“The Value of Distribution” Revisited

Ronald L. King

November 1, 2012

At
the National Insulation Association’s (NIA’s) 32nd Annual Meeting in Marco
Island, Florida in 1987, I gave a presentation on “The Value of Distribution.”
In April 1989, I participated in a one-on-one interview with Insulation
Outlook
staff related to the distribution channel within the mechanical
insulation industry. The resulting article, entitled “More Than a Middleman,”
discussed the value of distribution. We thought it would be interesting to
revisit portions of that interview to see what (if anything) has changed over
the past 23 years. This article offers a discussion on what was relevant in
1989 versus the reality of today’s market.

How would you
portray or describe the role of distribution in our industry?

1989
Response:

Distribution in our industry, as in others, is the central link in moving
products from the manufacturer to the ultimate purchaser or customer.
Distributors provide an array of value-added services for both manufacturer and
customer, such as marketing, financial, and logistical support as well as
transportation, market, and product intelligence.

Distributors have been called the economy shock absorber
because of their ability to react to change?vital to our industry’s economy.
They make available the supply channel that provides the best opportunity for
manufacturers to overcome the considerable geographic problems of product
distribution, defining and servicing customer requirements, and maximizing
production capabilities while minimizing administrative and sales costs. Most
importantly, customers are provided enhanced service, choice, and availability
of product.

Today’s Response: While the basic role of distribution has not changed, the
importance of the distributors’ role in our ever-fluctuating economy has
increased tenfold. The “Distribution Commandments” listed in the 1989 article
are relevant today (see page 6). Each of these commandments has a value and
cost associated with it. There are many more insulation contractors, the
profile of what constitutes a mechanical insulation contractor has certainly
changed, and there are more companies self-performing work than there were in
1989. More product manufacturers are participating in the industry, and
consolidation has impacted all segments.

How did
distribution evolve in our industry?

1989
Response:

Distribution within the industrial and commercial insulation phase of our
industry was initially generally recognized as a supplement to the contracting
business. There were geographical and company variations; but, basically,
manufacturers sold direct to all contractors. Those contractors would resell or
distribute a relatively small volume of materials?thus, the term
“contractor/distributor.”

It wasn’t until the mid-1970s that distribution became a
recognized, distinct segment of the industry. Circumstances that influenced the
market included general contractors and owners who regularly self-performed
their insulation requirements, as well as the growth of the merit (or
non-union) segment of the industry.

Some criticized the distribution segment as an unnecessary
link in the marketing and administrative process. However, observation that
distribution continues to survive and thrive proves that distributors are not
parasites on the economic system.

Today’s Response: The
distribution segment has clearly matured and is recognized as an integral and
important part of the mechanical insulation industry. A few
contractor/distributors still operate in some markets, and there always will be
those who do not appreciate the value distributors bring to the business.

There are three primary reasons why the
contractor/distributor dual operating structure still exists: (1) certain
geographical markets are not economically or effectively covered by
distribution; (2) long-term relationships exist between the respective
manufacturer and contractor; and (3) there are specialty products that, for one
reason or another, have not been traditionally managed by distribution.

Some of the old problems still exist
with the contractor/distributor role. Generally, the contractor/distributor is
somewhat limited in the distribution arena by the ever-present concern over
competing with customers (i.e., “I don’t want to buy from my competitor”). In
addition, the contractor/distributor does not always account for or allocate
internally the cost of distribution services in the same manner as a standalone
distributor, potentially creating confusing external market intelligence and
misleading internal profit recognition.

Is the
distribution segment’s history problematic to some aspects of the distribution
business?

1989
Response:
The
historical perspective still haunts the distribution segment. For example, many
contractor/distributors addressed warehousing, handling, and related costs as
an overhead burden associated with their contracting operation. They therefore
sold materials at or below cost relative to the actual cost of a transaction.
Broken cartons, return of merchandise, delivery, etc. were treated in a similar
fashion. Unintentionally, this had the effect of “spoiling” the customer so
that the distributor is continually trying to educate customers as to the cost
related to the services to which they have grown accustomed. The educational
process may require years to complete.

To add to this confusion, some contractor/distributors still
insist on continually or sporadically buying direct from manufacturers.
Although many manufacturers have abandoned their distribution function,
some?for legal, moral, or other business considerations?service that request,
which creates market fragmentation, confusion, and frustration for all parties
involved.

Today’s Response: As in 1989, industry fragmentation and marketplace confusion
results from the practice of some manufacturers of specific product lines
selling to contractors direct and supporting distribution, which further
complicates a complex multi-channel approach to the market. History may be
responsible for shaping many of the service practices, but the core structure
and makeup of the industry as it has evolved demands many of the service
practices.

Many mechanical insulation contractors are small businesses
that employ fewer than 5 to 10 people and are not capitalized to afford any
significant level of internal managed product service. Mechanical insulation is
by no means the core business for some companies. Accordingly, they require
product services. I would suspect that the majority of contractors employ their
capital to support their contracting operations versus the project product or
distribution requirements. Add to that the endless range of insulation system
variations, plus the reality of project management today, and the need and
value of distribution in our industry is of greater value than ever before.

Many distributors
also fabricate or perform other value-added services. Is that a benefit?

1989
Response:
Value-added
services, like products, have a life cycle. If a specific service is performed
by few companies, it can be used as a point of differentiation. If it is
performed equally by many, it is mature and perceived as providing less value,
likely making it less profitable to the distributor/fabricator. Value-added
services can be measured in distinct phases that characterize value to the
customer, manufacturer, and the distributor/fabricator.

The initial phase is when a new service, which may require a
considerable amount of investment but provides little marketplace value, is
researched and developed. As the concept becomes acceptable, its cost is still
relatively high. However, it provides a useful service, making it a valuable
sales and marketing tool for the customer, manufacturer, and
distributor/fabricator.

As the concept is perfected and accepted in the market, cost
may be reduced and/or recovered. At this stage, it still has high marketplace
value, since relatively few competitors have adapted the same value-added
service.

Inevitably, however, there are few things competitors cannot
adapt to their own company with the help of customers and/or manufacturers.
When this happens, the service becomes almost like a commodity or a necessity
to keep up with the competition. It provides very little, if any, marketplace
advantage.

I believe the vast majority of the large, commodity-type
fabrication or value-added services performed by distributors/fabricators in
our industry are in the more mature phase of their life cycle.

Distributors/fabricators need to keep a steady pipeline of
new value-added services for competitor differentiation and return on
investment. If a service truly adds value, at least a portion of that cost
could be passed on to the customer or manufacturer. Value-added services are
often bungled, however, and the service and its value are lost in the sale.

Value-added services should have a higher gross margin than
the product itself. Although it may be impractical to separate the product and
service in setting prices, distributors/fabricators must ensure they are
adequately communicating the value of service to the customer and manufacturer
in the selling and purchasing functions, respectively.

Today’s Response: The 1989 observations are still valid, although insulation
fabrication represents a larger segment of the market today. Many more
products, or combinations of products, are included in value-added fabrication
services now; and more companies perform some degree of fabrication off and on
project sites than ever before. Fabricators are continually focused on quality,
production efficiency, and service superiority?all of which lead to competitive
differentiation. Fabrication is probably one of the best examples of a
value-added service in our industry.

The customer profile of the industry
today versus 1989 is creating the need for more value-added services, and the
benefit of those services is increasingly relevant. We can expect that trend to
continue and the scope of services to expand.

What would be
another example of a value-added service? For instance, do distributors sell in
less than full carton quantities?

1989
Response:
Yes, I
believe the majority of the distributors do. However, I feel sure the vast
majority wish they did not. Quite obviously, anytime you break a carton, that
action creates administrative, inventory management, product damage, etc.,
complications.

The practice of breaking cartons, and the related cost, is
going to become an even more complex issue in light of the Occupational Safety
and Health Administration Hazard Communication Standard and the compliance
issues related to packaging and labeling.

Breaking of cartons is a value-added service. However, it has
fallen into the category where the true value is not appreciated and has become
somewhat standard to meet competitive pressures.

Today’s Response: With rare exception, breaking of cartons on many products
has become standard operating procedure and the value of that service is not
recognized. The customer profile of the industry, coupled with the project
management practices, almost mandates that approach.

Generally, less storage space is available on new projects;
or in maintenance applications, release quantizes?or in some cases, the scope
of a release?are not known until the last minute, and potentially the
contractors’ capital restraints make broken cartons a necessity. Breaking
cartons is not complex, but it can be costly. It was disappointing in 1989, as
it is today, that the industry does not recognize the value of that service.

When you think of
distribution, many business issues come to mind. For example, what is your
analysis of inventory levels and mix? Are they a problem?

1989
Response:
Inventory
levels and the mix of inventory are always a problem. Recently, an associate of
mine said, “You should think of inventory as money and not as boxes of
product.” That says it all. If salesmen had their way, you would maintain at
least one of everything to ensure securing the order and same-day delivery.
That’s just not economically feasible in today’s competitive business
environment.

Distributors are always faced with the dilemma that if it is
not on their floor, but on their competitor’s floor, they may lose the order. This
competitive pressure may be diametrically opposed to effective economical
inventory management, but that doesn’t necessarily justify making a bad
inventory decision.

The problem is further magnified by the short lead time that
is becoming more predominant between bid, award, and project mobilization. This
situation has become more pronounced in the last few years than at any other
time in the history of our industry.

In-depth evaluation would probably exhibit that 25 to 40
percent of a distributor’s inventory is not economically justifiable based upon
inventory turns, floor space, handling cost, etc. versus the profit margin
obtained. A portion may be justifiable due to specific customer demands,
economics of purchasing, fulfilling a product line, market development, future
requirements, and/or other unique situations. However, in reality, after all
those considerations, a substantial percentage is attributable to product
returns, over-buying, reaction to customers’ “guesstimated” needs, pressure
from the manufacturers, obsolescence, bad judgment, and/or some combination of
the above.

Recognition of these facts and development of a continuous
hands-on approach to inventory management is a necessity to correct the problem
and avoid reoccurrences. However, equally important is communication with the
customer and the manufacturer. It is a delicate balance between customer
service and inventory management that must be realized by people at all levels
of the company, including sales and service personnel.

Today’s Response: Distributors appear to be doing a better job with inventory
management today than in 1989, but the core problems remain.

One of the traps that many fall into is examining total turns
versus detail product line, or even individual stock-keeping units (SKUs). A
company may have total turns of seven, which is considered good in most
circles. But that does not mean everything is turning seven times. Half of the
inventory could be turning once and the other half 13 times. That is an extreme
example, but it illustrates the point that detail analysis is needed.

Everyone in our industry who is in the inventory management
chain, or has influence on inventory levels or mix, needs to fully appreciate
that inventory is real dollars disguised as mechanical insulation.

Customer communication also is vital to successful inventory
management. Customers need to appreciate lead times and plan their orders and
delivery request accordingly.

Defining a good turn level is really dependent upon each
distributor’s customer’s demands, mix of products, lead times, and a host of
other items. As a general rule, though, a good total level turn range is
between seven and nine turns.

How about
accounts receivable, or “days outstanding” as it is commonly referred to?

1989 Response: Accounts receivable is the most
important but probably the most frustrating asset the distributor has to
manage. Nothing is more disturbing than being confronted with the write-off of
receivable dollars. You may want to trust and believe in everyone, but, like so
many other things, the legal and judicial system, coupled with the fact that
some people try to abuse your trust and belief, ruin the system for the
majority.

In my opinion, credit will become more difficult and
collection efforts and the resulting legal maneuvers will intensify. Honest and
continual communication and mutual understanding are the only things that can
ease that pressure.

Purchasers (customers) must understand that distributors are,
in essence, banks from which they are asking for a short-term revolving line of
credit. Distributors may have more flexibility than a bank, but their exposure
is identical.

If you need a line of credit from a
bank, you go to its offices, explain your needs, discuss and present your
financial statements, and negotiate such items as collateral, interest rates,
payment terms, etc. Why should the distributor be any different?

I have seen customers become irate when
you try to discuss credit worthiness using credit criteria similar to that of a
bank. However, they provide a credit card company with more information than
you are asking them to provide. Customers should appreciate that a distributor
can be their biggest ally if they timely communicate their needs. Likewise, a
distributor’s credit department can be a big asset to a customer and to the
distributor by understanding the business and working with the customer while
protecting the company’s position.

I believe the future will see shortening of credit terms,
which will result in the reduction of days outstanding for the distributor. It
is not likely to happen quickly, as change of credit terms will probably meet
extreme customer resistance. Through a closer relationship with the customer,
improved billing techniques, and increase in discounts tied to payment,
significant gains can be realized. Offsetting some of these gains, however,
could be the increased use of receivable terms as a promotional tool for key
accounts.

Today’s Response: The basic struggle has not changed. Accounts receivable is
just like inventory: capital dollars required to run the business. Distributors
have become more stringent in establishing and managing credit limits, and
enforcing collection; but the customer’s expectations have not changed.
Likewise, I think the majority of purchasers have a greater appreciation for
the value of maintaining a good credit history and the consequences of not
abiding by agreed-upon terms.

Is data
processing playing a major role in distribution? What sort of automated
innovations would be the most productive?

1989
Response:
I believe
the distribution segment in our industry has, unfortunately, lagged behind many
other industries in adapting data processing technology in their businesses.

The major reasons for non-implementation or use of advanced
data processing technology have been lack of management commitment,
organizational or operations personnel resistance, and insufficient technical
knowledge and funding or commitment (probably the most difficult issues to
appreciate). With funding and commitment, the other reasons can be
appropriately addressed.

Bar coding/scanning offers great potential for the
distribution industry. Although the future of bar coding/scanning is exciting,
the lack of standardization is a key barrier that must be overcome before
scanning can be effectively and productively used by distributors.

The biggest question is: Who will take the lead in developing
the standards and systems to link participants in the pipeline as it pertains
to bar coding/scanning and/or customer/supplier links?

Today’s Response: Unfortunately, industry standardization has not occurred.
Most distributors are setting specific priorities and pace of implementation of
technology practices. I think our industry’s distribution segment is still
lagging in the use of technology in comparison to many other building product
segments. Our industry has some unique practices, but that should not deter
implementing the use of proven technology that would improve operational
efficiency and profitability.

What about trucking
or delivery cost?

1989 Response: Delivery is a vital and necessary
function the distributor must and should provide. It is a value-added service.
However, realization of the cost related to this service has gotten lost
somewhere in the maturing process of the industry.

If distributors accurately determined delivery cost, they may
be truly surprised as to the net gross profit or margin on a specific order or
customer. Make your people aware of the cost and, equally important, make your
customer aware. You may be able to tell your customer you could reduce your
price if you handled their delivery requirements in a different manner. You may
be surprised by the customer’s reaction. I cannot think of a single customer
who would not be interested in possibly helping to reduce your cost if it
subsequently reduced their cost and met their needs.

Today’s Response: Delivery is more
important than ever, and the cost in comparison to 1989 has easily doubled due
primarily to increased fuel cost. Even with fuel surcharge begrudgingly
accepted, the actual cost of delivery continues to be frequently overlooked.
Logistical, delivery patterns, and cost-versus-margin analysis should be
routine for a distributor; and the financial impact of the delivery service,
pro or con, should be communicated to the customer. Delivery continues to be a
major value-added service, and the customer needs to be involved in helping to
manage the cost and carrying the ultimate cost burden for the expected service.

In addition to
the operating concerns you share with the many sectors of the industry, there
are other issues of importance. For example, much has been written about the
need for vendor’s liability endorsements and/or indemnification. Does this
apply to the distributor?

1989
Response:

Absolutely, this applies to the distributor. The distributor sells to virtually
all phases of the industry, and if a problem were to develop, the distributor
could be besieged with the same degree of lawsuits as the manufacturer. There
are many misconceptions concerning the meaning and importance of vendor’s
liability endorsements and/or indemnifications. It is up to the distributor to
evaluate the merits of each.

One of the most costly items in
defending any product liability lawsuit is the legal cost associated with that
defense. Providing both vendor endorsement and indemnification allows the
distributor and the manufacturer to be on the same team, possibly through one
defense, which reduces overall legal costs and possibly eases the adversarial
relationship between the plaintiff and the distributor/manufacturer.

I am sure that after extensive evaluation many vendor
endorsements may be worth more than specific company indemnifications, but the
distributor has no way of evaluating that without continual review of insurance
policies and manufacturer financial statements. When the manufacturer provides
both, it tells the distributor that the manufacturer stands behind its product
to the full extent of the value of the company; eliminating any question as to
the value or sincerity of insurance coverage or company worth.

This is an extremely sensitive subject with many
manufacturers. However, distributors are not the manufacturers of the product.
Distributors should be held accountable for following safe and recommended work
practices, but they should not be held liable for health hazards or other
issues related to a product they do not manufacture.

Today’s Response: The sensitivity and importance of the subject has not
changed; and the complexities, if anything, have increased. This subject is
best handled by the companies’ insurance and legal departments, but it needs to
be addressed and not ignored by the distributor or manufacturer.

What are some of
the other concerns of the distributor? For example, what about employee benefit
cost? How does it compare to the contracting phase of our industry?

1989
Response:
The
problems of rising benefit costs, government regulations, administrative
burdens, etc., are not unique to the contracting phase of our industry. The distributor
is faced with the same issues. I have always been a firm believer in providing
as many benefits as economics and practicality would allow; but the direct and
administrative cost, and the liability, have become so prohibitive that I don’t
know how a contractor or distributor can continue past practices, especially in
light of proposed legislation that may mandate benefit programs.

Group insurance cost is literally increasing at such a pace
that I don’t think the average company or employee can continue to participate.
The sad thing is, you can’t afford not to. It is not unusual to hear of
increases ranging from 100 to 300 percent while coverages are decreasing.

It is a problem for all industries. Our industry is no
exception, and the distributor is not exempt. This problem will continue to
escalate and could become increasingly important when attempting to maintain a
stable workforce and provide employee motivation.

Today’s Response: The cost of health insurance has escalated to a point where
to maintain competitiveness and profitability, all benefits are being reduced
or the costs passed onto the employee. All segments are being affected. The
long-term impact on individuals, families, and the economy of reducing or
dropping health insurance coverage, reducing or eliminating 401(k)
contributions, and similar actions has yet to be determined. Without question,
due a host of issues ranging from governmental regulations to the United
States’ and global economies, the workplace environment has changed. More
responsibility is being put on individuals to plan for their future without the
financial support or guidance of their employer(s). Unfortunately, the concerns
expressed in 1989 have become reality.

You have stated
in several editorials that the profit or return on investment in our industry
is relatively small in comparison to the risk. Does that apply to distribution?

1989
Response:
Yes, I
believe it does. The attractiveness of an investment is primarily based on the
balance between its inherent risk and expected return. The higher the risk, the
higher the expected return. Some aspects of distribution make it less risky
than other investments, while others make it higher risk. In my opinion, the
distribution industry carries a slightly higher risk than the medium-risk
investments in today’s economy. Consequently, the return should be somewhat
higher.

Typically, a distributor’s balance sheet may reflect that 70
to 80 percent of its assets are a mixture of accounts receivable and inventory.
I cannot think of two more risky categories, especially in light of today’s
legal system, product liability, and the intensity of competition in our
industry.

When you compare distribution in our industry with other
industries, you discover that although the risks are very similar, the net
pre-tax earnings in our industry historically average below those of other
distribution businesses.

This condition can be related to the fact that distribution
in our industry is relatively young and has yet to be fully respected by all
phases of our industry. This increases and intensifies the competitive issues.
I am extremely hopeful that the future will increase profitability in
relationship to the risks.

Today’s Response: The distribution channel in our industry has proven its value
and continues to prosper. For reasons ranging from management practices to
maturity of the distribution channel in the industry, to customer and product
profile changes, etc., bottom-line profitability within the distribution
segment of our industry has increased. Whether it has increased to the level of
acceptability in comparison to the risk and investment is debatable.

Many distributors have diversified their product offering
outside the mechanical insulation industry, added value-added services, and expanded
their geographic reach by opening new grass-root centers. Consolidation also
has impacted the distribution segment. All of these changes, and others, have
had some influence on the distribution channel.

Beginning in the late 1990’s, private equity began investing
in the industry’s distribution channel, which has since increased
substantially. The discipline and philosophy that private equity brought to the
industry has been the catalyst for the majority of the consolidation efforts.
With today’s low cost of money, private equity has lowered the hurdle rate or
return expectations, which may continue to drive consolidation efforts for the
next several years. Those efforts also may lead to increased product offering
and diversification by the traditional mechanical insulation distributor.

We’ve discussed
the near future, but what long-range trends do you foresee?

1989 Response: Many experts indicate the world’s
business outlook continues to be manufacturer-oriented, even though our general
economy clearly is evolving into an information society where service
industries rival manufacturing industries. Distribution is based upon
information and service. Distributors are not just “middlemen,” existing in a
parasite relationship with manufacturers. Distributors are or will be
recognized as full partners to manufacturers and the world economy.

Louis Dehmlow wrote in his book, Superconductive Ideas, the
following comments about distribution:

“Our forefathers were the men of
commerce and trade. They drove the camel caravans and sailed the ships at sea
as the Phoenicians did three thousand years before the birth of Christ.
Manufacturers, by contrast are newcomers, they appeared a mere 250 years ago
when new technologies and inventions were making possible the industrial
revolution.”

So we are not the stepchildren of manufacturing or simply
another ?service industry.’ We have a noble history of our own and a leadership
role in shaping the future. The Encyclopedia Britannica says that, “commerce
began where civilization began.” We were there. We can be entrusted with the
unlimited dreams of youth, because, even with our long history, we still
represent unlimited possibilities.

I believe that summarizes the future of distribution in our
industry. Despite the complexities and day-to-day frustrations, the industry is
maturing, growing, and prospering, and will continue to be a vital phase of our
overall industry.

Today’s Response: I think that
still summarizes the future of distribution in our industry. The distribution
segment will not be without its challenges, but it will continue to prosper and
be a vital contributor to its customer base and supporting manufacturers.

With consolidation and diversification leading the way, and
an increasing and changing customer base, I expect the industry distributor
profile to look substantially different in the next 5 to 10 years. The core
values of distribution?the value of distribution?I do not expect to change. The
value of the manufacturer and distributor relationship will continue to
strengthen and become more strategic and tactical in their mutual planning
initiatives. Distributors will look to strengthen and expand their customer
relationships as they drive for sustainable and profitable growth.

The mechanical insulation industry and the distribution
segment have an exciting future.

 

The
1989 Distribution Commandments

1. Thou shall do the buying

2. Thou shall sell the product to thy neighbor

3. Storing the product will be thy task

4. To thy customer thou shall transport the product

5. Thou shall aid and comfort thy customer by financing

6. Risk-bearing will be thy covenant     

7. Thou shall keep abundant market information

8. Thou shall provide product service
to those in need