, from the U.S. Census Bureau's Economic Census and PAR Reports show an economic sector that is not performing well when compared to other sectors. And, the portent is changes in channel strategies, methods to market, and channel relationships that will continue well into the future.

Economic Census and Data Comparisons
The Economic Census is done every five years by the U.S. Census Bureau. The latest Economic Census is for the period of 1997 through 2002 with the completed data being issued in the Summer and Fall of 2004. Current versions of the Economic Census use the NAICS industry classifications versus the SIC code classifications of years past. The comparative statistics for this paper use the 1997 NAICS Classifications which were kept the same for the 2002 comparisons in the Wholesale Sector.2 Future comparisons will use an expanded definition of the Wholesale sector developed in 2002 but are not a part of the comparative statistics.

The Economic Census allows comparisons between economic sectors to gauge the relative health of any one sector and also gives an economic history to understand the trends of the sector in question. The Economic Census Comparative Tables can be accessed at (www.census.gov). The extracted data, for selected sectors (see table below), was then analyzed by to yield the following observations:3

• A five year average of sales per employee places durable goods distribution's growth at .59% per year which is in the bottom ten percent of the close to 100 listed two and three digit NAICS economic sectors.
• Other sectors with poor or negative sales growth were Transportation and Sightseeing sectors which were impacted by 9/11/2001 or Primary Metals which has largely moved to offshore facilities for manufacturing.
• Payroll per employee increased 2.75% per year during the period and is far in excess of the average sales growth of .59%. This places Durable Goods distribution in the third quartile of payroll growth in the listed two and three digit NAICS economic sectors.
• When compared to sectors that durable goods distributors serve or compete with (Construction, Manufacturing, and Retail) sales per employee for distributors lag these sectors by 3x to 6x factor.

Based on these analyses, the takeaways for Durable Goods Distribution show a minimal growth rate in productivity as measured by sales per employee and this growth lags the majority of other economic sectors. The growth in payroll per employee stands at 2.75% per year and this is at a rate that is four times faster than sales growth per employee.

Key Statistics from 2002 Economic Census and Industry Group Comparisons

These findings are commensurate with past and present Benfield Consulting research, from private industry PAR reports, in the discrete industries of Electrical, Industrial, and PHCP (Plumbing, Heating, Cooling and Piping) industries.4  Overall during the period, the U.S. GDP grew at an average yearly rate of sales per employee of 3% and an average yearly payroll per employee of 3%. In effect, the sales per employee and payroll per employee were even or balanced out. In most Durable Goods Wholesale sectors, however, there is a significant gap between sales per employee and payroll per employee.

Reviewing the table below, we selected seven merchant wholesaling industries from five and four digit NAICS codes. Of the seven industries, all but two (Chemicals and Allied Products, and Medical, Dental, and Hospital Equipment and Supplies) the payroll per employee exceeded the sales per employee by a wide margin. Warm Air Heating was essentially even in both metrics and closely resembled the economy at large. Since wholesaler employee costs are, on average, sixty percent of operating expenses, the gap between sales and payroll per employee severely squeezes the profitability of the firm and this is a contributing factor for some of the extremely low profits we have witnessed in many of these vertical markets in recent years. As a caveat, our research has found that employee cost reductions in wholesaling often lag the downturns and, perhaps, this contributes to a portion of the gap in sales per employee versus payroll per employee.

We also note that the figures are nominal or specific to the year and the average inflation rate during the period was approximately 2.8%. There were five of the seven listed industries that did not keep up with the average inflation rate. The portent from the Economic Census derived data and PAR data is not good, however, and we devote the rest of this paper to trends in both distribution and durable goods channels. These trends  converged to change the economic health of many Durable Goods Wholesale sectors. And the strategic direction and management of both distributors and manufacturers will change accordingly.

Selected Merchant Wholesaler Statistics

Convergence of Foreign Manufacturing, Service Unbundling and Transaction Technology
Channels and the cost to distribute has traditionally been a competitive environment. Most Durable Goods Wholesale channels, however, are highly fragmented with numerous manufacturer reps and agents and merchant wholesalers. The vast majority of merchant wholesalers are small businesses under 10 million in sales with the total industry count being 297,000 establishments. Consolidation of merchant channels has been a force for the better part of two decades but there remains a preponderance of small companies servicing industrial channels. Most industrial channels began growth somewhere in the Gilded Age as industrial manufacturing needed parts, close to market, to service their end products. By the Victorian Era, industrial channels and supply houses were increasingly common and a Sears and Roebuck catalog of the age touted the company as "The World's Largest Supply House." The establishment of supply houses was, in the early years, a highly entrepreneurial venture and many salesmen, from industrial manufacturers, found the need for supply and left the manufacturer ranks to start the supply house. As individual sectors grew and specialized trades emerged, sector specific Wholesaler Distributors began to emerge as specialized products needed place, unbundling, repackaging, delivery and credit services.

Most Wholesale Distribution continued through the 1920's through 1970's in a mode of product driven expansion and it wasn't until the 1980's that consolidation began to be common. Consolidation was driven by any number of factors including the aging ownership of Wholesaler Distributors, overcapacity in geographic-product sectors, and the rise of powerful chains in discrete sectors. During the late 1980's and early 1990's however, several factors began to emerge that are changing the wholesaler distributor landscape. These changes involve the movement of domestic manufacturing to foreign shores, the maturation of product technologies, cost of service and low cost transaction technology.

Domestic Manufacturing, over the course of the last 40 or so years, has slowly been moving overseas. The reasons for this include the need to penetrate foreign markets and the low cost production available in foreign countries. This trend began in earnest and was historically marked by the fall of the Berlin Wall, the Tiananmen Square Incident, and NAFTA Accord. These events, in the late 1980's and early 1990's were a bellwether for the triumph of capitalism and industrialism over the shared state policy of communism. Accordingly, Eastern Europe, China and Mexico emerged as the dominant investment choices for U.S. manufacturers.5 As factories moved overseas, their immediate effect was to reduce the sales of industrial distributors who served them as is evident in Industrial and Electrical Wholesale sector profit performance. Beyond this, as manufacturing technology became widespread, foreign companies increasingly began to manufacture industrial products at lower costs. As their expertise and product quality improved, they began to market these products to U.S. Wholesaler Distributors through a variety of channels of reps, master distributors, and domestic manufacturers. This was accelerated by the maturation and decreasing importance of domestic brands of industrial goods.

The lifecycle of many industrial goods are entering their 150th year of life. Drill bits, screwed fittings, abrasives, came into wide use with the advent of powered machine tools of the mid 1800's. Armament manufacturers for the North in the Civil War used machine tools for intricate parts and rifling of muskets and cannons and were followed by the explosion of modern plumbing, electrical, and building materials during the next 50 years. While many of these products have changed, the basic product designs are still in use today and are accepted industry standards. As the product life passes the century mark, the operative word for manufacturers is to get the cost out. And, consequently, brand distinction in many industrial products is falling as most end users don't care about the brand of a standard shop brush, drill bit, screwed fitting, toilet bolt, or electrical cable. End users do want an acceptable product quality and are increasingly interested in service options that surround them and the domain of services is a future playground of profit for distributors and manufacturers.

Services surrounding the industrial products are typically bundled in the price of the product. As products have commoditized, the cost to serve and unique services have become more valuable. Also, service costs, when bundled, were obscured by the product price and their individual value and cost to provide were largely under radar.6 With the increasing focus on channel cost and productivity, basic services will require unbundling and new services will need to be created to cover the loss of profit from maturing, commodity products. Not all customers want all services and sales assistance is becoming discretionary and is being challenged by lower costs of solicitation including e-commerce and catalogues.7

E-Commerce was frowned upon in 2001 as the dotcom crash became evident. Most wholesaler executives looked at the predictions of the early pioneers as so much bluster. In 2005, however, increasing amounts of customers are ordering industrial goods online and this trend will increase. The long run cost of maintaining an E-Commerce presence, from our consulting, is somewhere between .1% to .3% of sales. This compares to an inside and outside sales presence cost of 7% to 9% of sales. Most distributors are using e-commerce to augment their outside sales efforts. However, cost pressure will likely dictate that wholesalers will be forced to offer differing and, in some instances, unbundled prices for solicitation efforts. In essence, there will be a lower price if you buy online and a higher price for sales assistance. These options require technology to track solicitations by transaction and bill accordingly and the technology is being deployed today by forward thinking wholesalers. As e-commerce is more readily accepted and cost pressure continues, we will likely see new, low cost models of distribution called Transactional Distributors who compete for economic buyers with the lowest cost transaction.8

The convergence of solicitation technology, foreign manufacturing, maturation of products, service costs and low productivity will have a substantial change effect on the existing industrial channels. These effects will blanket North American channels and, if our hunch is correct, affect Western Europe also. In essence, anywhere there are mature channels of distribution, subject to the convergence factors, the following trends are likely to occur.

Likely Outcomes and Observances for the Durable Goods Sector of Wholesaling
Sales per employee is only one way to measure productivity and other methods including Total Factor Productivity are worthy of review. In general, however, rising productivity, as exhibited by sales per employee, is necessary for continued profitability, competitiveness, and investment. Based on the low productivity in Durable Goods Sector and convergence issue, our belief is that the following trends will be prominent in the sector. Many of these trends are in full bloom while others are beginning but will become more prevalent.

• Profits as measured as a percent of sales or assets (EBIT, NPBT, ROS, ROA) will, in many sectors, remain at historic lows. For example, the Industrial Goods sector of distribution is saddled with record low profits for the past five years with net profit before tax not making it above 1%. The Industrial Sector of Merchant Wholesalers lost approximately 22% of their establishments during the five year period while overall establishments were down approximately 1%. The Electrical Sector has been mired in historically low profits of less than 2% net profit before tax for the better part of a decade.
• Return on Capital, Return on Equity, and Return on Net Worth will remain low in the sector, and this will cause many private owners to sell or make cost cuts to improve profits. A recent study by the NAED (National Association of Electrical Distributors/TED Magazine 4 Decades of Distribution) showed Return on Net Worth being cut in half from 20% in the late 1970's to around 10% by 2004. Our review of large, public electrical and electronics distributors finds that less than 70 percent have recent returns that are greater than the average of the public markets of 11.7%. Many have returns on capital in the 6% to 8% range. It is questionable whether many firms in these sectors cover their cost of capital.
• Wage increases will likely exceed sales growth as distribution will need better, more educated managers and employees to change the productivity slide. Estimates on educational attainment for merchant distribution have been low as compared with other sectors. Employees, with better educations, will cost more in the short run but should help improve the picture in the long run by increasing the productivity rate with better process knowledge.
• The areas of customer service, inside sales and outside sales, will be under increased pressure to perform or their ranks will be thinned. Employee costs are 60% of distributor operating expenses and the sales functions represent 50% to 60% of all employee costs.
• Cost of service, as located in the operating expenses of the firm, will become a strategic focus and those companies who reduce or leverage costs will win the battle against top line focused competitors. Those companies with operating costs significantly below their competitors will take the cost advantage to the street and push marginal profit companies (there are many) toward insolvency.
• Leveraging costs with new models of distribution, new methods of solicitation, or through a focus on the most activity profitable segments and customers will become more common.
• Vendor consolidation and streamlining the backdoor supply chain will continue in importance to drive RONA (Return on Net Assets) and wholesalers will increasingly look to master distributors with global connections to source C and D items. Small wholesalers, who numerically dominate most sectors, will have an increasing dependence on master distributors as their cash position and loan covenants, as affected by poor profits, will not allow them to buy in bulk quantities, at lower margins, from major vendors.
• Consolidation in the industry will continue but consolidation will need to consider the front door focus of the acquisition candidate and those without a good strategic fit (front door focus) will be passed over. Consolidation has been prevalent in the recent past but is of questionable value in helping productivity. 9
• Increasing investment in software to provide information and leverage costs will continue. Software and knowledge brokers of productivity and cost management will be in greater demand.
• The use of alternative solicitation methods at a lower cost per sale will increase and telesales, catalogs, and e-commerce will accelerate.

The pace of these changes, in exact numbers, is unknown. However, the stage is set for dramatic change in the cost platform of durable goods distributors and the use of lower cost solicitation and greater technology and knowledge to manage costs. The dependency on top line sales to correct this situation, will, in most instances, not be a viable option.

Manufacturer Channel Issues
Channel management for industrial manufacturers has largely been taught around assigning the appropriate channel to secure the desired end user segment. The distributor is seen as a conduit to market and alignment of distributors with desired end user segment is the historic challenge. Substantially less literature and instruction exists on what to do with an existing channel that is undergoing the stresses of poor earnings, low productivity, and severe cost pressure. Many times, academics argue that new channels will emerge that give the manufacturer needed options in distribution. At this juncture, however, there are no dominating alternative channels, with substantially healthier finances, to provide manufacturers access to existing markets.

In building supplies and construction markets, Home Depot and Lowe's participate in contractor sales, but most research finds these firms serve the smaller contractors with limited product needs and low individual buying clout. Industrial and scientific markets have the presence of catalog wholesalers whose earnings pictures typically are better than that of sales intensive distributors and a recent article on the automotive aftermarket channels ("The Evolution of Distribution", Aftermarket Business, Dec. 2004) warns of share loss of industry "WD's" to retailers. For the most part, however, non-traditional and less sales intensive channel firms, while individually large, collectively count for only a small portion of their sectors' sales.

Based on the poor productivity and profit picture of many wholesale sectors, Benfield Consulting believes the following trends will be a challenge to manufacturers as distributors attempt to squeeze more profits out of the supply chain:

• Distributors, where it makes sense, will source directly from unknown or lesser know manufacturers in China, Mexico, The Pacific Rim, and Eastern Europe. They will bypass mature brands with high production costs in lieu of knock-off brands with passable quality. Some distributors may take an equity position in a foreign manufacturer and others will import containers of foreign goods and market them under their proprietary brand name.
• Master distributors, with global sourcing capabilities, will become more powerful and will expand their product offerings to A and B items. They will, because of their product cost advantage and small order sizes, compete with leading domestic brands across many product line offerings. Recent research by Benfield Consulting has found that distributors are increasing their purchases from Master Distributors by three percent to five percent per year and they expect this to continue into the future.10
• Manufacturers will find that demonstrable channel cost savings have increasing clout over wholesaler relationships. In some instances, channel cost savings will supplant brand recognition and quality as the staying power in the relationship.
• Sales promotion will likely decrease in importance as product cost becomes a primary concern to the end user. A survey of sales promotion activities in the Electrical Sector found that end user customers, in four of five segments, deemed sales promotion less important and of less satisfaction than other variables including inside sales knowledge and warranty policy.11
• Wholesaler performance metrics have moved from how much a firm buys to how much they sell and what segment(s) they sell to. This is being eclipsed by low cost service providers to the segment of interest including which wholesale firms have the lowest front door operating costs. Identifying and developing relationships with low cost service providers is of primary importance to the manufacturer's future but identifying these wholesale firms is difficult.
• Wholesalers will carry more competing brands and develop web commerce sites under different dba's and/or private brands to sell low cost imports. This will be especially prominent in territories where the high cost (read domestic) manufacturer has created a cost umbrella to support the maturing brand. The time to market for these efforts can happen in several months as e-commerce software, product content, distributor programming and foreign sources are readily available and the costs for technology are falling. A recent survey found that online ordering is expected to grow threefold, from 8% to 26% by 2008.12

In many markets, manufacturers may find that owning the capital intensive plant, property and equipment is not of a strategic advantage. Controlling the channel relationships with low cost supply chains, investing in the latest product research and development, and licensing the best fit foreign manufacturer are a better model than doing everything in house and under one roof. Where it makes sense, manufacturers may find that relationships with master distributors or "one off" collaborations with key distributors to source low cost goods are the best means to hold on to channel positions.

Caveats and Unknowns
The cited changes in this paper are not specific to all durable goods sectors. Some sectors will exhibit many of these issues while others will be subjected to only a few. Migrations in labor from manufacturing to other economic sectors cause an unknown effect on sales per employee specific to each sector. But, the overall lagging of wholesaler distributors in sales per employee versus other sectors is worrisome. In general, the major trends of low productivity, sliding middleman profits, end user demands for cost reduction, maturation of product technologies, new solicitation technologies and increasing acceptance of foreign goods will have a convergence effect that will cause major changes. Management change is eminent in the areas of sales deployment, service resource allocation, strategic marketing, channel management, and holding on to established channel relationships. Much of the outside seller dominance of industrial channels will take a back seat to cost reduction of channel transactions and service redeployment and new service development. Manufacturers and wholesaler distributors are advised to review their industry specific trends and scenario plan for the probable outcomes.

Scott Benfield is a consultant for industrial manufacturers and distributors. He is the author of four books, numerous research studies, and articles on channel issues. His firm, Benfield Consulting, is located in a suburb of Chicago and their Web site is www.benfieldconsulting.com. He can be reached at (630)-428-9311 or at bndldgp@aol.com.

1 Total Sales for Durable Goods Wholesale Trade NAICS 421 in 2002. See the following web address: http://www.census.gov/econ/census02/advance/TABLE2.HTM
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2 Comparisons for NAICS classifications in the Wholesale Sector between 1997 and 2002 with starting and ending classifications being the same were confirmed with Bobby Nusz, The Bureau of Economic Census, on October 13, 2004
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3 Full detail on all sectors available by e-mail request from www.benfieldconsulting.com. 
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4 Benfield Consulting has reviewed sales per employee from vertical sector (PAR) reports for various periods of 5, 10, and 20 years during the 1980's, 1990's and 2000. All of the reviews have found that real sales per employee have not increased to any substantial degree. See our article at Progressive Distributor for the initial research : http://www.mrotoday.com/progressive/online%20exclusives/questforproductivity.htm
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5 See, The China Syndrome, a research project on the movement of domestic manufacturing to foreign shores and the effects on wholesale distribution by Scott Benfield and Richard Vurva, 2003. Progressive Distributor Publisher, www.progressivedistributor.com. 
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6 For suggested reading on services, see the work of Adam Fein and Mark Dancer at www.pembrokeconsulting.com, or see our book, Services That Sell, 2004 reprint, at www.nawpubs.org. 
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7 For a read on the cost of solicitation of outside sales commensurate with their value, see http://www.mrotoday.com/progressive/online%20exclusives/outsidesaleseffort.htm
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8 See our article on Transactional Distribution at http://www.mrotoday.com/progressive/online%20exclusives/transactionaldistributor.htm
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9 Any number of studies of consolidation, mergers and acquisitions have found that post acquisition stock prices have a 70% or so chance of being lower than pre-merger prices. Simply use the verbiage "post acquisition stock price research" in your favorite search engine for any number of studies on this subject.
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10 Benfield Consulting research, Canadian Institute of Plumbing and Heating, 2004.
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11 NAED Research, Valuation and Reformation of Service Offerings, National Electrical Research and Education Foundation 2004/05 research project, Benfield Consulting.
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