There are many reasons why a company might use a distributor as a channel to market. For instance, some companies need to increase market share and simply lack the sales competencies to capitalize on opportunities. Sometimes companies have a solid product offering, but lack the ability to get that product to market. Yet, sometimes companies need to reduce their customer base in order to lower their service costs.
It’s that last reason that often confuses people. After all, why would a company reduce its customer base and sell through distribution, instead of just selling direct? Well, simply put, consolidating customers reduces service costs and dramatically increases gross profit. In fact, these are the most common reasons companies decide to sell through distributors.
Customer Consolidation Through Distribution
Consolidation is a reasonable solution to servicing multiple customers on small volume orders. For instance, let’s assume a company has 5000 customers, each customer buying one unit at a time. Imagine how much it costs to service those customers. How would this compare to selling 5,000 units to a distributor who then services those 5000 customers?
Obviously, the first scenario can be an operations and logistics nightmare with one order, shipment, invoice and collection occurring on 5000 separate transactions, instead of just one large transaction. Therefore, in this case, using a distributor can reduce a company’s day-to-day operating expenses.
Distribution can also help reduce your company's inventory financing costs, as well as your receivable financing costs. In the end, these channel to market sources can help, 1) lower your transaction costs, 2) lower your costs of goods sold (COGS), and 3) improve resource utilization.
Six Steps to Deciding Upon Distribution as a Channel to Market
The decision to use distribution comes down to defining your company's current costs to service a given territory or market. If you are servicing too many customers, with too many orders, then those costs are fairly obvious. If you aren't able to properly service customers, because you can't capitalize on the opportunities, then that too is fairly obvious. However, if you absolutely need to be 100 percent certain that using a distributor is the right choice, then use the following six steps.
First, define your product's costs of goods sold. Second, define your cost of capital - this is your interest rates on business loans and credit lines. Third, convert your cost of capital to a daily cost. Fourth, use your daily cost of capital to define your daily cost to finance your receivables. Fifth, define your inventory holding costs, or carrying charges - these are typically 3% a month of the inventory value on hand. Finally, define your per-unit freight costs to ship products to customers.
The above six step process is taken from the post: Benefits of Customer Consolidation Through Multiple Distribution Channels
An Example of Consolidation
The table below provides an example of how a company might go about deciding whether or not to use distribution as a channel to market. The table summarizes a fictitious example of a company servicing 10 different customers in a given territory. The company currently sells one of its products to each of these 10 customers.
The product’s cost of goods sold (COGS) are $5,000.00. The company’s yearly cost of capital is 4.5% (interest rate on loans). Its daily cost of capital to finance its receivables is 4.5% divided by 365, or 0.0123%. It costs the company $0.62 cents each day to finance its receivables (0.0123% X $5,000.00).
The average number of days on receivables collection is 45 days. This means the company’s average receivable financing costs are $27.74 for every unit sold. The sales cycle time is one month, so the company’s inventory holding costs are 3% of $5,000.00 - or $150.00 for each unit before it's sold. Finally, the cost of freight for one unit is $100.75.
The following table outlines all these costs for all 10 customers - based on their corresponding volumes. The six steps are included below.
Moving to a Distribution Model
Based on the above information, the company decides to move forward with a distribution model. In doing so, it avoids the high costs of servicing 10 separate customers with infrequent volumes, high freight costs, high inventory carrying costs and high receivable financing costs.
Instead of dealing with 10 separate customers, the company invoices one single distributor one large shipment. Fewer transactions means money is saved on freight, invoicing, inventory carrying charges and receivables financing.
To learn more about reducing your costs of freight, please go to: Sample Excel Sheet for Freight Costing & Inventory Cost Reduction
In the above table, the company is able to lower its freight costs by shipping larger volumes to one single distributor. Their inventory carrying charges are cut in half as they ship their finished goods to one location. Finally, they reduce their receivable financing costs because they are now collecting in 30 days - as opposed to an average of 45 days over 10 customers.
The "Delta" portion of the table summarizes the savings from servicing 10 customers in a single territory to selling through one distributor. Shipping costs are reduced by $543.25, holding costs reduced by $3,075.00 and financing by $379.11.
Four Points to Success With Distributors
Ultimately, what you must decide is how you want that distributor to service your company and your customers. In most cases, you'll need them because they can access a certain market, one that your team simply can't reach. In other cases, you'll need them for their product expertise and for their established list of contacts. Regardless of why you need them, it's essential that you work with the right partner. Here are four areas to be cognizant of.
1. Conflict of Issue: Be weary of those distributors that represent your competitors. It's common for distributors to represent multiple enterprises. They often use the information from one company to advance the sales and market share of another. In fact, some want to represent you in order to keep you out of the market. It's their way of guaranteeing you're not competitive in a market where their sales are higher with another company they represent. This can give your company a bad name and ruin your market presence.
2. Maintain Control Over Pricing: Should you choose to use a distributor, be sure to control your pricing, or at the very least have some way to know what your distributor is charging. As a business model, distributors often have low overhead and therefore settle on a 10% gross profit margin. However, some of them try to charge or make even more, and this can damage your company’s reputation with customers.
3. Avoid “Me-too” Distributors: Don’t deal with those companies that represent a huge client list with little manpower. In this case, they are using a shotgun technique and hoping something, somewhere, catches on. They don’t have a clear path for growth, and will provide one gigantic quotation to customers to meet every single possible need, without addressing and pursuing any one specific need.
There are some pros and cons to using distributors. The best can help increase market share, grow sales and reduce service costs. In essence, they can become true partners. However, for every good distributor, there is a bad one. Ultimately, you have to decide why you need to use this source as a channel to market. Once you've made that decision, be sure to analyze the savings and benefits of moving forward.
Vendor consolidation includes consolidating a company's vendor base in order to reduce supply chain management costs. To lear more, please go to: What is Vendor Consolidation? Strategies to Reduce Inventory Holding Costs