Squeezing the Distribution Channel

         How Transaction Economics and E-Business Transform the Supply Chain

     Buy-sell businesses of durable goods products transact approximately $7 trillion annually in North American commerce at the wholesale level. There are close to four dozen vertical product-markets represented; from nurseries to industrial mro (maintenance, repair and operations). Buy/sell businesses, however, are undergoing substantial transformation as e-business grows. Today, approx. 17% of all B2B goods are transacted via e-commerce. This means customers from manufacturing facilities to building contractors are online, every day, getting their needs met through self-serve options. Forrester forecasts that B2B online commerce will grow at a 10% CAGR for the near future and this is up from an 8% annual growth rate just a few years ago. By 2025, a full quarter of B2B durable goods will be transacted online.

  E-business began in earnest around the Great Recession. This was when software became specialized for B2B transactions and gave a sales-assisted experience. In the past decade, online commerce has grown rapidly in the B2B sector and outpaces consumer transactions. Looking closely at the durable goods sector, we find significant stress on traditional branch, store, and sales intensive firms as new entrants emerge. Often these competing firms don’t look and operate like the old-line firms they compete against. Often, they are newly founded entities from outside the space. Our work and research on these new, online competitors finds that they are handily competing against established buy/sell businesses. These firms represent almost half of all B2B online sales but represent less than a fifth of online firms.1 We count approximately half a dozen new models of online commerce, and their variants, that compete against traditional brick and mortar firms. And, while many take a slice out of the value chain offering a very different configuration of service and product, there is one model that is having the greatest effect and the operating and market strategy is based on transaction economics.

 Transaction Economics

    Traditional time-period accounting is limited in helping buy/sell managers make strategic decisions. The problem is that operating expenses are time-period based and do little to pinpoint which products, segments, customers, etc. contribute to operating income. Managers have long known that different transactions have different fulfillment cost profiles and yield very different contributions to operating profit. The field of activity costing found ready listeners in supply chain firms in the 1990’s and has continued to be refined for managerial insight and strategy. After several decades of usage, most executives acknowledge that terms such as gross margin percent, margin dollars, customer sales, etc. mean little, from a profit generating understanding, unless the underlying transactions are paired with fulfillment costs. The field, called Transaction Economics, has been studied both inter and intra-firm for over three decades. Our work, using labor coefficients with differing transaction types,2 finds that three transaction-based measures had the greatest return on capital including: type of transaction and its unique cost, size of the transaction in top-line sales, and mix of transactions in a given time period. Additionally, we found where margin dollars and margin percent, in any time period, had limited correlation to a transaction’s or customer’s contribution to operating profit; traditional time-period accounting metrics for buy/sell businesses count but do not adequately measure.

   While our findings may be difficult for some, a retail sector example illustrates our point. Costco, the $150 B+ retailer, has gross margins of 13% on sales but yields a respectable 3% of sales in operating profit and return on invested capital of 17%. This is compared to retailers who strive for 25% or more in gross margins, have operating profits of 5% + of sales, and returns on invested capital that are 50% to 70% less, comparatively, than Costco. Additionally, Costco pays hourly employees significantly higher (often 30% +) more than its competitors. 

   A countervailing argument regarding Costco membership fees exists in that the firm earns some $3B (2% of sales) on the fees. However, if the firm raised prices 2% and did not charge for membership, a resultant 15% gross margin would still be significantly less than competitors. 

    Unlike traditional staple retailers, Costco sells large transactions of staples. Large sales transactions cover their fulfillment costs and drive profitability in a buy/sell business as they outrun fulfillment costs. However, we find attempts by traditional brick and mortar firms, to increase transaction size alone, often cause the firm to lose money faster and these efforts are questionable as e-competition grows. 

    Our work and research have found traditional brick and mortar firms’ attempts to drive transaction size often back-fire. The problem is that effort is concentrated on small customers and small transactions. This includes seller time or “high-touch” options and while average transaction size may increase for small transactions, seller time is wasted on making small customers and small transactions less unprofitable. Small transactions may increase their average revenue and/or more net new small customers are sold, but the operating costs, in any time period, increase faster than sales. Hence efforts to drive sales on small transactions and sell more to small customers back-fire, the firm simply loses money faster. This is to the delight of competitors who understand transaction economics at a strategy level and are all to happy to let less enlightened competitors load up on money losing, small account efforts.

    In most firms, a full 40% or more of transactions and customers don’t reach breakeven over their fulfillment costs. This means that there is a forty percent chance that sellers and management spend extra time on loss producing efforts. A better, more strategic approach is needed than simply trying to load up small orders and small customers with more lines per order.  Our work, over 10 years of activity costing with labor coefficients, finds that 40% of customers and transactions produce 135% of operating profits, 20% of transactions breakeven or nominally add to operating income and 40% of customers and transactions lose scads of money.  Fortunately, for a few enterprising firms, this observance has turned into business models that are quickly taking share from traditional distribution firms. 

 Transactional Distribution

    As software for B2B e-commerce came to market around the Great Recession, we noticed new online business models competing against traditional brick and mortar distribution.  For the most part, these firms did not emulate their wholesale competition; they didn’t look like distributors as they had few branches and sellers. In 2011, Grainger launched Zoro Tool to go after small customers with a competitive price and self-serve format. The entity was separated from core Grainger that, for most intents and purposes, served medium and large customers with a high-touch experience. Today, we estimate Zoro Tool at close to $700mm in sales while operating out of 10 or less warehouses in North America and Europe. The growth of Zoro is exceptional in that the firm started from scratch less than a decade ago and their growth is organic in an industry that grows at 2.5% per annum.

   Zoro’s success is in its platform that is primarily for self-serve customers and avoids the traditional Grainger high-touch offering. Before Zoro, Grainger’s online efforts were an extension of their existing value proposition. As Zoro was developed, management realized that it needed a different environment and different culture than the corporate parent, hence they placed the company in Burr Ridge, IL, approx. 45 min from corporate headquarters. Grainger is an example of Transactional Distribution, a moniker giver to supply chain firms that use e-commerce and a new operating strategy to get cost out of the supply chain and pass the savings on to the customer. Transactional distributors can typically sell at prices 10% or less than full-service/brick and mortar firms and their ROS is 3x that of traditional competitors. 

    Transactional Distributors, today, play at the small and large transaction end of the channel. They are becoming more powerful putting margin pressure on traditional distribution and hard-goods retailers.  Exhibit I gives a visual of transactional distributors and their ability to squeeze existing distribution.  There are two basic models of transactional distributors, the Small Order Size and

Large Order Size variety. Small order size models are aggregators of “gazillions” of skus for commerce. Zoro Tool, for instance, has over 3 million skus3 and calls their offering an “endless aisle.” More well known is Amazon Business, the five-year-old effort by Amazon to enter the B2B arena. The forecast is for Amazon Business to sell $25 Billion by 2021 and up from 1 Billion in its first year.4 Amazon Business offers partnership options and sells almost half of its revenue from these relationships in a marketplace arrangement where fees are typically 12% of sales volume. Recent forecasts by distribution subject-matter experts predict that marketplaces will overtake individual distributor websites as a preferred buying experience.5 

    Small order size transaction firms go after small buyers or non-specific buyers. They drive transaction breakeven by large sku counts, best in class faceted search, limited in number but massive distribution centers and top-notch logistics and e-commerce. Most distributors have a transaction breakeven of $150 to $250 dollars at a 25% margin. Amazon’s breakeven transaction is $15; hence they can leverage cost by a factor of 10x and take the cost advantage to the market place. Far too many executives of buy/sell firms underestimate the application of technology to the supply chain to reduce cost, improve quality and deliver a better experience with a better price. A lesson from history will explain our case.

    In a study of the livestock supply chain from 1860 to 2000, the price of a steak dropped from 2 days’ wages to less than an hour. Across the 140-year history were a series of technologies including barbed wire, rail transport of livestock, refrigerated trucking, and grain-fed silage which drove down product cost and increased the buyer universe.6 Winners rose and losers fell with changes in technology. Cowboys were replaced by the railroad, large ranches by grain-fed beef, and stock-yards by refrigerated trucking. When it comes to winning supply chain strategies, firms would be well-served to remember lessons from history in that the low-cost supplier, who applies technology to process, usually wins.

   Large order size strategies have appeared, for the most part, within the last five years. They are predicated on the fundamental principal of transaction economics that large orders absorb operating costs while contributing, inordinately, to operating profits. Large transactions are often the result of professional users or constant users of product which includes industry, contractors, and institutional segments. As e-commerce has grown, professional users are comfortable in ordering commodities and consumables online. Traditionally, their orders have been large and repeat but, today, they use e-commerce, and new supply chain models, to drive cost out of transactions. As distributors analyzed their customer segments, professional users were a target for new business models that used online technology to drive cost down while designing new business models to improve transaction size per sale. 

    An example of large transaction strategies can be found in distributors as diverse as Ferguson, Fastenal and Home Depot. Ferguson has proven adept at buying and funding new online business models including the 2017 acquisition of A/C Wholesalers. The company is one of a growing group of online firms that sells HVAC equipment to the end user and bypasses the dealer who duplicates sales, storage, and transaction costs. The HVAC channel has used a three-step configuration (Mfg.-Distributor-Dealer-End User) for decades, however, firms such as A/C Wholesalers bypass the dealer and sell direct. The transaction size for replacement condensing units, for instance, is well over $1000 and there are enough margin dollars to pay for fulfillment costs in the vast majority of orders. The Ferguson advantage, in acquiring A/C Wholesalers, is that they can offer same day delivery to a national footprint, something their competition cannot do. 

    Fastenal has driven significant growth with their vending machine solutions. For the recent year, the company has over 100,000 vending machines transacting nearly $1 Billion in sales. This means the average vending machine sells $10,000 per year and, more importantly, it takes an average $30 transaction and lets the customer transact it on site while taking redundant order entry, packing, shipping, and delivery cost out of the channel while reducing loss.7 

   More recently, Home Depot announced a Pro delivery service for contractors. Contractors for the big box store are 4% of customers but 45% of sales. The pro customer is highly desired in the retail business as numerous small transactions are part of the existing business model. The Pro delivery service for Home Depot uses a flatbed truck that is aptly named the Flatbed Distribution Center (FDC) for palletized quantities of goods that go through an automated warehouse. The transaction sizes, by dint of the warehouse and logistics design are large and considerable cost is taken out of the transaction over local store/branch fulfillment. 

    The initial FDC in Dallas is over 800,000 square feet and can handle 65 to 75 trucks per day, delivering thousands of transactions, within a 75-mile radius.8 The FDC strategy is planned nationwide over the next few years and is well-positioned to compete against the branch-intensive distribution in phcp, electrical, and building supply verticals. The FDC pricing strategy is unknown, however, transaction size business models often reduce transaction cost and use the advantage in the marketplace over less efficient competitors. The service holds hope for the commercial construction sector which has been bedeviled by low productivity and where current distribution models appear to a part of the problem and not part of the solution. 

 Operating Costs, Service Inefficiencies, and Future Steps

    E-business strategies using transaction economics are just beginning their growth in the supply chain. Often these business models drive new value streams that slice apart traditional distribution/retail models. They are greeted with skepticism by established brick and mortar managers; they don’t look or act like traditional firms. Existing distribution and retail execs think branches and stores and, too often, their e-business strategy is sales driven through existing brick and mortar footprints. Mostly, they add e-commerce to their existing model and consider it strategy. Transaction based models, however, have shown a deeper understanding of the cost behavior of existing models and how to use economics of transactions, combined with e-commerce, to create models that are disruptive.  

   In the history of buy/sell firms, is a model driven by geographic saturation where the local branch or store was tasked with getting as many sales as possible. The result is that many transactions lose money and a small part of the money-making transactions are responsible for the profitability of the whole. Our financial modeling has found where disruptive strategies can target the 40% of accounts that make up 135% of operating profits and a mere 15% sales loss can equate to financial disaster.9 Adding to the vulnerability of the brick and mortar firm is an operating model that is sales driven and, to drive higher revenues, sellers have fomented service promises to differentiate commodities. Today, the central operations of many buy/sell firms are impossibly complex with service promises that resemble a Gordian Knot of complexity. Every process is an adventure and SOP (standard operating procedure) is whatever you imagine it to be.

   The upshot is that many supply chain firms can’t adequately map process flows and get redundant costs out. This is especially true if their I/T systems are dated and not sufficiently integrated. In these firms, labor costs, the largest operating expense category, remain stubborn as reduction in operating expenses reduces service quality as knowledgeable employees are need to inspect quality into basic processes. Hence, they cannot be easily streamlined. Time and again we see executives cut labor costs in these firms only to find that service quality suffers and, in a later time period, per location sales fall as customers experience sub-par service quality. 

   Executives in old-line buy/sell firms can learn from the moves of existing firms including Grainger, Ferguson, Home Depot, and Fastenal. The following observations can help:

 ·       Develop an accurate transaction model and aim it at customers, segments, departments, and business units

·       Review the most profitable transaction entities and ask “Can we enhance the entity by using e-business models in a new configuration or can we develop a new business model that targets the transaction profits of our competitors?”

·       Consider that many of the most successful online strategies are new entities, separated from the old-style brick and mortar firms replete with a new mandate and new management.

·       Review existing channels for inefficiency that can be disrupted. For example, in targeting the HVAC channel, Ferguson’s A/C Wholesalers is taking advantage of a channel with too many steps and hence redundant costs.

·       Move small transactions, as much as possible, online or even to competitors. Note: Amazon Business does this within a marketplace format; they outsource low profit transactions to partners while getting paid for managing the marketplace. 

These are the more prominent observations from our experience in using transaction economics, combined with online commerce to develop disruptive and highly-successful strategies in buy/sell firms. While there is still room to improve the fortunes of existing brick and mortar firms through additional technology and better processes, the future is leaning toward new supply chain firms that have a keen understanding of transaction cost, cost behavior, and taking cost savings to the customer to drive financial gain.

 Scott Benfield is a consultant for durable goods firms in e-business strategies. He is the author of six books on supply chains and has consulted for Fortune rated and mid-market firms for two decades. He resides in Chicago and can be reached at [email protected] or (630) 640-5605.                                                     

 1 Bughin, J., Van Zeebroeck, N., “The Best Response to Digital Disruption,” Sloan Management Review, April 2017

2 Benfield, S. “Building Value: Driving Wholesaler Returns Through Strategic and Tactical Investment,” Nov. 2012

3 Hockett, M. “Grainger . . .Details Zoro Growth Plans,” Industrial Distribution at: https://www.inddist.com/earnings/news/21093766/grainger-q3-sales-up-4-yoy-details-zoro-growth-plans Oct. 2019

4 Power D., “Amazon Business: Bent on being the go-to B2B platform,” CO Magazine, July 2019, at: https://www.uschamber.com/co/good-company/the-leap/amazon-business-b2b

5 Galentine, E. “Are online marketplaces the future of distribution . . .” MDM Online, Feb. 2020 at: https://www.mdm.com/blogs/20-distribution-operations/post/40720-are-online-marketplaces-the-future-of-distribution

6 Benfield, S., Griffith, S. “Cowboy Economics: A study of the livestock supply chain, 1860 to 2000, White Paper, 2006. Abstract at: https://www.inddist.com/operations/blog/13764434/what-are-we-selling-when-we-sell-ecommerce Industrial Distribution, 2015.

7 Statistics derived from Fastenal Report on Vending Machines for 2019 at: https://investor.fastenal.com/news-releases/news-details/2019/Fastenal-Hits-Industrial-Vending-Milestone-100000-Active-Devices/default.aspx

8 Halkias, M. “Home Depot launches new pro customer delivery in Dallas,” Jan. 2020, Dallas Morning News at: https://www.dallasnews.com/business/2020/01/28/home-depot-launches-a-new-pro-customer-delivery-system-in-dallas/

9 Benfield, S. “Distribution’s Achilles Heel in Online Commerce,” April, 2018 at: https://www.dhirubhai.net/pulse/distributions-achilles-heel-online-commerce-scott-benfield/