Tough Times Call for the Right Measures
Julian Dent explains that for distributors and vendors facing flat sales revenues and big strains on their dwindling credit capacity, using the 'right' measures could make a real difference in getting through the tough times.
It’s become very fashionable for politicians to claim their measures to respond to the current economic crisis are the 'right' ones as in, 'this is the right thing to do'.
For distributors and vendors facing flat sales revenues and big strains on their dwindling credit capacity, using the 'right' measures could make a real difference in getting through the tough times. By measures we mean the financial ratios used to manage the business and support decision making. Too many distributors and vendors focus their attention on the wrong measures that in the good times, simply wasted opportunities and capital. However, in the current climate, failing to learn from these mistakes could mean failure of the business for the distributor and the loss of market access for the vendor. And don’t think size gives protection – CHS, Europe’s largest technology distributor at the time went bust spectacularly, owing hundreds of millions of dollars to the vendors who had seen it as a healthy alternative to Tech Data and Ingram Micro.
The complex subject of choosing the right measures can be boiled down to four, and in each case you will usually find there is a wrong measure that is more frequently used instead:
Business performance aspect | Wrong measure | Right measure |
Profitability | Gross margin | Contribution margin |
Productivity | Return on sales | Return on capital |
Sustainability | Net Profit | Economic Profit |
Survival | Growth | Cash flow |
If you think that anyone is too sophisticated to be using the wrong measures, then take a look at their recent annual reports and press releases and look at how they describe their performance and the rational for their strategic decisions…almost every major distributor and vendor has selected terms exclusively from the middle column.
How can Gross margins be a wrong measure? Easy, they are just too simplistic. Distributors need to take into account all the elements of the vendor relationship (brand marketing support, supply chain integration, soft funds, funded heads, and warranty burden, etc) as well the specific aspects of the product (sales rates, returns rates, pre and post sales support requirements, etc). These are all captured in a well-structured contribution margin measure.
Return on capital is for the shareholders isn’t it? Yes, and who is about the only source of capital in town these days? (Clue: it’s not the banks). And here’s the issue; to deliver an acceptable return on capital, distributors and their vendors have to concentrate on making their capital work as hard as possible. The way to do this is to make capital turn over faster, so spinning the inventory, controlling credit given to customers and securing more credit from vendors. There are a whole raft of measures that are return on capital measures that can be applied within product management, vendor management and customer management roles. The better distributors are using measures like Return on Invested Capital, Gross margin Return on Inventory Investment, both to measure their business and to incentivise their managers.
What’s Economic Profit (sounds complicated)? The concept of economic profit is to compare the profit earned from operations to the cost of the capital that was needed to generate that profit. So is $100m operating profit a sustainable outcome? Well, only if the cost of the capital used was less than $100m. Otherwise, over time the sources of capital will dry up. A business that has operating profit > cost of capital can be said to be creating value; and one with operating profit < cost of capital is said to be destroying value. Which one would you trust with your $100m? Exactly. That wasn’t too complicated was it?
If you don’t grow, you are going backwards…Maybe, but if you don’t have cash, you aren’t going anywhere. Survival means being able to balance the flows of cash in and out of the business. And that means having a very clear view of these cash flows over the next few weeks and months. With everyone struggling to stretch credit limits, it can be very sobering to add a few days to the assumptions you make about when you will get paid. Businesses can run out cash within days if the cash to cash cycle gets stretched at both ends (customers and suppliers). Divide the cash balance into the sales turnover to see how many days’ trading your cash reserves represent. Even twenty days can disappear quickly…
Whether you are a vendor or a distributor, start asking different questions, using the measures in that right-hand column. Go on, you know it’s the “Right thing to do”.
