The Problem with Standard Costing in Distribution
A couple of days ago I had the opportunity to “talk shop” with a group of knowledge-based distributors. During recessionary times, distributors discover that pricing pressure puts a strain on their margin levels and profits in general. After recessions of the past, the pricing pressure eased and margins quickly moved back to a more comfortable level. However, during the current slow-growth recovery, the normal margin bounce has not occurred.
There are a number of potential reasons for this phenomenon. Consumer confidence has spilled over into the distributor world. Remember, distributor sales types are consumers too. They may be seeing improvement with their customers and incoming orders, but many still know colleagues looking for work. This leaves uncertainty and doubt in their minds. They reason, “Why risk an order, when you can trim a couple of points off the margin and have a better chance of grabbing the order.” They exchange fables and war stories of struggling competitors cutting prices to gain marketshare or capture new accounts. To them, the recession isn’t over.
Further, lower margins beget increasingly lower margin. Back in the dark ages when I was a salesperson, the unofficial word among sellers was – “if you don’t know the price add 25%.” But, sometime during the 1990’s 25% migrated to 20%. Based on some of the recent Profit Reports, I can’t help but believe that somewhere out there a senior guy is having beers with a young co-worker – only now 25 has migrated down to 18%.
This is taking its toll on wholesale distribution and managers are scrambling to find ways to fight the trend. During our conversation, one member of our group brought up the topic of standard costing. For those of you unfamiliar with the term, a standard costing strategy is developed by taking the “normal” price paid to your supplier and adding a “standard” costing factor. The formula looked something like this:
[Normal Price] x [1 + Standard Costing Factor] = [New Cost]
Typically the standard costing factor is expressed as a percent. A very long time ago, we helped a distributor calculate a standard costing factor for a product line with unusually high freight charges into stock (in this case 9%). His business system was antiquated and he had no real way to recoup freight, hence the costing factor. So, the standard costing factor was 9%. And from that point on the “normal cost” plus 9% became the calculated system cost.
At first glance this sounds like a simple fix to a very challenging problem. Why not add a costing factor to various lines and reap the benefit? A few tweaks in the IT department might generate invisible margin points and boost profits. We have even heard of distributor owners bribing their IT department to do this in a covert manner. Problem solved? Well, not really. Like band-aid fixes everywhere, the root cause of the problem remains - festering under the surface.
Let’s take a more thoughtful approach to the issue. What are some of the long term ramifications to standard costing?
- Standard Costing damages employee morale
No matter how you explain things, sales people see standard costing as a potential tool for screwing down their commission plans. Whether it’s right or wrong, in our industry the vast majority of sales people’s compensation is tied to gross margin. Artificially shrink the gross margin and they start seeing red.
- The sales team still pushes against the margin
The root cause of the margin erosion remains the same – only this time it’s a slightly inflated number. Furthermore, when the team learns of the “standard cost factor” in use, it becomes an excuse for lost orders (real or imagined). Smart sales types find access to the real number and the whole program begins to spiral downward.
- There is no distinction in order size, customer type or price sensitivity
This is a major problem. Not all customers, products or markets are created equally. Gigantic companies buy large quantities with deeper discounts than the little guy, yet somewhere along the way, sales people only remember the lowest price paid – and they extend that price to everyone.
Back in the 1980's, standard costing might have made some sense. It is simple, easy and at least a little bit effective. Distributor business systems lacked the power and communications capability to analyze data in a cost effective manner. Calculations, price comparisons and the like were largely done manually – if they were done at all.
Successful distributors were taught to “triage”. Sorting and prioritizing what analytics they did based on customer size and product velocity. And these techniques were passed down in our industry. Truth is; most distributors do a passable job of managing the margin levels of their top product SKU’s when sold to their top customers. But they never get around to looking at the pricing strategy applied to lesser lines and smaller customers.
But reports from the front lines indicate a growing number of distributors are implementing modern technology-based systems that push pricing strategy from those top few to the entire customer base. They let the computer do the heavy lifting of the analytics and then make decisions accordingly.
For instance, David Bauders and his team at Strategic Pricing Associates have built a model that not only predicts pricing sensitivity but also generates reports that indicate which sales people are using the right process in their daily selling practices. Rather than generate a single dimensional matrix, SPA’s software develops a pricing cube which considers customer type, size and product pricing sensitivity. As one distributor principle reported:
What the SPA system does you just can’t do yourself. The price cube in our industry is just too complex. In our business we have over 35 cells and thousands of products. In a successful pricing process, the low hanging fruit falls with small customers and slow moving items…
Allow me one more time, band-aids don’t cure the disease. And in our industry, we have had the disease for a very long time. Cure the disease and you’re bottom line will feel better – much better. How much, you ask? According to David Bauders of Strategic Pricing Associates, "...distributors see a two point increase in gross margin when a process is put in place." That's a cure!