Driving enterprise value in wholesale distribution—Part … · wider distribution network, ... Note: 3 year averages for Gross Margin, Inventory Turnover and ROC ... This implies

Driving enterprise value in wholesale distribution—Part IIThe need to balance SG&A efficiency and effectiveness

2

IntroductionAlbert Einstein used to say that "everything should be made as simple as possible, but not simpler." A similar principle applies to managing selling, general and administrative (SG&A) expenses in wholesale distribution (WD). Companies should strive to leverage SG&A spend to effectively execute their business strategies, while controlling SG&A cost, which in case of wholesale distributors includes distribution operations as well. In many cases, this means spending more than the bare minimum on SG&A. This finding seems to fly in the face of conventional wisdom, which has long viewed lower SG&A costs as the key to improving return on operating capital. So what’s really going on?

Our research(1) shows that top-performing wholesale distributors—those with the highest return on operating capital (ROC)–tend to have higher SG&A-to-revenue ratios than their peers with lower ROC. Is this because top performers enjoy the luxury of larger profit margins and can thus get away with less than optimal SG&A efficiency? In part, yes. But the bigger reason is that top WD performers typically feature a much broader product portfolio and larger geographic footprint, enabling them to serve customers more effectively. This service-oriented strategy generates much higher margins, but also increases overall complexity which in turn drives SG&A costs as a result of a more skilled sales force, wider distribution network, and supporting capabilities such as pricing, category management and network optimization.

In this second article in our series on “Driving Enterprise Value in Wholesale Distribution,” we take a detailed look at the industry’s SG&A practices, and offer new insights into how companies at every performance level can manage SG&A costs more effectively to support their business strategies and improve their return on operating capital.

A contrarian finding on capital efficiency and SG&AThe first article in our series(2) revealed that the traditional mantras of operational excellence and cost reduction are no longer the keys to success in wholesale distribution. In fact, our analysis of three different WD lines-of-trade (denoted by the large bubbles in figure 1) showed that companies that emphasize revenue quality over pure operations excellence (denoted by the darker shaded smaller bubbles) often deliver increased returns on capital. We identified four strategies- product portfolio expansion, price optimization, sales-force effectiveness and operations excellence – to drive higher returns. As is obvious, supporting these strategies will require re-thinking of SG&A infrastructure.

Figure 1: Performance in wholesale distribution varies widely

(1) Deloitte Consulting Survey, 2014 (2) Driving Enterprise Value in Wholesale Distribution—Sanjay Agarwal and Raj Nagarajan, January 2014

Company G, 22.7%

Company L, 27.8%

Company M, 26.3%

Company J, 15.0%

Company P, 17.0%

Company N, 18.4%

Company K, 19.9%

Company O, 19.5% Company Q, 21.3%

Company I, 27.3%

Company T, 10.8%

Company R, 15.2%

Company U, 37.7%

Company S, 9.3%

Company A, 42.2%

Company B, 51.8%

Company C, 43.6%

Company F, 38.2%

Company W, 33.5%

Company H, 20.1%

Company E, 32.4% Company V, 25.7%

Company D, 32.0%

-2%

8%

18%

28%

38%

48%

58%

5 10 15 20

TBD

Note: 3 year averages for Gross Margin, Inventory Turnover and ROC considered based on FY10, FY11, FY12 figures; ROC = EBIT/ (NFA + NWC) Source: Deloitte Consulting Analysis; S&P Capital IQ Database

Inventory Turnover (3 yr. avg.)

Line of Trade

Industrial Supplies

Grocery & Food Service

Electrical / Electronics

Cluster 3

• Low to Medium Margin

• Low to Medium Inv Turns

• Low to Medium ROC

Cluster 1

• Medium to High Margin

• Low to Medium Inventory Turns

• High ROC

Cluster 2

• Low to Medium Margin

• High Inv Turns

• Low to Medium ROC

Gro

ss M

arg

in %

(3

yr.

avg

)

Top Performers within a cluster

As used in this document, "Deloitte" means Deloitte Consulting LLP, a subsidiary of Deloitte LLP. Please see www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Certain services may not be available to attest clients under the rules and regulations of public accounting.

3

SG&A as a % of salesPeer set Top RoC performers Rest OverallElectrical/Electronics 18% 8% 11%Grocery & Food Services 22% 11% 15%Industrial Supplies 21% 18% 17%Note: 3 year averages for Gross Margin, Inventory Turnover and ROC considered based on FY10, FY11, FY12 figures; ROC = EBIT/(NFA + NWC) Source: Deloitte Consulting Analysis; S&P Capital IQ Database

According to our in-depth analysis(1) of SG&A spending in the wholesale distribution industry, top performers have made a strategic choice to feature a broader product selection, greater geographic coverage, and superior customer service (i.e., one-stop shopping, better fill rates, faster delivery times, and more knowledgeable sales team), which helps them grow revenue and market share while earning higher gross margins. Of course, these superior capabilities don’t magically appear out of thin air; they require a higher level of investment and ongoing spending in SG&A. The good news for top performers is that their increased SG&A spending is more than offset by faster revenue growth (4x) and higher gross margins (nearly 2x), resulting in higher financial results and return on capital (figure 2).

Figure 2: Higher rates of SG&A spending correlate with faster revenue growth and higher gross margins

Peer set Rev CAGR SG&A CAGR Gross marginTop performers 6.7% 5.5% 29.1%Rest 1.6% 2.2% 15.0%

This is not to suggest that wholesale distributors should go on a mindless SG&A spending spree. Far from it. The key is to strike a balance between efficiency and effectiveness: spending as little as possible on SG&A to effectively support a winning business strategy. Wild spending on SG&A in single-minded pursuit of growth can be recipe for poor performance. But so can single-mindedly focusing on SG&A cost reduction at the expense of strategy.

To help companies identify a targeted balance, we have developed a simple framework that categorizes SG&A activities and capabilities based on two dimensions: (1) centralization vs. decentralization (locally managed) that impacts the ability to leverage scale—across Y-axis in figure 3, and (2) efficiency vs. effectiveness across X-axis, which impacts the focus between transactional and value-added capabilities. Activities for each SG&A function can be evaluated by mapping them to the framework based on where they are performed within the organization, and whether they primarily focus on efficiency or effectiveness.

Capability or Knowledge-Based Work

Shared or OutsourcedDelivery

Com

pany

-wid

e or

Cen

tral

ly M

anag

ed

Local Delivery

What transaction work needs to be in Business Unit (BU) or Distribution Center (DC)?

Business Partnership

What knowledge based/specialized capabilities need to be located in Business Unit (BU)or Distribution Center (DC)?

What transaction work can be delivered centrally to leverage scale?

Centers of Excellence

What knowledge based/specialized capabilities can be delivered centrally to BUs and DCs?

Transactional Work

Efficiency- Focus Effectiveness- Focus

Busi

ness

Uni

t (B

U) o

rD

istr

ibut

ion

Cen

ter

(DC

)sp

ecifi

c/lo

cally

man

aged

Figure 3: SG&A Framework: Balancing efficiency and effectiveness through SG&A service delivery model

4

Efficiency-focused initiatives typically contribute to overall performance by reducing transaction costs in SG&A activities such as payables and collections by leveraging economies of scale and labor arbitrage through centralization in a shared services center or outsourcing. Effectiveness-focused initiatives typically contribute to overall performance by improving business competitiveness and building strategic capabilities in knowledge-intensive areas such as pricing and category management that are delivered centrally through “centers of excellence.”

Top performers, who have already made significant investments in SG&A as part of transforming their business models, should focus on optimizing their SG&A platforms by leveraging scale in transactional shared services and centers of excellence. This implies that they would need to shift the center of gravity of their SG&A models towards the bottom of our SG&A framework. The rest of the peers have a more challenging proposition. They will not only need to shift to the bottom of our framework to optimize their current SG&A models, but also build out SG&A capabilities towards the right of SG&A framework in support of transforming their business models to realize ROCs similar to top performance.

Figure 4: Transitioning from current to future models for top performers and rest of peers

Current SG&A models Future SG&A models

Higher SG&A investments in both transactional and value added areas, but SG&A center of gravity is biased towards BUs/DCs...

...which can be optimized by lowering the center of gravity to become more center-led SG&A

model

Cen

ter-

led

BU/D

C le

d

Cen

ter-

led

BU/D

C le

d

Transactional Value-added

Top

perf

orm

ers

Cen

ter-

led

BU/D

C le

d

Transactional Value-added

Cen

ter-

led

BU/D

C le

d

Transactional Value-added

Cen

ter-

led

BU/D

C le

d

Transactional Value-added

Lower SG&A investments in largely transactional areas...

Rest

of P

eers

...which can be first optimized by center-led transactional shared services...

...to free-up investments and expand SG&A to include value added capabilities in support of ROC expansion.

Center of Gravity representing concentration of SG&A resources

Low High

Concentration of resources

5

2.5% 2.1%

Top Performer IS Median

4.3%

3.2%

Top Performer IS Median

6.7%

5.4%

Top Performer Average Performer

Selling Operations General/Administrative

Further analysis of the survey data reveals specific capability areas within each cost category where top wholesale distributors are out-investing and out-performing their lower-performing peers.

“Selling” capabilities where top WDs out-invest and out-perform their peersTo support their high margin strategies, top performers significantly outspend their peers on selling costs as a percentage of revenue. Their investments in selling are targeted in three areas, each supported by comparing a relevant metric between top performers and their peers in the survey. First, investing in a capable and skilled sales-force that is able to leverage a broader product portfolio to cross-sell and up-sell – as observed in higher average sales rep compensation from our survey. Second, investing in sales expertise and account management capabilities for growing national accounts – as observed in allocation of selling expenses between national, field and inside sales segments. And finally, higher technology investments in sales capabilities – as observed in technology investments as a percent of revenue.

These strategies contribute to top performers realizing 30-60% higher gross margins per sales rep. A sales support center of excellence with supporting pricing and analytics is key to increasing the return from these investments. Mapping these investments and resulting capabilities onto our SG&A framework shows that when it comes to selling, top performers primarily focus on improving effectiveness. At the same time, top performers are delivering these capabilities (e.g., pricing, territory optimization, request for proposal (RFP) response, customer service) through central centers of excellence (CoE) to leverage economies of scale.

“Operations” capabilities where top WDs out-invest and out-perform their peersAccording to our survey, for distribution operations, top performers spend twice as much as average. In particular, they spend 90% more on operations staff in order to support a more expansive distribution network that puts them closer to their customers, enabling them to provide high service levels across a wide geographic market. Also, they pay 30% more for product supply labor in order to maintain the higher category management and product supply capabilities required to support their broad portfolio of product offerings. In making these investments, top perfomers are adopting efficiency measures through evaluating outsourcing models to not only optimize operating costs of the expanded network, but also to exercise flexibility in network design where needed.

This higher level of spending on distribution operations results in higher on-time delivery rates and fill rates, both contributing to higher customer service levels and gross margins. These results often offset the additional spending required to achieve them, enabling top performers to produce higher market growth, capital efficiency and bottom-line profitability.

Digging deeper into SG&A spendingAs we discussed, top performers tend to spend more on SG&A in order to support their high margin business strategies. But SG&A is a very broad cost category. Where exactly are they focusing their spend?

To find out, we conducted an in-depth SG&A survey(1) to better understand what top performers are doing differently than the rest of the pack. The survey looked at companies in similar and adjacent lines of trade, dividing SG&A spending into three major categories: Selling, Operations, and General/Administrative (figure 5). The survey results show that top performers focus most of their additional SG&A spending on Selling (about 25% higher than their peer group of wholesale distribution companies across Industrial supplies, Electrical/Electronics and Grocer/Food Services), and on Operations, (about 35% higher than peer group). For General/Administrative, the spend levels are comparable, implying that top performers are generally competitive with peer group.

Figure 5: Selling, Operations, and General/Administrative comparisons as % of revenue

6

Figure 6: Moving up the G&A maturity curve

Top performers are focusing on efficiency by balancing captive and outsourcing mix for warehousing and logistics and also improving effectiveness by delivering network planning and route optimization capabilities through “centers of excellence” (CoE) to leverage economies of scale.

Improvement opportunities for “General/Administrative” spendingGiven the relatively small difference in General/Administrative spending between top performers and the rest of the pack, it is difficult to draw conclusions that are statistically significant. However, a cross-industry benchmarking analysis suggests that wholesale distributors as a group have significant room for improvement. The manufacturing industry provides a particularly good benchmark in this area, since manufacturers have faced severe cost pressure and global competition for decades and thus have invested a tremendous amount of time and effort moving up the maturity curve to reduce and optimize their G&A spending. If wholesale distributors can achieve maturity levels anywhere near those of the manufacturing industry, the positive financial impact could be significant (figure 6).

Ef

ficie

ncy

Fragmented G&A infrastructure residing in Divisions

Single function shared services (mostly regional)

Multi-functional G&A shared services/Outsourced

Multifunctional business process based SS/Outsourced

Effe

ctiv

enes

s Sc

alab

ility

Current positioning of Wholesale Distribution

G&A models with high maturity

(Manufacturing Industry)

Target G&A model for Wholesale Distributors

Achieving maturity levels similar to manufacturing would require significant scale , a strong ERP foundation, process standardization and relatively stable growth levels

% of Headcount Centralized

0% Finance

HR

IT

Procurement

Wholesale Distribution Manufacturing

100%

0% 100%

0% 100%

0% 100%

7

Figure 7: Future optimized SG&A models with a bias for center led capabilities

Potential Future State SG&A ModelAn optimized SG&A model with positive impact on both efficiency and effectiveness across all three SG&A cost drivers of Sales, Operations and G&A is shown in Figure 7.

Moving forwardOur research and analysis highlights the importance of aligning SG&A spending with business strategy. To achieve the higher returns, wholesale distributors need strategies with the potential to deliver improved margins and market growth. But they also need to support those strategies with adequate levels of SG&A spending. Blindly focusing on SG&A cost reduction at the expense of the business strategy is likely a losing formula.

Wholesale distributors in the middle or bottom of the pack might want to follow the lead of top performers and move toward a high-margin business model that features a broader product portfolio to enable one-stop shopping, a more expansive distribution network to enable higher fill rates and faster delivery times, and a more knowledgeable sales staff capable of supporting a broad category of products and delivering superior customer service. Key investment areas to support this new business model include selling, distribution operations, product supply, and category management. Such an approach has the potential to deliver much higher margins, but will almost certainly require a company to increase its SG&A spending -- a bold choice that flies in the face of conventional wisdom for managing SG&A costs.

On the other end of the spectrum, many top performers face the opposite challenge. Having moved to the front of the pack through a combination of organic and inorganic growth, these leading companies may need to take some time to consolidate their complex SG&A activities and infrastructure to improve efficiency and scalability. Although their SG&A investments to date may have been purposeful and rational, in many cases their absolute SG&A levels have grown rapidly and inefficiencies may be somewhat masked by strong revenue growth. In the future, complexities and inefficiencies could multiply -- or growth could slow -- causing SG&A costs to quickly eat away at their margins.

At every performance level, managing SG&A successfully involves a delicate balancing act between optimizing efficiency and enabling an effective business strategy. This means keeping SG&A costs as low as possible -- but not lower.

Optimized future SG&A model(with illustrative examples of resource deployment)

Sales• Local order fulfillment and trackingOperations• Pick-pack and ship

Sales• Local/regional salesOperations• Operations scheduling• Backhaul planningG&A• Onboarding and recruitment• IT infrastructure support

Sales• Sales reporting• Sales trainingOperations• Purchase order managementG&A• Payables• Receivables• General Ledger and Fixed Assets/Accounting• HR Data Administration• Help desk• Benefits Administration

Sales• Inside sales• National Account Management• Pricing CoE• Sales and customer service CoEOperations• Enterprise wide network optimization• Inventory management• Route planning CoE• Center-led Category managementG&A• Analytics & Reporting• Performance Management• Technology architecture• Recruitment strategy and compensation

Future SG&A models

Cen

ter-

led

BU/D

C le

d

Transactional Value-added

Cen

ter-

led

BU/D

C le

d

Transactional Value-added

8

Authors Sanjay Agarwal Principal and Wholesale Distribution Consulting Industry LeaderDeloitte Consulting LLPStamford, CT+1 917 331 [email protected]

Raj Nagarajan DirectorDeloitte Consulting LLPWilton, CT+1 440 991 [email protected]

Abhijit Chakraverty Senior ManagerDeloitte Consulting LLPBoston, MA+1 952 270 [email protected]

A special thanks to Karan Rao, Consultant, Deloitte Consulting LLP, for his contributions to this article

This publication contains general information only and Deloitte is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte shall not be responsible for any loss sustained by any person who relies on this publication.

Copyright © 2015 Deloitte Development LLC. All rights reserved. Member of Deloitte Touche Tohmatsu Limited