Distribution Channel Profitability

By Kenneth H. Manning

Copyright © the Institute of Management Accountants, Management Accounting (US), January 1995 Kenneth H. Manning This work is protected by copyright and the making of this copy was with the permission of Access Copyright. Any alteration of its content or further copying in any form whatsoever is strictly prohibited.

The methodology assumes that the practitioners have at least a conceptual view of an ABC approach. which makes the translation to channel or customer difficult using conventional approaches. the methodology presented here allows practitioners to determine the relative profitability of their distribution channels and customer groups. general. you need reliable and accurate information. This approach creates two cost pools: product costs and sales. is shown in Figure 1. As major retailers. although a working knowledge of ABC techniques is highly recommended. but there are numerous issues that it cannot address. . and administrative (SG&A) costs. and supplier. this approach may yield accurate profitability figures.1 ABC provides a more accurate view of a company's cost structure than a standard cost approach. wholesalers. One approach to gaining the necessary data is constructed around activitybased costing (ABC) concepts that many companies have adopted over the last several years. Distribution costs are a fact of life for almost every manufacturer. COMPARISON OF THREE APPROACHES The typical approach to developing knowledge of channel profitability. it has all the drawbacks associated with traditional standard product costing. distributors. The benefits of ABC have been discussed in great detail in other publications and will not be presented here. using standard product costing. If the organization is aligned by channel or customer group. which have been shown to distort costs in many situations. Manning Which of your distribution channels is most profitable? If you analyze them using an approach built on activity-based costing (ABC) concepts. particularly for companies that produce a broad range of products and volumes. all participants in the supply chain need to understand the revenue and cost trade-offs associated with the various channels through which they deliver products and services. companies are aligned by region.Distribution Channel Profitability By Kenneth H. product line.2 Building on these ABC concepts. This approach may help answer some questions related to distribution costs. you may find an unexpected answer. and manufacturers reconfigure their supply chains. and estimate the impact of improvements on the overall business. In addition. But most often. To evaluate strategic issues within the distribution system. The product costs are transferred to the channels based on standard unit costs and the product mix sold through that channel. or facility location. The SG&A expenses typically are allocated to the channels based on net revenue or sales volume by channel. formulate potential responses to those issues. distributor.

Because this approach makes no attempt to adjust product costs. The result is improved accuracy over the typical standard costing approach. FIGURE 2 ABC APPROACH TO CHANNEL PROFITABILITY Product A Activity Costs Product B Product C Product D Product E Product F Product Related Cost Product A Product B Product C Product F Channel A Product A Product D Product D Product E Product F Channel B Product costs allocated to distribution channels by volume mix. SG&A Expenses Product Costs Based on standard costs and product mix sold thru channel. FIGURE 1 STANDARD APPROACH TO CHANNEL PROFITABILITY Allocations based on standard costs or net revenue. SG&A Expenses SG&A Expenses SG&A Expenses Product Costs Product Costs Product Costs Total Cost Structure Channel A Channel B Channel C A more refined approach to channel profitability is to use an ABC methodology. Overhead costs are allocated to product lines in a more logically related fashion than under the conventional approach. Figure 2 illustrates the more accurate ABC approach to this problem. Product A Product C Product E Channel C Material Costs Total Cost Structure . the analysis related to product costs can be misleading. The ABC approach has one large advantage over the conventional approach: It costs products more accurately.

. it was not possible to detect if product costs were high due to certain customer groups or to certain channels. Examining the cost structure from this perspective allows management to understand cost differences related to any one of these categories or related to interactions between these categories. For most companies. Focus on relevance over precision. this approach gives us additional insight into the reasons for the product line cost position by creating three different types of costs: product-related costs. the analysis is based on one major assumption that is probably not true: that all costs are product-driven costs and therefore must be traced or allocated to products.) FIGURE 3 SCM APPROACH TO CHANNEL PROFITABILITY Activity Costs Customer Customer Customer Customer Channel Nonactivity Costs Product Product Total Cost Structure Related Costs Channel A Channel Channel Channel Product Channel B Product Channel C DEVELOPING ACCURATE CHANNEL AND CUSTOMER COSTS The approach used to develop this view of costs relies on several guidelines: § § § Include all costs (direct. (See Figure 3. indirect. The strategic cost management approach outlined below recognizes that cost is not driven solely by the products produced but also by the customers served and the channels through which the product is offered. Under the traditional ABC methodology. Removing the restriction that all costs must be related to products allows the development of a more accurate view of cost consumption.The drawback to this approach is that while we are allocating cost in a much more logical and rigorous manner. overhead. and customer-related costs. organizational costs are driven by more than just the products they produce. However. implicit). channel-related costs. Use issues to drive analysis.

If a cost component cannot be related to just one category. or customer related. it is necessary to identify the tracing factor that relates those costs back to the appropriate products. TABLE 1 COST BEHAVIOR OF ACTIVITY COSTS AND NONACTIVITY COSTS Product Related Activity Costs § Schedule Production § Setup and Changeover for Machine A § Test Quality Parameters § Maintain Equipment Channel Related § Attend Trade Shows § Order/Invoice Processing § Sales Force § Telemarketing § Advertising Brand A § Arrange for Shipping § Trade Discounts § Freight Customer Related § EDI and Computer Interfaces to Customer § Special Shipping and Handling Requests § Collect Bad Debt § Technical Support for Customer A § Prepare/Deliver Annual Sales Bid § Bad Debt Expense § Customer Rebates 2. channel-related. Each cost component should be related to only one category. which is outlined below. Trace these costs to the individual products. Table 1 lists several activity and nonactivity components one would expect to see in a manufacturing company. or. They are used to trace the activity cost to the individual component groups. The number and detail of these components should be determined by the issues the study is addressing. product line A. The activity and nonactivity components are organized into three categories of cost behavior: product-related. and channel-related (see Table 1).The methodology follows a four-step process. or customers. . channel A. and so on. customerrelated. Once the different cost components are classified as product-related. and customers. Tracing factors are quantifiable. repeatable measures that closely approximate the level of effort associated with an activity. either further decompose the activity or nonactivity definition.. Through the use of traditional ABC concepts. Nonactivity Costs § Material Costs § Royalties Identify the cost behavior of all activity and nonactivity costs. product line B. The cost structure of the organization should be translated into activity and nonactivity components that reflect the operations of the enterprise. channels. 1. Separate the organization's cost structure into activity costs and nonactivity costs. e. channels. assign the component to the primary behavior category. the cost associated with each of these components should be estimated.g. 3. if it is judged immaterial. The sum of these component costs should equal the organization's total cost structure.

or channel that created them. Attempting to perform these manipulations without the assistance of a powerful PC would be impossible.140 208. As companies develop future business plans. TABLE 2 ACTIVITY COST OF NON-EDI ORDER PROCESSING Activity: Non-EDI Order Processing $ 78. These two matrices then are used to translate the costs driven by each channel into a total cost view for product. product. channels. In essence. Nonactivity costs are treated in a similar manner. But alternative views certainly are becoming more important as products are served through increasingly varied channels – distributors. and customer. and customers for which costs were calculated. The second matrix links the customer and channel view by capturing the customer purchases by distribution channel. The first matrix links the product and customer view by capturing the customer purchases by product. the activity cost of "non-EDI order processing" was determined to be $432. CHANNEL/CUSTOMER VIEW The traditional ABC approach is probably most consistent with the way corporate planners think about business strategy and planning: by product area. catalogs. The majority of businesses are formed around product lines and product groups. it is now . PRODUCT VIEW VS. Translate the product. The final step requires that two matrices be constructed for the purpose of linking these three views.903 $681. as shown in Table 2. The number of order lines filled was identified as the tracing factor. 4. nonactivity.For example.095 229. channel. In most cases it will be possible to allocate those costs directly to the product. except direct cost linkages are easier to find for these items.043 Channel A Channel B Channel C Total This same procedure is performed for all cost components to develop a total cost view for the three types of cost categories. Obviously. but with the introduction of the PC and numerous software applications. or channel. and so on. it is also necessary to capture revenue information for the same products.500 Tracing Factor: Number of Order Lines $123. mega-stores.500 for the one-year period.045 328. a fact that obviously influences the way we think about them. customer. Following this methodology will provide any necessary cost view of the organization. direct mail.358 146. and customer cost elements into a total cost view for the business. understanding the cost and profitability of serving different channel and customer groups will become critical to making good business decisions. channel. we have recast the entire company's costs and created a database of costing information around several new views: activity.002 $432. customer.

He believed that the targeted segment provided a significant portion of the division's profit although the financial report indicated that it was not very profitable due to above average discounts. bulk delivery. accurate channel and customer costs is worth making only if you need to address business issues. The gross sales generated by small customers did not cover even the cost of selling and servicing these accounts. a direct sales force. due primarily to less customer service. lower bad credit expenses. which slowed process run rates. It turned out that smaller customers often had limited resources § § § .relatively easy. The "true" cost difference among the different delivery options was surprising. The key issues should be identified. Cost differentials within the large customer grouping depended on the use of the product. The effort to arrive at good. or less-than-truckload (LTL) delivery. The head of sales and marketing decided to sponsor a study to understand the "true" profitability of the various delivery options and customer groups (or market segments). and articulated in advance of any analysis. Customers in the food industry consumed more technical marketing. The data are organized in a way that encourages analysis of a number of different issues. the sections below describe how two companies facing different competitive issues could use the approach to develop their strategic responses. The study team uncovered several significant findings: § The large customers did provide a disproportionate percentage of the division's profits. The products were made primarily in-house although some were purchased and repackaged and then sold through a network of representatives. documented. The vice president of sales & marketing particularly was concerned. The management team knew that the impact would be negative but did not know to what extent. The best results have been obtained when this methodology was used in an issues-driven approach – the type and nature of the decision being made should drive the level of detail and direction of the analysis. consumer products. demanded more research support. It recently had become known that a new competitor was planning to enter a key segment of the company's market. and a telemarketing customer service center. FOCUSED COMPETITOR ENTERING MARKET A specialty chemical manufacturer supplied products to a broad range of customers in the food. For instance. and reduced handling charges on large orders. The study revealed that the customer pick-up option after adjustment for freight charges actually cost less than the other delivery options due to much lower damage claim losses and reduced freight scheduling costs. and manufacturing industries. Customers could opt for several delivery and pricing options including customer pick-up. The conventional cost approach assumed that the only difference between these options was the freight costs. despite their much lower gross margin. and required a finer-grade product.

§ Several of the large-volume outsourced products did not provide sufficient margin to cover their full distribution costs. several competitors recently had started to shift their focus to other distribution channels. The company began to look actively for other suppliers for the products they outsourced so as to improve the profitability of this operation. these costs went undetected for the most part. food processors. The sales force then attempted to discover customer problems that could be solved by making these valuable resources available to the customers. While the impact of the new competitor definitely would be negative. the company's management decided to undertake a distribution profitability study focused on understanding the strategic value of the sales force. While competitors moved away from dedicated sales forces. the head of sales & marketing worked with the vice presidents of operations. The customer pick-up delivery price was lowered to attract more volume through this channel. because these companies did not use sufficient volume to take advantage of the new price discounts. This move was intended to attract the largest-volume users of the product – consumer product and manufacturing. the overall effect would be mitigated substantially by these responses. Because there was no rationing mechanism or internal R&D tracking system. 2. Using the cost and revenue information in the model. R&D.with which to solve technical problems and relied on the company's assistance in this area. As a result. It also had the advantage of encouraging the competitor to take away our lowest-margin business. management was able to estimate the impact of these changes on the overall results under several different scenarios. the study indicated they were unprofitable once the inbound logistics cost and purchasing cost were taken into account. Due to several periods of unsatisfactory results and the continued growth of alternative distribution and sales channels. . however. Technical resources were shifted away from smaller customers and assigned to work exclusively on the large consumer product and manufacturing accounts. they decided to redesign the vendor relations group and reengineer the purchasing process with the goal of reducing the overall handling cost by 50% for purchased goods. The R&D department also created a simple time reporting system to track these "soft" costs better. In addition. Given this information. SALES FORCE RESTRUCTURING An industrial equipment supplier had one of the oldest and most capable sales forces of all the suppliers in its field. 3. the management team chose not to pursue these alternative methods because they still considered the in-house sales force a source of real advantage in the marketplace. and finance to develop the following set of responses: 1. While they appeared profitable under the standard cost and profit reporting system.

The primary issue management wanted to address was sales force effectiveness. Sales volume did not correlate with restated customer profitability. in fact. management became aware of several points that had not been clear before: § § § § Some high-margin product lines that were thought to be profitable were. management estimated the impact of several changes to the structure. . With this cost baseline. relatively profitable. One product line that was low margin and thought to be a loss leader was. several representatives were taken on to serve those customers who were smallto medium-volume purchasers and did not require technical expertise from the sales force. By building this detail. management formulated several changes in response to this new information: § § The loss leader was priced lower to attract additional volume from existing customers. Based on these findings. § The sales force then was refocused on those customers who valued their technical expertise and would be likely to buy additional product lines from this supplier in the future. unprofitable due to the channel-related costs. A FRAMEWORK FOR DISTRIBUTION ISSUES After performing the analysis. The cost savings from shifting the sales force more than compensated for the margin passed on to the distributors. so the analysis was structured to focus on this aspect of the cost structure. the company could see the relative profitability of the various channel configurations and the source of cost differentials. In addition. These reps were offered a margin that encouraged them to deal exclusively with this company. depending on the activity. Another product line was dropped because the primary customer base for it was extremely unlikely to buy any of the other products. The detailed log of sales-force activity was tracked to customers or channels. In addition. The cost of selling product differed dramatically depending on the customer application. Combining these cost and profitability views with an understanding of the customer buying factors provided insight into several issues. By creating a very detailed cost picture of the various channels. and the revenue from these single-product customers would never justify the cost to serve them through a sales force. in fact. management was able to see the sales force costs consumed by different customer and product groups. the cost differential between the company and its competitors was estimated from knowledge of how its competitors' activities and sales volumes differed across their sales forces.

pp. this company was able to shift its sales resources to those opportunities that provided better long-term growth and profitability. The analysis described above forms the basis for multiple types of decisions including: pricing levels. The findings and models developed in this phase can be used to evaluate current performance. September/October 1988. August 1992." APICS. cost reduction targets. This approach is not presented as the complete solution to the distribution issues of the 1990s." Harvard Business Review. warehouse investments. pp. . and track improvements from new distribution strategies. 1 Robin Cooper and Robert S. 2 Philip Rhodes. new channel options. "Measure Cost Right: Make the Right Decision. Kaplan. "Activity-Based Costing: What Will It Do for You?. but it is a very important analytical framework that should accompany most distribution strategy developments. and selection of target markets and key customers. estimate future impacts. make/buy decisions.By assessing the cost and profit differentials among customers and channels. 96-103. channel rationalization. 29-31. It forms the basis for developing a solid quantitative understanding of the current distribution and customer situation.