“It’s a recession when your neighbor loses his job; it’s a depression when you lose yours.” — Harry Truman in the
Observer (UK), April 13, 1958
Economists debate the timing and severity of the next recession, but most agree we’re overdue. Other than the brief COVID-19 economic setback between February and April of 2020, the United States hasn’t experienced a true, economy-wide decline since the 2007 to 2009 Great Recession. That’s 13 years, while the average time between recessions since World War II is about six years.
For most distributors, the hiring market is still very tight, and the supply chain delivers products at a rate that doesn’t come close to demand. However, there are signs that conditions are beginning to change, which can spell trouble for distributors who aren’t prepared.
On Aug. 2, the Bureau of Labor Statistics announced in a news release titled, “Job Openings and Labor Turnover Survey” (www.bls.gov/news.release/jolts.nr0.htm), that the number of job openings decreased slightly in June vs. May, with the largest declines in retail (down 343,000) and wholesale trade (down 82,000). The New York Federal Reserve reported that its Global Supply Chain Pressure Index reached the lowest level since January 2021.
This matches anecdotal observations we get from distribution CEOs and other executives in our work at Distribution Strategy Group; it’s still hard to find talent and products are being delivered slowly, but things are getting better — gradually. Recent high inflation has led to large interest rate hikes by the Fed, which brings with it the concern that our central bank will “overshoot the runway” — cool things off too quickly and trigger a recession earlier than it would have happened without its intervention.
Nothing good lasts forever; whether it’s this year or soon after, the U.S. economy is going to enter a recession — thankfully a mild one, according to the economists I rely on the most.
However, the impact on distributors could be pretty severe — dramatic enough to trigger some companies to scramble for cash and or even face the specter of bankruptcy. And the two areas that can cause the biggest challenges if recession hits are the headaches you face today: labor and supply chain.
To riff on Shakespeare, “Double, double toil and trouble; beware the talent and inventory bubble.”
Supply Chain Bubble: The Bullwhip Effect
When I worked at Grainger years ago, some smart (aleck) analyst told me, “There are two kinds of inventory forecasts: wrong ones and lucky ones.” In the succeeding decades, I’ve learned — sometimes the hard way — that this is true. Humans aren’t rational.
Customers and salespeople don’t usually worry about your return on working capital. If they can get you to keep more inventory on hand, it’s all upside for them, even if it means you’re burdened with huge carrying costs — not only interest on your line of credit but ad valorem costs if you happen to operate in the dozen-or-so states charging taxes on business inventories.
These are ordinary operating challenges that most distributors know how to manage effectively. What’s not ordinary is the current environment in which the supply chain is so frozen up that rational decision-making is out the window. Humans being humans, we’re all ordering more than we need so we can stock up in case we can’t get more.
During the pandemic, this was reflected in retail shortages of face masks, hand sanitizer and toilet paper. In wholesale distribution, it results in duplicate orders on hundreds of thousands of items. When your customer places an order with you and you can’t deliver it for weeks, there’s a pretty good chance she’ll call another distributor and order from there, too. And maybe a third wholesaler, just in case.
Whoever delivers first gets the sale; the customer will simply cancel the order from the other two distributors. That means there’s three times the demand in the system than what’s real.
But don’t feel smug. Distributors do the same thing for products they can buy from multiple suppliers — and customers are more willing than ever to accept substitutes. There’s a good chance you have purchase orders out to multiple suppliers for the same customer order, and you intend to cancel the ones you don’t need as soon as your ship (literally) comes in.
It creates a multiplicative effect, as shown in Figure 1 (you can change boilers to something you sell).
Here, the actual demand for 10 boilers turns into supply demand for 90 boilers. Now extrapolate this effect across tens of thousands of SKUs. You can see one of the underlying causes of the supply chain crisis as well as a looming problem: What if a third of your backlog is false demand, but your manufacturers start fulfilling your inventory orders at a fast pace?
Remember that when supply chains thaw, they usually do so abruptly and unpredictably. Distributors risk seeing a lot of working capital on the balance sheet moving from cash to the inventory account and — well, you see the problem.
However, there’s a follow-on problem: Current shortages contribute to inflation, so prices are rising rapidly. You’re paying top dollar for all the incoming inventory. Yet when the supply chain thaws, prices on many items (especially commodity-based) often drop. That means you not only have way too much inventory on hand (and way too little cash), but now you need to write down a lot of your stock. For more information on why this is bad, see Chapter 11, but skip Chapter 7 if you can.
Managing Supply Chain Risk
with One Simple Formula
We’ve been in a supply shortage situation so long that it’s easy to forget it will end — but nobody knows when. And that’s a major challenge because you need to manage this risk of having too much stock because, while you don’t want to run out of cash, you also want to maximize your sales from all those backorders.
So here are a couple of suggestions — a basic one from me and a more complex and robust approach from G. “Ravi” Ravishankar at the University of Colorado.
Basic Working Capital Risk Ratio
1. Go through your backlog and identify the largest orders making up 80 percent of it.
2. To adjust to a cost basis, estimate your gross margin on those orders and deduct it from the total value.
3. Now, have your sales reps contact those customers and ask them to assign a probability that they’ll still need the product when it arrives in stock.
4. Multiply the dollar value of the outstanding orders (at cost) by the average probability the customer will still want the product when it comes in.
5. Add up the outstanding purchase orders to suppliers to support those orders.
6. Divide the number you get in step 4 by the one you get in step 5.
7. Try to keep your number at one or below.
Here’s a visual of this simple formula: My friend Ravi’s method relies strictly on your own data. He looks at two factors: supply and demand as a function of your ordering and sales of specific SKUs based on the number of units per period (e.g., monthly).
• Coefficient of variation of supply
• Coefficient of variation of demand
He then prescribes this formula:
If A (amplification factor) > 0, you face the risk of the bullwhip effect.
If A <, you face less risk because you dampen the demand variation.
I realize this is hard to summarize here and so it may be hard to follow. But you can read the awesome whitepaper Ravi did for us at https://bit.ly/3BsPs5F or watch the webinar (https://bit.ly/3TTVaoe); both are free.
Preparing for an Overstaffed State
If you’ve been a manager for any length of time, you’ve probably been involved in a layoff or two — sometimes as the leader letting people go, sometimes as the person losing your job. I know one person who was a part of both during the same layoff. First, his boss made him lay off several of his best people. When it was done, his boss laid him off, too. That’s how you avoid most of the dirty work if you’re in charge, I guess.
I’ve been managing professionally for 30-plus years and firing people is a terrible responsibility. It’s even worse when it’s not about their performance; the budget cuts have simply reached the point where you can’t afford to keep all your talent.
It’s painful and perhaps why many managers are unprepared when the time comes to take hard action to reduce compensation costs. Of course, it’s better if you don’t get into that situation in the first place, so I want to offer two tips to help prepare for a recession. I’ll start with the kinder, gentler approach; be aware that hardly anyone does this, which is surprising.
1. Avoiding overstaffing prior to a recession
What would happen to your P&L if all your outstanding job requisitions were filled tomorrow? Go ahead and look at your job postings and total up the salaries, commissions, bonuses and benefits and add them to your current employee cost line.
This is an important exercise to do from time to time because most companies have an approval process before human resources can post a new position, but hardly anyone keeps track of the total cost of all those outstanding requisitions. It’s usually not a problem because companies are growing and it takes a long time to hire people, so the ongoing attribution of employees who leave offsets some of the costs of the new hires.
But when a recession hits, several reactions occur at the same time. Your outstanding requisitions begin to get filled quickly; candidates get fewer offers as the job market cools, so you have less competition. Natural employee turnover slows down dramatically because there are many fewer alternatives and people are nervous, so they keep their current jobs. And you quickly find your total compensation as a percent of sales climbs dramatically as you’re trying to scale costs down as revenues flatten or decline.
So, I recommend that distributors continuously monitor the total costs of their outstanding job requisitions and review them all on a regular basis. Another smart step is to create three revenue scenarios for the next 12 months and, if you think a recession is coming, scale your compensation limits to the pessimistic case.
I know how maddening it is to have a dire talent need and not be able to fill it. It’s even more frustrating when you have an open req and suddenly hiring is frozen.
But absolutely none of that compares to laying off great employees. A little measurement and prudence may allow you to avoid that miserable, stressful work by keeping an eye on how you’re trending to build up employee costs right now.
2. Plan your layoffs now
Don’t wait until you need to do this awful thing to plan for it. Very few companies get by for years and years without a general layoff. It’s likely to happen to your company, and the sooner you have a plan in place, the better.
Educate yourself now on labor laws relating to employee actions such as this — you not only want to be fair but you don’t want to get sued. It’s very easy to think you’re being perfectly objective and lose a lawsuit anyway.
Have human resources prepare the documentation (with no names filled in, of course) so that when you need it, it’s passed legal muster and is ready to go. If you don’t have one, develop your severance policy now and accrue for those expenses if they’re significant. Ask your CFO, controller or a trusted analyst to run various models showing what levels of employee costs you’d need to achieve using the sales scenarios I mentioned earlier.
There are risks. Word gets out quickly that layoff plans are underway, and it can spook some of your best talent to jump ship. However, if you think you can keep it quiet, begin educating senior leaders on the legal aspects of layoffs and coach them on how to have those tough conversations. When you sense a recession getting closer, develop lists of employees who would get the bad news and review them for legal exposure.
In my experience, it takes some iterations and time to get managers to a place where they know what they must do. If you rush it because you aren’t prepared, you will not only expose yourself to liability, but you’ll potentially do the layoff wrong, causing avoidable pain and watering down your talent more than necessary.
The Times are Changing
I’m sure at this point, with a red-hot economy, supply chain shortages and a tough labor market, you’re probably reading this and thinking (sarcastically), “I bet this guy is fun at parties.” However, there are always boom and bust cycles in economies and we’ve been booming for a very long time. The bust is coming — and I hope it really is a mild one. In any case, there are a few cracks showing and when things go bad, it’s likely to happen fast.
As a distributor, your two biggest expenses are people and inventory. By planning properly now, you can not only survive the recession when it hits but be positioned to thrive, at least versus your competitors.
Keep in mind that even if you think you’re preparing a little early, it’s better than being taken by surprise.
Ian Heller is co-founder and chief strategy officer for Distribution Strategy Group. He started his distribution career as a truck unloader at a Grainger branch and rose to vice president of marketing for the company. Ian later served in similar roles at GE Capital, Newark Electronics, Corporate Express and HD Supply. He writes, speaks and consults on technology-driven changes and disruption in the wholesale distribution industry. He can be reached at firstname.lastname@example.org