"We're in the process of renewing contracts with our distributors early this new year. Most of them, in light of higher distribution costs, are requesting adjustments in the distributor contract like additional discounts and extended credit terms. Given a flat sales forecast for our products this year, we need to look at other ways we can help our loyal distributors beyond just these. Do you have any suggestion for us, especially for our sales team?" - Chris Brews
There are many ways to help your distributors improve their financial health beyond giving sales discounts or extended credit terms. One is to examine the efficiency of their operations and financial management. While this may seem obvious, there's an inherent structural barrier that prevents both supplier and distributor from considering this. It's in the system on how we compensate our distributors.
When suppliers pay distributors with a certain percentage sales discount, distributors make money from their purchases and not necessarily on being operationally efficient. That's why it's common practice for distributors to load up on inventories and sell on extended credit terms so they can take advantage of the supplier's volume discounts. Afterwards, if there are still inventories left, the distributor often demands for sell-out supports from suppliers to deplete excess stocks. The crazy cycle then repeats itself, usually, at the expense of suppliers. There are suppliers, though, who pay their distributors largely based on their operational efficiency, but that's for another article.
A very important metric that your salespeople need to learn to understand this point is called Return On Working Capital (ROWC) and they should know how this is managed. This isn't very technical but is something your own salespeople can manage with your distributors.
Why a financial metric? As a supplier, your own salespeople also need to see your distributor's business from the lens of an entrepreneur. For distributors, it's not just about market share, brand equity, or distribution reach, but the actual profit these bring to their business. So, before jumping the gun on more discount or credit, check first what the distributor's business really needs. Often, it's only just effective management of working capital.
A manufacturer (i.e. supplier) will likely give more importance to Return On Investment (ROI) as a metric, while a distributor on ROWC for a simple reason. ROI includes capital employed on fixed assets, which weighs heavy for a manufacturer who needs to acquire assets like property, plants, and equipment. On the other hand, a commercial distributor's capital is largely tied up in current assets like merchandise inventory and accounts receivables. It's best if you can show your sales team comparative examples of Balance Sheet reports from a distributor and from a manufacturer for clearer illustration. In those reports, point out the difference in Fixed Assets and Current Assets ratio of the two companies. In most cases, a distributor’s Current and Fixed Assets ratio is about 70:30, while a manufacturer’s ratio would be highly skewed toward Fixed Assets.
Now, there are three key components of working capital: Merchandise Inventory, Accounts Receivable, and Accounts Payable. Cash is also a component but is intentionally omitted here because a distributor does not normally keep cash in the bank for long. His cash is mostly tied up in inventory and receivables. Besides, his inventory and receivables are the ones within your influence and control. A good distributor manages each component almost on a daily basis. His goal should be to have faster turns of inventories and receivables which consequently are converted to cash. When merchandise inventories stay too long in the distributor's warehouse and customers don't pay on time, needed cash doesn't flow in, the business eventually dies even if the distributor gets more discounts from you. Hence, even if a distributor’s Profit & Loss Report shows a positive operating income, it does not guarantee business viability. A distributor’s business might look profitable (i.e. positive Net Income) but may not be viable if cash is tied up mostly in his Working Capital. There’s a vast difference between profitability and viability.
The working capital formula is: Merchandise inventory + Accounts Receivable - Accounts Payable. In the next part of this article, I will show you a few examples on how you can help your distributors manage their working capital following this formula. Meantime, ask your distributor specialists to get you the actual inventories and accounts receivables values of each of their distributors on a monthly basis.
Emilio Macasaet III is the Chief Distribution Strategist of Mansmith and Fielders, Inc. He will be running the programs, 5th Distributor Management on February 5-6, 2014 and the 5th Key Account Management on March 6-7, 2014. For more information, email info@mansmith.net, call (+63-2) 584-5858 / 412-0034 or text (+63) 918-81-168-88.