Slow the soaring cost to serve in distribution

 

Some distribution companies are struggling to turn a profit, even if they have growing revenues. “One of the biggest issues right now is what we call supply chain cost to serve,” said Grant Thornton Growth Advisory Principal Jonathan Eaton.

 

“That has nothing to do with the raw material cost, intermediate cost, or the cost of conversion and production. It is very strictly warehousing and logistics cost — how we get product from point A to point B,” Eaton said.

 

He noted that logistics costs, as a percentage of net sales, doubled for Amazon from 2009 to 2021. “That would have been profitability, but now it's being borne as cost,” Eaton said. “Then, when you recognize that a company like Amazon has the very best distribution infrastructure, how much more pervasive is that for other companies?”

 

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This chart shows that the logistics costs have eaten into the net sales revenue more and more for Amazon, between 2009 and 2021. In 2009, logistics costs took 15.6% of sales revenue but, in 2021, logistics costs took 32.3% of sales revenue for Amazon.

 

Why are costs rising, and what can companies do to keep them under control?

 

 

 

Confront the cause

 

One of the top reasons for the soaring cost to serve is the struggle for space. “The cost of storage is much higher than it's ever been. In fact, it's hard to find space,” Eaton said. “We talk to clients every day who have no more capacity, and warehouse space is hard to come by in various markets.” Companies that need cold storage often need to build it, and the lead time is 12 months or longer. 

Headshot of Jonathan Eaton

“The cost of storage is much higher than it's ever been. In fact, it's hard to find space. We talk to clients every day who have no more capacity.”

Jonathan Eaton

Grant Thornton Growth Advisory Principal

 

Workers are another important cost concern. “Everyone is battling for the same labor,” Eaton said. “I’ve had clients tell me that employees will go across the street and work in another warehouse job for a 10, 20, 30-cent raise.” In trucking, there are not enough young drivers to replace the retiring workforce. Both scenarios are fueling a fight for workers. “It means wages are being driven up, so workforce costs for companies are higher.” Another factor is fuel itself. “The cost of fuel is higher than it's ever been, and I don't think it's going down anytime soon.”

 

When inventory doesn’t move, that introduces inventory-carrying costs. “Interest rates are going up for many companies. Some companies can use their cash cycle and their balance sheet to fund inventory,” Eaton said. “But the majority of companies use debt.” Higher interest rates, and SKU proliferation, mean that most companies need to pay more to keep a wider variety of products in stock. “If I have a hundred different products where I used to have six, now I have to anticipate the demand for all of those products from all of my customers. That requires a much higher net investment in inventory. Frankly, the return on the invested capital in the inventory for some of those products isn't great.”

 

Distributors often wind up facing all of these factors together, because they’ve been following the revenue — seeking the sales and growth that come from being the one to meet growing needs. However, revenue can be an illusion if it doesn’t come with profit.

 

 

 

Examine the lure of revenue

 

“If you're growing, and your growth is absorbed by increasing costs to deliver, that’s really the opposite of operational leverage. You can be more disadvantaged than when you started,” said Grant Thornton Mergers and Acquisitions Partner Patrick McAuley.

 

Headshot of Patrick McAuley

“If you're growing, and your growth is absorbed by increasing costs to deliver, that’s really the opposite of operational leverage. You can be more disadvantaged than when you started.”

Patrick McAuley

Partner, Transaction Advisory

“You can be lured by some of those growth prospects, and some of the actual growth, while you're getting upside-down from a cost perspective,” McAuley said. “Where we see this the most in distribution is with your physical footprint and your rent-versus-own decision. Then, the same thing with your people costs and W2-versus-temp. You want to be in a position where an incremental dollar is falling to EBITDA and not being absorbed.”

 

“Gross margin matters, but you have to understand what the cost to serve is,” Eaton said. “From a gross perspective, you can look fine, but where some companies are getting toasted is that the cost to actually get the product through their network from point A to point B, and ultimately to the customer, is higher. They pull up the numbers and say, ‘Good grief, we're hemorrhaging money and we don't know why.’”

 

“Ultimately, somebody has to pay the bill,” McAuley said. However, it can be difficult to have these conversations with your customers.

 

 

 

Engage and evaluate your customers

 

For many distribution companies, the biggest risk is inaction. “It’s not having the conversations with your customers, and not leveraging the strength of your relationship,” McAuley said. “You have to have the fearless conversations with their customers and work through, over a period of time and contracted spend, how to get to a fair and equitable spot.”

 

Distributors also need to evaluate their prices in relation to their customers. “What's the actual profitability of every combination of product and customer that you have?” Eaton asked. “What should my pricing strategy be? Can I have that pricing strategy? Do I need to differentiate my order fulfillment logic to get the product to market?”

 

It’s also important to evaluate service models in relation to customers. “If you can't raise prices, the other thing that you can do is change the service model,” Eaton said. “The minimum order quantity might go up, the frequency with which you can order might change. You need a view into supply chain cost to serve, to decide the delivery model or the price you're going to charge.”

 

When you understand the factors you need to control, you can understand the data you need to gather.

 

 

 

Gather the data

 

You can start by establishing that top-line revenue along with the gross margins. “But you also have to know the actual cost to serve, for every combination of product and customer, with customer segmentation,” Eaton said.

 

“It’s shocking that I see clients every day who believe that every customer should have the same price, use the same price list, and have the same order fulfillment logic, regardless of how meaningful they are in the grand scheme of things,” Eaton said. “In transportation and distribution, companies need to better understand how profitable or unprofitable their products and customers are, and they need the data to do that.” 

 

Once you have the data, it’s time to plan.

 

 

 

Plan your pricing

 

One leading practice is to use a digital twin, using AI technology to build a virtual replica of your supply chain and experiment with what would happen in different scenarios. This can help you establish your cost to serve with a balance for the best profit and stability in your proactive pricing strategy.

 

Your strategy should balance a range of variables, like:

  1. How often will you take that customer’s order?
  2. What is their minimum order quantity?
  3. Are you going to pay to ship it, or is the customer going to pay to ship it?
  4. How many times in a particular period can they order?
  5. What days of the week will you ship to the customer?

“Mondays are heavy shipping days. The first and last days of the month are heavy shipping days. So, there are strategies where you can make a meaningful impact operationally and financially by pushing some customers to different days of the week or different days of the month,” Eaton said. “Lead time is another variable. If you order from me today, will I ship it to you today? The combination of order fulfillment logic and pricing strategy is hugely important, but you have to know your customer segments and your cost to serve.”

 

 

 

Update your plan

 

Your strategy needs to be both complete and current. “It is amazing to see companies that say, ‘Here's our price list for 2024,’” Eaton said. "For 2024? What's the price list for this customer, for this month, or for next month, and how often do you update that?"

 

Eaton acknowledged that it takes time, people and resources to make that happen, but the payoff is important. “If I was a CFO, and I couldn't call someone to ask, ‘Last month, what was the profitability or the cost to serve? How did we do for this product and this customer?’ I'd have to find new people to work for me.”

 

“It's just mind-blowing to see companies that don't have that level of maturity,” Eaton said. “There’s a better way to run your business. If you look at the companies that are performing well, there's a reason. It's because they have very resilient, high-performing supply chain.

 

Contacts:

 
 
Patrick McAuley

He has developed extensive transaction experience serving as an adviser to publicly traded companies, private equity firms and privately held businesses.

Charlotte, North Carolina

Industries
  • Manufacturing, Transportation & Distribution
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  • Transportation & distribution
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