Pat Bailey was shocked by the response. As finance director for Electrolux Europe, Sales and Marketing Division, he had arranged a meeting with half a dozen other blue-chip household names to compare ways of measuring the profitability of different retailers. 

He found that none of these prestige names had any clear idea of how profitable different retailers were for them.  "They had no numbers to back up their hunches on the profitability of their accounts."

He smiles, and says: "Perhaps I shouldn’t have been so surprised.  Before we implemented a system internally I asked our account managers which accounts made us money and which lost us money."

The result?  "They got the right answer half the time. Yes, there were a few very obvious cases where the account managers could gauge whether an account was a loss-maker. But, with many, they were unable to gauge hidden costs. An account with a high gross margin might be horrendously expensive to work with. Or it might be tying down a lot of assets, such as inventory and accounts receivables.  There was some surprise when I revealed the real figures!"

Bailey’s experience is not untypical.  In many suppliers, when it comes to numbers the sales force is still banging the rocks together.  Some sales forces are still measured and rewarded according to revenue.  Many have now migrated to gross profits. But few know what the cost-to-serve for an account is. Fewer still measure assets incorporating assets and inventory costs.

What measurements you choose should depend upon your needs.  But, for most suppliers, the gold standard is probably something that measures value creation – the real profit you make from an intermediary, taking into account cost-to-serve, assets and the cost of capital.

There are many good reasons why large companies struggle to measure channel profitability.  Often, internal accounting is based on geography or  product divisions.  Sales staff tend to shy away from using complex numbers.  And some companies question whether account managers should have access to profitability data at all.

So perhaps the first question to be asked is, why bother?

The answer, for Julian Dent, chief executive of VIA International, is simple. "Hugh Collum, finance director at GlaxoSmithKline, once said: ‘If you don’t keep the score, you are just practising.’ He is right."

Bailey agrees: "Back in my rugby-playing days I remember coming off the pitch cock-a-hoop after scoring three tries. The coach ripped me apart. He said I should have scored five. The point is that, unless you have measurements in place, you simply cannot monitor your performance. So what if an account is making you a 6% profit? Perhaps it should be making you 12%!"

At a deeper level, unless you have the right numbers, how can you be sure you have the right strategy?  Bailey says: "Companies make investments in factories and product development.  But it is the front-end that determines whether these planned profits are actually made. Therefore, suppliers need to be investing in the customers, who in our case are the big retailers.  You cannot begin to do that unless you understand the profitability of different accounts."

All this information can be used in many ways.

At a basic level you can use it to spot unprofitable accounts (see graph 1), says Dent.  Often this shows that a whole raft of small accounts is not making money.  Equally, says Dent, it can throw up unpalatable facts about your largest accounts.  "Many suppliers give huge concessions to big resellers or retailers without analysing the real costs."

Or you can start to compare the cost-to-serve of different accounts (see graph 2).  This example shows that large computer resellers cost a lot to serve because they demand big- deal discounts. 
You can also map the cost-to-serve against profitability (see graph 3).

It is also vital to look at cost-to-serve when selecting new intermediaries.  An enterprise software vendor who was used to selling direct was able to break cost-to-serve down into 340 separate actions. It was then able to swiftly identify which actions it had to do internally and which could be delegated, to whom and at what cost.

But perhaps the real value of these numbers is in empowering the account manager. Finally, he or she can understand the financial dynamics of his or her customer. Perhaps the gross margin is fine, but inventory levels and receivables need to be pushed down. Or perhaps it costs a fortune to service it.  It is only by carrying out such an exercise that the account manager is able to begin a constructive dialogue with the customer.

Electrolux has taken this forward to the stage at which account managers are equipped with various spreadsheets showing the dynamics (see graph 4). Says Bailey: "When the account asks for a further 2% discount we can look at what alternative steps we can take with the retailer to maintain our profitability."  Electrolux also stresses the importance of focusing on what Bailey terms "the win/win".  "You need to find areas, such as driving down inventory or changing returns policies, where there is a gain that both parties can share."

The data also throw up new opportunities. Electrolux combines profitability by product group and market-share movement to analyse market and account attractiveness. Bailey says: "Perhaps we have gained significant market share in cookers in a particular account, but that business is currently done at a loss. What steps can we take to improve it?  Market share is only of value if it is profitable market share."

Data can also be shared with partners, says Dent.  "Why should one distributor cost 7.6% to do business with and another 3.4%?  If you can understand this, then you can either push business to the lowest-cost channels or you can encourage your other partners to move towards better models."

An alternative approach is to carry out an end-to-end analysis.  This aggregates the total costs of the supplier and its channels to come up with total go-to-market costs. This can be split down by function.  Thus a supplier can establish what it is spending on product returns or marketing and what additional sums its distributors and dealers are also spending on this (see IBM and HP case studies).

Dent suggests that it is time companies started to include the customer’s costs when they measure real end-to-end profitability. "How many suppliers are measuring the internal costs incurred by the end-user in purchasing their product?  In some areas, such as selling technology products to small and medium businesses, this is an increasingly important issue."

Whatever approach is adopted, the benefits for suppliers who put the right system in place are enormous. 

One large supplier switched from a loss of over ten million euros in one country to a similar profit. In this case the trick was axing a long tail of unprofitable business and accepting lost market share. 

For another supplier, its understanding of channel financial dynamics is a tool to keep competitors out.  Peter Nolan, senior vice president, Electrolux, said: "We want very close relationships with profitable retailers.  We want to set up firewalls around them.  Equally, we want to actively divert our competitors to work with expensive channels that we don’t think will work.  Let them deal with the retailers who only want to buy on price."

A cost-to-serve analysis at IBM revealed a massive duplication of costs, said Martin Beckwith. “We found that often five resellers, each working with a different IBM salesman, were all competing to sell IBM to the same account.”  IBM responded by keeping a closer eye on its direct-sales teams and by helping its partners to develop unique skills sets, leading to less competition.

End-to-end profit analysis meant that HP was able to spot areas where it, its distributors and their dealers were duplicating their efforts.  Why have three companies handling the return of a single product?

The data can also be used to shift products to lower-cost channels. Dent says: "It is very hard to argue with hard numbers. Often you find suppliers are reluctant to shift mature products to commodity channels. To do so may damage existing relationships. Equally, you often find that the best account managers are focused on the higher-margin channels. That can also lead to institutional inertia. If you know the real profitability of different channels you can ensure that products are moved at the right time."

Our Analysis: Unless you have a clear understanding of channel profitability, you cannot select a winning channel strategy. Even more importantly, unless you understand channel profitability on an ongoing basis, you cannot hope to implement it successfully.  It is no exaggeration to say that whether or not you understand and measure channel profitability is what determines whether you are an amateur or one of the tiny minority who can claim to be real professionals!

IBM: Measuring end-to-end costs

IBM has embarked on an ambitious project to measure the end-to-end cost of its seven main routes to market from direct telesales to direct face-to-face sales and from working with big IT consultancies through to the traditional reseller channel.

This involves breaking down all the processes in the sales cycle and costing them, says Martin Beckwith. "Almost all sales processes involve an identifier who spots the opportunity, a closer who wins/gets the business and a fulfiller who delivers the solution.  Who should we be using at which stage in the process?"

The aim is to ascertain which is the most appropriate route to market for each customer and each type of business, and so enabling IBM to answer questions like "When should we be using internal telesales?" or "How much does it cost us to go to market through traditional resellers?" 

This should enable IBM to maximise its customer satisfaction and competitiveness.

HP: Finding cost savings

What do you do when your major competitor’s cost of going to market is apparently less than half of yours?

This is the invidious situation faced by HP’s Commercial Channels business, which sells $12bn of PCs, printers and enterprise systems through business-to-business channels in EMEA, according to finance director Etienne Rouvillois. He says: "Dell claims a cost of 8-9%. If you include the costs incurred by our distributors and resellers, as well as by HP, ours is in the range 15-20%."

These figures have provoked a major study of end-to-end costs, through all the channels used by HP – direct, two-tier and single-tier. Rouvillois says: "We wanted to study in detail precisely where and on what we and our distributors and resellers are spending money.  For instance, how much are we jointly spending on product returns?"

There were two aims: "Firstly, we wanted to identify areas of duplication where we could save large amounts of money.  Secondly, we wanted to find out precisely where our channel partners were adding value so we could reward it and market it." HP needs to do all this if it is to succeed in its aim of moving to a new channel model where partners are rewarded for added value, rather than for simply reselling products. 

Rouvillois firmly believes that the comparison with Dell is unfair to HP and its channels: "I am sure we are adding value in many ways whilst Dell is effectively passing on costs to the end-user. It is probably more expensive to buy from Dell than it is from HP.  For instance, we have better availability on a wider range of models than Dell."

The study is in two phases.  The first, at a macro strategic level, used samples of distributors and dealers to find out what the real costs are and where they are incurred.  This data will be used to plan HP’s channel strategy, to plan incentive schemes for partners and to spot where HP and its channel is delivering value.

In the second phase a system will be constructed to monitor channel costs on an ongoing basis. This will enable HP to measure the profitability to HP of individual partners. This data will be used internally. HP also plans to reward its most profitable partners. So far HP has completed the first phase of the project.

All this is quite a tall order.  Rouvillois notes that: "From the merger with Compaq we inherited two accounting systems, neither of which measured channel profitability. Compaq looked at profitability at the level of its national subsidiaries. HP looks at the profitability of product divisions."  This means that getting a clear idea of HP’s own internal costs is sometimes even harder than getting a clear idea of how partners are spending their money!

In the first phase, consultants visited HP’s top distributors and a sample of their customers – small resellers who sell mainly to small- and medium-sized businesses. 
 
Rouvillois says that HP has many partners who are prepared to throw open their books to HP. "They trust us and they know that the more we know about channels, the better we can run them. They also know that we plan to reward them partly on their profitability.  Obviously, there are confidentiality agreements."

Initial findings are encouraging. "We have identified certain areas such as claims handling where there is duplication and where it would make much more sense for the entire process to be handled by one party, rather than partially by all three of us."

Rouvillois says the exercise has also highlighted end-to-end functions, such as sales-force deployment, where HP and its channels appear to spend too much money. He promises: "We are going to launch some very specific programmes to address these."