Using ROI To Reduce Supplier DuplicationWritten By Jason Bader
Article Date: 06-01-2006
Copyright (C) 2006 Associated Equipment Distributors. All Rights Reserved.
Doing the math can add substantially to your bottom line.
If you are like most distributors, duplication of supplier lines is a thorn in your side.
The sales reps love it. When you carry duplicate lines, you make it far easier to say yes to the customer. The ability to take an order, rather than sell, is increased dramatically. So what’s the problem? Aren’t we in the "give-the-customer-what-they-want" business?
The practice of carrying several different lines that represent essentially the same product can be referred to as the Baskin-Robins approach to supplier selection. Carry 31 flavors and let the customer make the decision.
Unfortunately, this practice leads to difficulty in making supplier purchasing requirements.
Meeting freight minimums can lead to inflated orders and result in lower performance over the entire category. When the strain on the credit line becomes painful enough, the edict comes down to reduce product duplication.
But, how do you choose between several product lines?
If you want to justify a decision, and your name isn’t on the front door, prove it mathematically. When you run the numbers, all the emotion is taken out of the decision.
Faced with this particular dilemma, I like to utilize a return on investment tool known as the Turn and Earn Index. Some prefer to use Gross Margin Return on Investment (GMROI) to analyze their supplier lines. This is another strong tool; but I like the way that Turn & Earn exposes the weaknesses in under-performing lines. This open exposure makes it easier to get to the root problems causing the line to produce poor returns.
To find the Turn & Earn (T/E), simply multiply the inventory turn of the supplier by the average gross margin produced by the supplier line.
Before all you purists start screaming, I want to acknowledge that T/E was originally taught using markup on cost on the earn side of the equation. We use gross margin primarily because most system software thinks in these terms. Gross margin is a much easier number to extract. When we are using T/E as an index, gross margin works very well.
For example, if a supplier line has a turn rate of 4, and an average gross margin of 25 percent, the T/E would be 1.00. It should also be noted that T/E is usually stated by dropping the decimal point. In our example, the T/E would be 100.
The next step is to rank duplicate product lines by their corresponding T/E number. For example:From the table, it’s clear that we’d want to eliminate Brand 4 — if we’re basing our decision solely on return. Take a look at Brands 2 and 3. Without running the math, what would be the probable outcome of a decision to eliminate one of the lines?
From a sales perspective, the gross margin percentage is lower on Brand 2, and the product would probably get the axe due to most distributors’ compensation methods.
Actually, Brand 2 is a better investment for the company because it will yield a better return on investment. This is powerful stuff. Savvy distributors have actually used this information to change their sales compensation programs. They give a higher commission percentage on the lines that yield the highest return on investment.
How can you implement this strategy in your business? If you’re just using the T/E calculation for inventory performance analysis, the tool gives direction as to where to find the root of the problem.
How can you implement this strategy in your business? If you're just using the T/E calculation for inventory performance analysis, the tool gives direction as to where to find the root of the problem.
Go back to the table - if I felt Brand 2 was under-performing, I'd take a look at improving the gross margin side of the equation. The turn rate of 6 is good. To improve gross margins, we have several options. We can go back to the supplier and ask for better pricing. We can try to justify buying at volume that increases the discount. I prefer using a pricing matrix, i.e. to increase prices on slower moving items. This "pricing by velocity" strategy can usually bump the overall line by 1 or 2 percentage points. By slightly manipulating the price, you can significantly increase ROI.
When we look at Brand 3, the obvious point of attack is on the turn side. Most distributors wouldn't be upset with five turns; but for the sake of this example, let's consider five turns as sub-par.
How do we affect inventory turns? The best way is to reduce average inventory value in the line. I'd typically look for any dead or slow moving stock in the line and actively pursue returning material to the supplier or liquidating the material through sales.
In addition, I'd look at an HITS report to identify items to drop from active stock status. A HITS report tells us which items show up most often, regardless of quantity, on sales orders. It's kind of like an items "popularity contest." Items with fewer than four hits annually are candidates for non-stocking status. Once these are out, overall inventory value will drop, and as a result, turns will increase and so will ROI.
Calculating T/E has some pitfalls. As a negotiating strategy, I‘d often share the T/E calculation with under-performing suppliers. Once when I was presenting a low T/E to a supplier and getting ready to launch into a plea for better pricing, the manufacturer asked, "How do you account for rebates and terms?" Since this manufacturer provided generously in both categories, he had a valid point. Unfortunately, I did not have a response.
Rebates and terms provide significant value and need to be accounted for in the gross margin side of the equation. Rebates aren't too difficult to figure out; but terms tend to trip people up. My rule of thumb is for each 30 days in additional dating, add ½% to the gross margin. I figure this is the amount of interest savings I'll receive by taking advantage of the terms.
Whatever system you use, you want to get everyone on the same playing field when making comparisons between lines. Whether you use the Turn and Earn Index to compare duplicate suppliers or simply to identify under-performing lines, doing the math will go a long way toward solidifying your argument.
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