Drilling Down Deeper for Profits
by Gino Morelli

Most companies have a clear idea of their overall profitability, and can drill down to determine the profitability of individual products as well. But many miss out on one of the most valuable ways to analyze their operations – the channels used to get their product to the end user.

Some product may be sold through a channel that includes direct salespeople who sell to retailers or end users. Other product might move through agents or brokers, through mail order or newer technologies including the Web and online auctions such as E-Bay.

But as an old-style retailer once remarked, “I know that half of my advertising budget is wasted. I just don't know which half.” Many companies find that their channels form a “black box” and they can't see inside of it.

Why would this matter – and do we really need yet another way to slice a company's numbers? Here's why.

Consider an imaginary company that sells two main product lines, A and B, through three channels – a direct sales force, third-party resellers who buy in bulk and distribute, and small-volume independent agents.

Determining the direct cost of serving each of these channels can be relatively straightforward. Salespeople will be paid a salary, commission and perhaps some benefits. Resellers likely will receive a discount on the product, which needs to be factored in along with the cost of any company staff dedicated to their support, but they may command a high level of volume. Agents will likely pay a higher price for the product, driving higher profitability for this channel, but the cost of shipping many small deliveries to them may eat into that profitability.

In some cases, allocating a fair share of overhead expenses may make this analysis a challenge; our experience is that these numbers are easiest to develop through an activity-based costing approach.

It is also necessary to factor in the opportunity costs in considering a channel's profitability. Determine the capital and staff used to serve the channel, and factor in the costs of having them not available to serve other company needs, including the cost of capital.

While this “first-level” channel profitability analysis can be fruitful, the real value lies in going one level below this – to the sub-channel, which considers individual customers or types of customers.

In this, we might find that “Product A” sells well to “Customer 1,” which is where much business analysis would stop, in the belief that all is well. However, channel analysis might indicate that while all three channels compete in this segment, only direct salesforce and resellers are profitable. Although the Resellers channel is more cost efficient than the direct salesforce (lower costs/sales ratio), the low sales volume of Resellers indicates that selling Product A to Customer 1 probably involves extensive customer service. Therefore, a Direct Sales Force may be a better channel for this segment than Resellers.

Identifying the reasons for differences in channel performance leads naturally to making business decisions that can improve overall profitability. For example, we might consider:

• The direct sales force may be able to obtain higher prices (and therefore margins) because its members are better trained, more knowledgeable and motivated by higher commissions. Would changing these factors for Agents and Resellers, help?
• Why can't the Agent channel sell successfully to Customer 1? It could be that the customer just doesn't want the product – or maybe the customer has not been convinced it has value, because the Agent has not been properly trained to uncover needs.
• Why are both the Direct Sales Force and Resellers not profitable in selling to Customer 3 while the Agents channel is? Could it be that the terms of payment are attractive for Agents but not Resellers or direct salespeople?

Other potential factors influencing a channel's performance are competition, market conditions, product life cycle, customer needs, channel capacity, operational efficiencies, conflict between channels (such as Agents and Direct Salespeople both calling on the same customers) and incentive or support issues.

Determining the different levels of profitability among customers, and seeing the sometimes dramatic differences, can be a powerful incentive for digging deeper to find reasons for the difference. This can lead to significant changes – for example, the company may decide to eliminate its Agents as these are not profitable, or perhaps understand that the Agents are profitable – but only with certain customers; with the others they create a loss.

It could also be that better training for Agents will pay off dramatically in higher sales, better retention of Agents, and higher morale.

In some cases, your analysis may lead you to a new sub-channel. For example, you may find that Resellers have proved their worth selling Product A, so what could they do if you permit them to carry B as well?

As with all business analysis, crunching the numbers is only part of the process. The rest comes from taking action on what you find, to build higher profitability for the company as a whole.

Gino Morelli is the president of IF Consulting Inc., based in the firm's Boston USA office. Reach him at gmorelli@i-fconsulting.com.