Distribution is a competitive business with thin operating margins. The difference of a few percentage points on a product can make the difference between a sale and losing a sale. This is especially true for commodities which comprise some 60 percent or more of distributor product sales. With the increase of Internet competitors (see part 2 of this series in the July 2019 issue), there has been tremendous pressure on full-service distributors to compete with low-cost, made-for-e-commerce competition.
These e-commerce competitors began to form in the last 15 years. They go to market in different ways including bypassing links in the supply chain, consolidating redundant functions, limited outside sales efforts, limited branch locations or reworking the supply chain relationship with assembly and engineering services. For the most part, these competitors have a much lower operating cost than full-service distributors and they take this cost advantage to market in the form of a lower price.
To compensate, distributors competing against these firms have increased their usage of special pricing allowances (SPAs) to their manufacturers. SPAs, and special pricing dispensation, has been around for decades in the form of exclusive quotes for projects in decades past.
Today, however, we have seen a sharp increase in their usage. Our 2018 research on vendor funds usage found that 18 percent of wholesalers, labeled top performers, used SPAs at the rate of 7 percent of the cost of goods sold (COGS), while average performers (66 percent of all wholesale distribution firms) used them at the rate of 2.1 percent of COGS. The difference of 5 percent of sales in COGs is substantial in a business where the before-tax return on sales is in the 3 percent to 5 percent range.
Top-performing firms, on further review, were more likely to lead in online sales and are expected to go after contested sales coming from made-for-e-commerce firms. We call these sales assisted and they are a quickly growing part of distribution selling with significant implications for the distribution firm as we know it.
The Assisted Sale, Volume Projections and Effect on Distribution Value
SPAs grew, in large measure, in the past 12 to 15 years. They started in a big way with the electrical sector in the mid-2000s and quickly spread to associated industries.
They can take any number of configurations but involve a competitive price for a specific customer, contested sale or product for an identified period. Distributors typically have to substantiate the sale of the product with sales records and the manufacturer reimburses the distributor. SPAs are voluminous and require specialized software to track them. We categorize seven different steps for processing the standard SPA transaction and, repeated thousands of times, the amount of detail is difficult to perform with spreadsheets.
Exhibit I shows the difference between top, average and below-average performers in SPA volume for an account with $1.5 million in purchases. Top performers, with 6.7 percent of COGS in SPAs, use 215 transactions and 645 lines, as opposed to average performers who have $22,500 in SPAs and use 65 transactions and 195 lines. (Note: We used a 25 percent gross margin for the exhibit and three lines per transaction).
When top performers’ SPA volume is multiplied across numerous accounts, it is rather apparent that spreadsheets are inadequate to identify, track, compute and remit for funds. This is why 80 percent of top performers use specialized software in SPA management.
The use of SPAs will change the management structure of the firm with respect to vendor relationships. Today, sales and purchasing largely control SPAs but we foresee where executive management will want to see their progress and usage regularly as they grow in importance. A quick review of the volume growth of SPAs gives insight into the need for executive oversight.
In Exhibit II, we compare top performer vs. average performer usage of SPAs for a distributor with $250 million in annual sales averaging a 25 percent GM and 20 percent SPA margin. The top performer starts at 7 percent of SPAs as COGs vs. 2.1 percent for the average performer. High-performer SPA growth follows the growth of B2B online sales at an 8 percent CAGR vs. 2.5 percent for the average performer that grows at gross domestic product rates.
Over six years, ending in 2025, the top performer has $38.65 million in SPA volume vs. the average performer at $8.47 million. The implications for top performers are greater leverage with vendors in the usage of special pricing allowances, more flexibility with vendors in the usage of pricing dispensation, and a greater market presence for customers as they move online and put pressure on the full-service distributor for competitive prices.
The use of SPAs and their increase is, primarily, a response made for e-commerce firms who have streamlined models and offer better pricing to their customers. Full-service distributors are responding with increased usage of SPAs and those firms are expected to maintain their lead as they grow their e-commerce presence.
Today, 20 percent of full-service distributors sell 80 percent of the online volume of traditional distribution. Research finds that these firms make extensive usage of SPAs and engage in specialized tracking and remittance software to do so. As other distributors increase their online presence, their usage of SPAs will broaden.