Managing fee-based services

Texas A&M researchers find that successful service-based distributors anticipate customer and supplier needs—and tailor their businesses accordingly

By Ben Zoghi and Rafay Ishfaq, Texas A&M University -- Industrial Distribution, 4/1/2007 6:00:00 AM

The U.S. wholesale distribution industry has experienced a strategic shift in recent years, with companies adding fee-based services to their business offerings. This article focuses on the issues these organizations encounter in their efforts to manage fee-based services—issues related to operational capabilities and business processes, which must be adjusted to match the new service business needs.

The research is empirical, involving interviews with executives from 15 wholesale-distribution organizations in the United States from two distribution channels. It shows that these organizations have revised every aspect of their business functions spanning resource management, sales management, marketing and financial management.

This study offers wholesale-distribution organizations an understanding of the challenges they face in managing fee-based services and will help them formulate strategies to effectively manage their service business.

A changing role
Historically, wholesale-distribution organizations have given customers a convenient way to acquire products from different suppliers by maintaining local inventory. They’ve also provided value to the manufacturers/suppliers by giving them access to markets on a widely dispersed geographical basis. Through these distribution channels, the manufacturers/suppliers have been able to reach customers without the cost associated with holding local inventory, per-forming a local market sales function, extending credit, breaking bulk, etc. This time-and-place utility represents a service to the manufacturer/supplier as well as to the end user/customer that remains today.

In the last few years, however, wholesale-distribution organizations have been on the lookout for new business opportunities to guard against increased competition and declining revenue growth (IBISWorld 2004). An opportunity has emerged in the form of fee-based services.

In his book, “Forces of Change: The Road to Opportunity,” Adam Fein reported that in addition to products, distributors have added service offerings to their portfolios. These service offerings encompass supply chain activities that are carried out to provide for a solution to a particular customer need. The customer pays for these services according to the value they provide. Services include product application; field technical support; financial services; in-formation technology services; repair and maintenance services; kitting and labeling services; and logistical services, including materials management programs, in-plant stores, bin stocking, inventory consignment, etc.

As wholesale distributors have developed services portfolios, they’ve been challenged in demonstrating the value of the services to their customers. Some of their initial service offerings were basic (such as overnight delivery, extended line of credit, reverse logistics or installation services) and previously had been provided as part of the purchase price of the product. It was in distributors’ interests to un-bundle these services and start charging for them. At the same time, it was difficult, if not impossible, for customers to consider paying for services they’d been getting for free.

To overcome this obstacle, many distributors developed new services around pre-use, use, and post-use of their products within the internal business processes of the customers. This approach has identified new service opportunities for wholesale distributors.

A paradigm shift
These changing dynamics within the wholesale distribution industry have brought about new management challenges. Distributors’ business processes have been perfected over the years for a product-based business. But when it comes to fee-based services, distributors struggle with developing the skills set required of a services provider.

This empirical study explored the issues that impact the success of a wholesale distribution organization within the context of fee-based services. These issues were studied through analysis and documentation of the current fee-based services in two vertical channels: electri-cal and pharmaceutical. We analyzed fee-based services in light of their effects on distribu-tors’ profitability, customer value and the issues associated with migration from a pure product selling business to the fee-based services business.

Reaction to changing dynamics
A couple of decades ago, manufacturing companies started to build their strategies around deep knowledge of a few highly developed core service skills. At the start of the 1990s, 76 percent of all U.S. workers were employed in service industries, for example, communications, transportation, health care, wholesale, retail, financial services, etc. Many companies have become large, capital-intensive, technology-dominated organizations. Their approach is to fo-cus on their core competency and outsource other functions to make them leaner and effi-cient. Examples are Honda and Apple Computers, which kept key processes in-house while outsourcing functions.

The radical marketing approach to address individual customers underlies one of the dynamics of this paradigm shift from the mass-marketing approach. Fee-based service providers need to assess their resources relative to the need of select individual customers. These customers may not have similar service expectations and do not necessarily want the same level of service. Thus, service providers need to identify core customers best suited for their value-added services. The nature of this business requires that service providers are capable of quickly reacting to change rather than depending on anticipatory deployment of offerings to handle planned requirements. The focus should be on effective accommodation of unique customer needs, as well as on the ability to react to unexpected operational circumstances.

Shift in management strategies
Wholesale distribution organizations have usually classified markets in terms of their offerings. What the customer buys is not a product, but is the utility of the product. Customers seek particular business outcomes and they engage in activities to achieve them. Successful companies carefully study the what, where and how of the customer experience, as well as the ser-vice product, the setting and the delivery system. These companies involve employees in discovering the root cause of customer complaints and service problems.

Another dimension of the fee-based service business is the consideration of how the ser-vices will be rendered (manually, with people, or automated, through equipment/process). Growth through acquisition in the services business is risky since the services business is closely tied to people that are not concrete assets and may defect. At the same time, service companies have focused on achieving strategic alignment between customer segmentation strategies and organizational capability development. These companies are developing capa-bilities that enhance efficiencies and quality.

It will help wholesale distributors to develop a comprehensive understanding of the volume of work fee-based services entail and the opportunity to identify the costs borne by the cus-tomer in performing these themselves. This evaluation of the existing state of affairs helps to clarify the customers’ true needs and reduces the chance that a blind services offering may miss the real issues.

Research study details
For this study, a sample of wholesale-distribution organizations was selected in consultation with a major wholesale-distribution trade association. The sample consisted of five large (an-nual total sales revenue in excess of $1 billion), five medium and five small (annual total sales revenue between $20 million and $100 million) distribution companies from two vertical chan-nels: electrical wholesale distribution and pharmaceutical wholesale distribution. The sample companies selected belong to the cross-section of the two channels because of their size and visibility through their service initiatives. Some of the companies included in the sample were Graybar Electric, Rexel, Sonepar, McKesson and Cardinal Health.

We conducted in-depth interviews with the people responsible for leading and managing the fee-based services initiatives within those organizations. We needed to choose top execu-tives whose understanding of their services business allowed them to comment on the subject matter of this study. The participants had the following titles: director of supply chain man-agement, director of inventory management, or vice president of sales. Interview logs and notes from these sessions, along with other supporting documentation, were used as data for the study.

In addition to interviews, we also collected data from other sources, such as business and industry publications, consultancy studies and organizational annual reports. These additional sources of information not only provided us the background and historical perspective for our study, but also allowed us to triangulate the views of interviewees against the general opinions of the industry for validation.

Management issues
The following information describes the issues encountered by wholesale distribution or-ganizations in the realm of managing fee-based services.

Customer management
Know what customers need.
Understanding customer needs is one of the most significant issues concerning fee-based service business. Service business growth stems from the distributor’s ability to understand what customers want, which in many cases is not known even to the customer. If one does not correctly identify and serve the needs of customers, this issue alone can pose a big hurdle for service business success. No matter how extensive and elaborate a resource and skill set one has accumulated, if a customer doesn’t see the benefits in acquiring the service, it will fail. On the other hand, knowing what the customer wants and expects can pay huge dividends in terms of sustained business opportunities. Such identification of customer needs is crucial for distributors in order to align their core competencies to deliver customer satisfaction and meet or exceed customer expectations.

Customer-led service initiatives
A majority of organizations that participated in this study reported that their initial entry into the fee-based service business was in response to a customer-led initiative—customers sought solutions to challenging situations on the supply side of their business. Vendor-managed inventory is one example. In a VMI contract, a wholesale distributor will assume re-sponsibility for the indirect materials requirements of the customer. Indirect materials are nor-mally all of the products purchased by the customer with the exception of raw materials or sub-assemblies.

These contracts are usually initiated by the customer because they recognize that the ac-quisition and possession of these kinds of products is not “core” to the business and are in fact a drain on its resources. The customer will usually contract with a wholesale distributor to own the inventory in the customer’s warehouse, provide personnel to man the warehouse, provide in-plant delivery to the point-of-use, manage all second-tier suppliers, etc. Most VMI contracts include some or all of these services for which the wholesale distributor is paid a fee.

Credibility is in the eye of the beholder.
Another critical issue for wholesale distribution organizations is their credibility as a service provider. Considering the impact a distributor’s performance will have on a customer’s suc-cess, there has been increased scrutiny of a distributor’s competence.

There is added pressure on distributors to convince their customers that they cannot only show required capabilities on paper and in sales presentations, but that they can back these up through performance records of (supply chain) activities from the product side of their busi-ness. This is why most distributors striving for success in the fee-based services business fo-cus on their existing customers who can verify such competence through their own experi-ence. This helps bridge the credibility gap.

Managing the scope of work
Another dimension is to manage customer expectations regarding the quality and scope of service output. In the case of traditional product businesses, distributors have relied on the manufacturer/supplier to provide protection against customer dissatisfaction about the prod-uct. In the event of poor product performance, customers are asked to deal directly with the supplier (the only exception is when a wrong part is shipped). But in the services arena, this dimension has added complexity for distributors.
In their new role, distributors now act as suppliers of services. In this role, distributors need to carefully manage the scope and scale of their service offerings, including contractual issues dealing with quality, performance, after-service warranties, conflict resolution, etc.

Financial Management
Know what it costs you to deliver services.
The decision to adopt fee-based services can be risky. Service business deployment car-ries high costs, so the economic case for fee-based services must be evaluated carefully. The complexity of this issue is compounded by lack of costing practices that can allow distributors to accurately measure what it costs them to deliver these services to customers. This lack of knowledge impedes distributors’ attempts to show the monetary worth of their service offer-ings. The customers need to see the gains in dollar values if they are to ask distributors to take over their internal business processes. One way distributors have made gains in the ser-vice business is through measuring customers’ internal process costs and using them to show what savings can be realized if the customer contracts for those activities with the distributor.

Pricing services
Pricing is crucial for an appropriate return on investment, and also as a tool for business growth. Effective pricing of fee-based services can enhance profits and deliver customer value to ensure a win-win proposition for both. Unlike the service business, the product business uses “unit cost” structure. Each product has a distinctive purchase, handling and processing cost, which can be aggregated and divided over the total volume of products to get an aver-age—the unit cost of a product.

In the service business, the unit cost principle can’t be used, since the unique scope and complexity of a customer’s service order requires a different pattern in usage of resources. This aspect is managed by aggregating all the resources, grouped by activities, to come up with a unit cost of an activity, which can then be added to get the true cost of a complete ser-vice offering.

A common practice in charging for fee-based services is adding markup to the product sale price. This additional markup is based on perceived (usually not measured) costs incurred in delivering the service. Since most distributors are more comfortable with this type of pricing ar-rangement, they tend to utilize it often—too often. There is no effort to quantify and document for the customer the potential financial impact of such services on their business, which may provide an opportunity for higher gains in distributors’ profits through fee-based services.

Resource Management
Strategic planning
Wholesale distributors have struggled to develop business processes through which new services can be designed. Most distributors have entered the fee-based service business in a reactive manner, responding to a customer’s initiative to address a specific, defined need. In such instances, distributors evaluate existing resources and capabilities on an ad-hoc basis to determine if they can accommodate this new business opportunity. This approach restricts the strategic perspective on fee-based services for wholesale distributors.
Successful distribution organizations have developed strategic operational plans in accor-dance with the projected service business in the near future. Having a well-documented proc-ess plan not only helps run successful operations repeatedly, but also acts as a confidence–building measure for customers who will see credibility and authenticity in a distributor’s changing role as a service provider. For a customer, assurance that a proper business plan is in place, with the right kind of performance matrices, goes a long way toward lending credibil-ity to the distributor’s service business.

In general, few (mostly large) distributors have started to formalize the process of manag-ing fee-based services. This move is necessary to ensure a repeatable and reliable process to deliver quality service offerings. This includes seeking advice from professionals with experi-ence in other service sectors, devising performance metrics for service businesses, engaging the sales force in creating new service offerings, etc.
It’s understandable that when distributors initially approach this subject, they’re unsure whether to use current resources or employ new ones to match the requirements for services. Usually, this concern deals with two areas: the infrastructure (management, skilled labor, equipment, space, etc.) and additional financial capital. Due to the opportunistic reasons for distributors to move into the fee-based services business, most distributors have hesitated to invest heavily in both of these areas.

Marketing Strategy
Channel differences
Wholesale distributors’ engagement level in fee-based services varies by channel, and is affected by factors such as fragmentation of market, market position, product brand, customer type, etc. For example, electrical distributors whose customers are largely contractors and in-dustrial users (more than 50 percent) are more advanced in offering general and sometimes niche services, compared to the building supplies wholesale industry, which is more frag-mented and faces strong local-market competition. In pharmaceutical distribution, the buying power of the top three largest distributors has given them ample space to maneuver into the role of consultants, providing services to retail pharmacies and extending their reach to offer services in the medical equipment and medical supplies markets.

Market of one
In a traditional role, wholesale distributors have marketed their products to a large group of customers. Such marketing approaches were focused on an industry segment of specific cus-tomer groups such as OEMs, contract manufacturers, etc. In the services business, it is mar-keting to a market of one. It targets a specific customer or small set of customers that would need, value and be willing to pay for a particular type of service. Thus there is a completely different marketing approach for fee-based service businesses targeting identified customer segments.

Sales Management
Value proposition
Traditionally, the distributor’s value proposition has been to provide needed products at the right time, at the right place, in the right amount and for the right price. This value proposition is based on the efficient movement of material from origin to destination. Due to the drive to-ward selling services, distribution organizations are experiencing an evolutionary shift from selling products. This shift is evolving in such a way that the distributor’s engagement has ex-tended beyond the traditional boundaries of the wholesale business and entered into the do-main of business partnerships. Selling services deals with offering products combined with other capabilities as a means to solving customers’ problems.

Consultative selling
The service business requires a shift from a transaction to a consultative form of selling. The services sales cycle is typically a longer sales cycle; so, salespeople need to be patient and should understand how to create value rather than just look for an order.

The most challenging aspect of such a sales process is to quantify the benefits in monetary terms for the customer. Again, it is very hard to undertake such an effort without active partici-pation from the customer.
A distributor’s sales force is required to position itself with a selected segment of customers to develop business relationships for this purpose. One can demonstrate the benefits to the customers only if they are willing to allow the distributor’s sales force to gather data and evaluate the processes. Distributors that have succeeded in fee-based services report capital-izing on high levels of trust and mutual respect as prime drivers. It is still a hard sale, because showing financial benefits is dependent upon the distributor’s ability to interpret and under-stand the customer’s business.

A new skill set for the sales force.
An extraordinary understanding of customer processes is needed, dissecting each process to comprehend the discrete activities integral to each process. Wholesale distributors must also understand the rationale or problem that is being solved by each discrete activity unit, the systems and human capital requirements, and the interrelationships and interdependencies involved.

This intimate knowledge of upstream and downstream supply chain partners cannot be garnered without a deep-dive analysis of customers’ business processes. The conundrum is that few wholesale-distributor personnel are adequately trained to develop this keen assess-ment skill set. Mastery of the traditional sales process does not prepare the wholesale distribu-tor with the consultative skills required. This can be tricky, since customer firms tend to covet institutionalized business practices although they may not add value, and often can be a drain to the organization in terms of human capital and systems resources, leading to unrecognized profit leaks.

Up to this point, wholesale-distribution organizations that have succeeded in the service business have exhibited an extraordinary ability to anticipate customer and supplier needs, executed effective needs-assessment methods, and transitioned from a product to product-plus-service model. Distributors need a capable, fee-based service business unit that can drive enhanced profit margins, competitive advantage, and sustainable business engage-ments. Such forward-thinking and strategic business approaches can facilitate a turn-around, but require a change in the fundamental structure of the wholesale distributor.

Conclusions
Over the years, distributors have been identified by the products they sell. A shift from a strictly product-based business to one that includes services as well, on an equal or larger footing, has tested the distributor’s ability to change the business processes.

As wholesale distributors develop product-plus-service offerings, they can help customers offload non-value-added activities from their internal processes. Developing services around activities that require unique skills, systems, or processes limits the potential for replication from competing organizations. Ultimately, the goal is to expand the offering in a way that cre-ates value for supply chain partners, thus solidifying the foundation for a long-term, sustain-able engagement.

Viewing the supplier-distributor-customer relationship as one interconnected, interdepend-ent, value chain, our research study has analyzed issues that the wholesale distributors en-counter in fee-based services. This will help these organizations understand and better man-age opportunities and challenges in fee-based services business.

Given the consistent pressure on gross profit margins, a distributor’s best opportunity for a viable financial future may well lie in augmenting their business by developing and incorporat-ing a fee-based service business component. Since traditional services were included with the products, the difficulty for wholesale distributors has been in identifying new service opportuni-ties that can be sold as distinct “offerings.” The traditional wholesale distributor’s pricing meth-ods—essentially, a cost-plus methodology or mark-up on cost of goods sold—does not fit well in a service-based business. Services must be priced and sold on a cost-to-provide combined with a value-derived process.

In conclusion, the prospect of fee-based services is an exciting opportunity for the whole-sale distribution industry. It offers distributors the ability to completely change their value proposition to customers in such a way as to more fully integrate the wholesale distributor in the customer’s business process. This degree of integration provides the potential to create new revenue and value streams.