In these tight economic times, retailers are being asked to squeeze costs where ever they can. Improving profitability with vendors seems to be on everybody’s mind. Yet few, if any, retailers know the true profitability of their vendors, much less how to improve it.

Most retailers rely on their merchants to manage vendor profitability, but buyers don’t have the incentives, or the tools, to look at the big picture of a vendor’s total profitability. Buyers are measured on Sales, Markdowns, COGS—the items that impact gross margin (GM).  But not all allowances and discounts hit the GM—many components of profitability lie below the GM line and are managed by other functions. Payment terms, cash discounts, shipping performance, packaging, vendor compliance, freight charges—all affect vendor profitability yet are largely invisible at the company level.  As a result, when retailers attempt to manage these components, they often fall victim to the “squeeze the balloon effect”—a concession negotiated by one group gets added back somewhere else. If Finance drives a payment terms initiative, the vendor reclaims those savings in freight charges. If the warehouse institutes penalties, those penalties are reabsorbed in COGS.  Individuals and departments may hit their metrics but the net effect to the company is neutral—or worse.

Understanding vendor profitability requires a broad, cross-company effort

Total profitability cuts across departments, channels, and functions. This is tricky because the people who need to be involved all have different incentives, and their definitions of vendor profitability will be skewed accordingly. Worse, the data required to develop a big picture is scattered in various, disconnected systems, and no one person knows what data sources even exist.  Currently, if a retailer looks at total profitability, it is a one-off exercise for very large vendors—total profitability analysis is time-consuming, requiring spreadsheet analysis and intensive manual processes to pull data from disparate systems. Measuring and managing vendor profitability will require the work of a cross-functional team and dedicated resources.  Most retailers will need outside help to build a widely-accepted vendor profitability methodology.  A neutral third-party can:

• Provide industry perspective that cuts across functional biases
• Facilitate development of a robust profitability formula
• Develop a tool to pull data and support efficient, repeatable analysis
• Help determine accountability and drive alignment

The most robust measurement gets you nowhere unless someone is accountable

Practically speaking, you will never get one party responsible for all of the components of vendor profitability, and it may be difficult to enforce accountability for individual components. The goal of accountability is to drive alignment in how individual groups work with the vendor and awareness of the overall goals of the company with respect to each vendor. Part of the team’s work is to implement processes that ensure collaboration and communication amongst the various groups to drive the best possible outcome for the retailer.

For the most part, vendors will appreciate this. Imagine being a vendor who has been responding to demands—some of which are in conflict—from the warehouse, Finance, and multiple buyers. With a total profitability approach, the retailer either funnels requests through an informed Buyer, or the vendor at least deals with an aligned, cross-functional team.

A model is as good as its uses

The data from a vendor profitability model is invaluable if it is used to feed interactions and negotiations, allowing the retailer to develop a unified approach rather than having functions, departments and channels working at cross-purposes. Having visibility to the total picture helps the Buyer understand the pain points and develop more informed negotiation strategies against those levers.  A well-informed Buyer is a powerful negotiator.

If you need help designing and implement robust vendor profitability systems, contact PRGX at .(JavaScript must be enabled to view this email address).