Is distributor profitability influenced by strategic decisions to get into the right industry? If it is, then management should focus heavily on migrating to the most profitable distribution opportunities. Or, is profitability the result of operating the firm as effectively as possible? If it is, then management should forego the strategic analysis and emphasize operations.

The question of strategy versus operations, and its huge implications for management action, has been debated by distributors and industry analysts for years. A new study from the National Assn. of Wholesaler-Distributors sheds some empirical light on the issue.

The NAW study, Improving Distributor Profitability , examines the profitability results of more than 10,000 distributors in 40 different lines of trade (for example, general MRO products, safety equipment, fluid power, etc.). As such, it is the largest cross-industry financial benchmarking study ever completed. The study evaluates the participating companies in two ways: by line of trade and by individual company within each line of trade. The results show that while both industry and operations affect profitability, operational issues have a deeper impact.

Exhibit 1 (see p. 62) should remove any doubt that industry conditions are an important determinant of the profit results produced by every firm. The exhibit tracks return on assets (net profit before taxes as a percent of total assets) for the 40 key industries analyzed in this report, arrayed from lowest to highest. The exhibit also includes two comparison levels, one at a five percent ROA, and one at a 10 percent ROA.

The median ROA across the 40 industries was 7.5 percent, which represents acceptable financial performance. At the low end, the median ROA in the least-profitable industry was only 2.3 percent. At the high end, the median ROA was 14.2 percent. This means that three different firms that were typical within their industries and all of which had an asset investment of $10 million would have produced the following dramatically different levels of profit:

The difference between the high and low figures is slightly more than six times the profit on the same level of investment. Clearly, structural factors deal the cards that management must play.

The five percent line in the exhibit represents the minimum level of ROA that is generally considered acceptable in distribution. In most cases, industries with a median ROA below this level experience significant acquisition activity, as well as the outright abandonment of the industry by some firms. Eventually, such a reduction in the number of firms should cause ROA to move upward, at least to the minimum standard. About fifteen percent of the industries fall below this standard.

The 10 percent line in the exhibit represents outstanding performance for an entire industry. Such industries might be expected to attract additional competitors over time, assuming the free migration of capital, which would eventually move the median ROA down. Slightly less than 15 percent of the industries are in this enviable high-profit position.

The remaining 70 percent of the industries are somewhere in the middle. Even among the mid-range group there are significant variations in performance, ranging from barely above five percent to nearly 10 percent. Within the middle group, the profits generated on a given level of investment still vary by 100 percent.

Given the differences in profitability between industries, the logical question is "Why did they occur?" Improving Distributor Profitability examines nine different structural factors that management should consider in making strategic decisions. Two of them are reviewed here — industry sales growth and the level of commoditization.

Industry sales growth . One of the oldest management adages is that growth covers up a lot of problems. If so, then sales growth should correlate significantly with industry profitability. A couple of the industries analyzed here actually experienced sales declines, while a few industries had spectacular growth.

The 40 industries were divided into four categories — varying from less than two percent sales growth per year to over 10 percent. The results indicate that growth really does cover up at least some problems. The firms in industries that grow rapidly enjoyed a dramatically higher level of profitability than firms in the other sales growth categories, with the difference being 2.5 percentage points of additional ROA.

Commoditization . Firms in nearly every industry feel that their products are, or are rapidly becoming, commodities. Clearly, this is not the case. In many industries, the product offering is diverse with numerous opportunities to avoid direct competition. Even if the most basic SKUs are commodities, there are almost always some extended product offerings to wrap around the commodity base. At the same time, there are a few industries that are not selling much more than commodities.

The level of commoditization proved to be a key industry profit driver. The firms in commodity-oriented industries produced an ROA nearly four percentage points lower than firms in industries with more specialized product lines. This does not suggest that high profitability is impossible in a commodity-driven industry, but it does suggest it is a difficult undertaking.

Those two factors, along with the seven others discussed in the report, indicate that a company's line of trade plays an important role in determining its profitability. While firms cannot change industries immediately, they can migrate their product line, change their service profile, add and delete both suppliers and customers, and make a number of strategic changes to take advantage of industry drivers. Ultimately, however, firms have to find a way to run the existing business better than before.

Despite the importance of strategic actions, the report suggests that operational issues have the most effect on profitability. This is demonstrated in Exhibit 2, which once again presents the median ROA figures by industry. The exhibit adds both the 25^th and 75^th percentile results for ROA. In other words, in every industry 25 percent of the firms did better than the top of the line on the exhibit and 25 percent did worse than the bottom of the line. As the exhibit indicates, there are wide variations around every median figure.

Even in the most difficult industries, some firms produced adequate, or even exciting, profitability. Conversely, in the highest-return industries, some firms still produced disappointing financial results. In the short run, operational effectiveness is the name of the game.

The way that such actions impact performance is demonstrated in the critical profit variables (CPVs). The CPVs include sales, gross margin, expenses, inventory turnover and collections. Of the CPVs, two were especially important: company sales growth and expenses as a percent of sales.

Company sales growth (as opposed to industry growth). Five sales growth categories were evaluated:

Very Slow — Growing five percentage points slower than the industry rate of growth.

Slow — Growing two to five percentage points slower than the industry rate.

Typical — Growing within two percentage points of the industry rate.

Fast — Growing two to five percentage points faster than the industry rate.

Very Fast — Growing five percentage points faster than the industry rate.

The difference in ROA between the very slow sales growth category and the very fast one was 3.3 percentage points. It is one of the largest single differences in ROA seen among the CPVs. However, the influence of sales growth was only dramatic at the two extreme growth rates. As long as the firm is growing reasonably close to the industry norm, there is no major impact on profit performance.

Expenses as a percent of sales . The expense percentage breakouts were all in comparison to specific industries:

Very High — More than two percentage points above the industry median.

High — One to two percentage points above the median.

Typical — Within one percentage point of the median.

Low — One to two percentage points below the median.

Very Low — More than two percentage points below the median.

For the expense percentage ratio, the difference in ROA between the very low category and the very high category is more than 4.5 percentage points. To put the difference in context, this one factor produced an ROA change equal to about half of the combined ROA change produced by all of the industrial structural factors.

The importance of expense control is due in large part to the severe expense pressures that distributors have been under during the last few years. Some firms responded to the expense control challenge, but many did not. The result was extreme diversity in the operating expense percentage and the movement of expense control to the top of management priorities.

Improving Distributor Profitability is a 67-page document focused on distributor profitability. It suggests that much of the "common wisdom" about profitability is wrong. It also suggests that profitability is highly controllable with specific management actions.

To order Improving Distributor Profitability, visit the NAW Web site at www.nawpubs.org.