John T. McDonough
President, Foodservice Division
Hobart Corp., Troy, Ohio

"It has long been time to renew our focus on profitable growth."

Charlie Fusari
Vice President, Economy
Restaurant Fixtures, San Francisco

"It’s time for the leaders of this industry ... to take control ... of eroding margins."

At all levels of the E&S supply chain we are addicted to the aggressive pursuit of top-line growth. The addiction has become acute in the sense that it has long stopped being about chasing profitable top-line growth, but simply about growth itself. Following are a series of broad observations about the nature of our markets.

End-Users:
During new construction or major renovation, the typical foodservice operator needs a variety of services: design/specification support, project management, procurement, staging, delivery, installation, final hookups and check-outs, and operator demos/training.

When purchasing an item for replacement, however, the typical foodservice operator needs few of these services. Given the very high incidence of “like-for-like” replacement, most operators simply need a channel that accepts and delivers from a purchase order. Only when the operator wants an alternative to the item being replaced do additional offerings become relevant.

Channels:
The traditional full-service dealer was the primary model of distribution 20 years ago but new models of distribution have emerged to serve the operator spectrum. Among them are such models as the design/contract house, the bid house, the broadliner, the chain logistics manager, the catalog house and the e-dealer, all of which have been validated by a growing number of end-users who are willing or prefer to buy from these various models when the services they need are aligned with the services each provides.

With the varied service capabilities of each of the above models comes very different implied costs-of-doing-business. The net result of this effect is that when dealers with different business models compete over a given transaction, the lower-cost dealer can accept a commensurately lower markup than his higher-cost competitor, thereby driving down the available margin opportunities for the full-service dealers. One could argue this is the natural evolution of markets. If we were all simply punching sheet pans for a living, with each pan being sold as a discreet replacement item, I’d agree. Given, however, that at least half of E&S industry volume is sold in some form of new construction or major renovation project through those dealers most able to support them, it is imperative that value-added channels remain a viable distribution element.

Manufacturers:
E&S manufacturers’ channel compensation models have long been driven by an out-of-date view of the channel construct in which the majority of players still fit the traditional full-service model. The emphasis of these models has been almost exclusively on volume/growth.

The net effect of this approach has been that all channel players are effectively given the same starting point on the buy side regardless of their value-added capabilities, an effect compounded by the volume-oriented bias built into virtually all buying group programs. The lower-cost players have been able to leverage their cost models like a club against the higher-cost players, thereby lowering the margin opportunities of the very ones we depend upon to populate the factory community’s installed base through the servicing of the new construction/major renovation markets, which later become replacement business.

While their margins have eroded over the last 15 years, value-added providers have generally followed a two-pronged approach in seek of remedy: First, they have cut the quantity and quality of services, resulting in an escalation of factory sales and marketing expense to offset functional erosion; and second, they have increasingly leveraged the factory community for deeper and deeper back-end incentives resulting in a gradual inflation of every factory’s back-end cost of doing business with its channels.

Impact Summary:

• Higher-value channels witnessed front-side
• margin erosion
• Higher-value channels have become increasingly dependent on back-side incentives to remain viable
• Factory sales and marketing costs have escalated in an attempt to offset functional erosion in the channel
• The primary emphasis of virtually all factory rebate programs on volume/growth has forced the channels to chase that volume and growth to ensure optimum rebate returns, compounding the pressure on front-side margins c The self-perpetuating cycle of chasing volume to drive maximum rebate payouts has only further destabilized our distribution base and raised factory costs.

It is for these reasons that in 2005, Hobart and Traulsen introduced a considerably revised channel incentive system based on the idea that we should reward our channels based less on how much volume each player delivers and more on what functions they perform in support of our lines. In essence, we shifted our emphasis greatly from volume delivered to functional value provided. The primary objective is to motivate the higher-value-added channel players to reinvest in their functional capabilities over time. The feedback to our freshman effort has been extremely favorable. It is our hope that the idea will catch on across an array of manufacturers.

It has long been time to renew our focus on profitable growth. Accomplishing this objective requires effort from the manufacturing and channel communities.

We have seen the results and can project the likely outcomes of the current path. To do nothing in the face of that insight would, quite simply, be irresponsible.

In reading the results from the FE&S 2005 Distribution Giants study, several statistics struck me as interesting:

• 71% of the Top 100 Dealers support functional discounting as a means to increase profit margins.
• A majority of those same owners (52%) feel strongly for margins to improve there needs to be a “cleansing” within the dealer channel. Bluntly put: A reduction of the number of dealers is necessary.
• The Top 100 dealers indicated eroding profit margins was a primary concern as we move into the future.

I agree with all of these survey items. Margins continue to erode year after year, resulting in reduced service at both the manufacturing and dealer levels. I continue to hear a lot of talk about how to improve margins and service levels but see very little action. I am one who puts the onus on the manufacturing community to take the lead on the issue of eroding margins and do something about it. But few manufacturers are willing to tackle this very sensitive and terrifying solution known as “functional discounting.”

While I have been asked to write the counterpoint to functional discounting, in theory I can’t because I agree with it. Therefore, I will spend my editorial time writing about how we are missing this golden opportunity to improve margins and service levels through functional discounting.

I applaud John McDonough and the folks at Hobart for their willingness to at least tackle the issue head-on, but it is now up to other manufacturers to follow suit. I, as many others, have had the opportunity to listen to John’s view on the value of functional discounting. While I agree with a majority of John’s view, I do believe that size does matter and volume must be rewarded. The formula must include compensation for both volume and functions.

With that said, I would like to share my perceived understanding of functional discounting in very simple terms. We are a full-service dealership that performs most all functions for our manufacturer partners. This includes maintaining a sales force of more than 35 people and a showroom. We also offer a variety of other services such as design, specification, installation, project management, procurement, staging, delivery, final hookups, start-up, demos, marketing and, last but certainly not least, replacement business, which requires an extraordinary commitment to inventory dollars. I believe these to be the most important functions that any dealer can perform for a manufacturer and only those of us that perform all of these functions know the high cost of overhead associated with each.

My understanding of functional discounting is that we as a full-service dealer should be compensated, via discounting, for these functions. Those dealers that do not perform certain functions should not be compensated for them, regardless of their volume “potential.” This seems like a very logical plan for getting back margins, thus improving service levels. With all of the talent we have in this industry, though, I am perplexed that this remains an unresolved issue for all of us.

While many manufacturers are very willing to talk about functional discounting as a viable go-to-market strategy, most are not willing to step up to the plate and face this tough issue. As a manufacturer it’s easy and very safe to talk positively about functional discounting; after all, 71% of the industry’s top dealers would like to see it in some form. But the reluctance is in implementation. Why? I have a theory. Manufacturers fear that implementation of functional discounting will, in some way, adversely affect their volume. And no one is willing to mess with that.

To support this theory all you have to do is look at how many manufacturers belong to nearly every buying group in the industry. Why? Same reason: “If we are not in the group my competitor will be and that will cause our company to lose volume.” Most manufacturers fear that if they implement a functional discounting strategy, and pay certain dealers for the functions they provide, they will pay the price in volume. I strongly believe that the reverse would take place. Additionally, I believe that proper implementation of functional discounting would allow dealers once again to capture healthy margins, resulting in an increase of service levels.

While I applaud my good friend Mr. McDonough for all of his efforts in making an attempt to implement functional discounting within Hobart’s own program, I say this program has not gone far enough. If there is to be an effective functional discounting strategy for our industry, then truly pay those that perform the functions and do not pay those that are not performing the functions.

In this case being tentative isn’t going to work. John, it’s like standing on the 18th tee at Pebble Beach ... If you approach this with any fear or reservations, then you will hook your tee shot into the ocean. But if you just go for it without fear, you’ll hit the ball 275 yards, leaving it just left of the tree and down the middle of the fairway!

It’s time for the leaders of this industry, both in the manufacturer and dealer communities, to take control of the universal issue of eroding margins. It’s time for other manufacturers to follow Hobart’s lead. What will our industry look like in five or 10 years if we fail to make these necessary changes now?

Do you have an opinion on this topic? If so, put it in an e-mail to Joe Carbonara and we will post it on www.foodservice411.com.