The ABCs of DSD

The retail supply chain is loaded with variables and incremental costs, and anyone looking simply at gross margin to compare DSD and warehouse-delivered product may be in for a rude awakening on the bottom line.

Activity-based costing analysis of the top 100 food categories in supermarkets underscores the fact that DSD categories account for a staggering 52% of store profit and one-quarter of store sales. However, studies clearly indicate that evaluating DSD items and warehoused items on the basis of gross margin can be grossly misleading, since these percentages do not take all retail costs into account. Even dead net gross, which includes manufacturer rebates, merchandising allowances and promotional support, is inaccurate, according to a study by Boston Consulting Group, Chicago.

Warehouse-delivered product can rack up significant direct and incremental costs from the receiving dock to the retail shelf. And, as volume increases, so does the retailer's operating expenses.

ABC has measured the direct and incremental costs incurred by both manufacturers and retailers along the supply chain, and, by adding in such items as warehousing, delivery, merchandising and administrative costs, has come to the conclusion that "contribution margin" is the best calculation. This boils down to what's left after variable costs that can add to fixed overhead.

To illustrate these costs, BCG offered the example of higher prices charged by third-party wholesalers to retailers that don't self-distribute. Even retailers with their own distribution networks can use these services in rural or distant markets where they have a low share and they know that the costs associated with warehousing and distribution show up on the bill, according to BCG.

Under the DSD system, the retailer only pays for backroom check-in—the cost of receiving product as it's arriving at the store. This accounts for a profit reduction of only 0.2 to 0.5 points. If all products currently warehoused, delivered and merchandised by DSD vendors were to go through the retailer's own facility, the additional costs and investment in equipment, real estate and labor would be enormous. In fact, incremental costs to the retailer would result in an estimated reduction of 8 to 10 points in profit.

These collateral costs include:

Labor at the distribution center to receive, rotate, pick and ship the product.

Incremental fleet and shipping costs to deliver product. Most retailers run full trucks and weigh or cube out the vehicle.

Additional volume means more labor hours in-store to order, stock, rotate, and merchandise, build displays and to manage inventory, space and promotions.

Additional warehouse space—rented or built—to handle bulky items such as beer, carbonated soft drinks and salty snacks.

On its own, in-store labor provided by DSD vendors is an enormous sum. For an average store earning $150,000 to $250,000 in net operating profit, 5,000 additional labor hours could account for 30% to 45% of the store's after-tax operating profit, according to BCG. On average, the 55,000 to 60,000 DSD vendor reps are providing 95 to 100 in-store labor hours per week in the typical supermarket, which translates into $15 to $20 per hour. This includes 10 to 12 hours weekly on staging; 15 hours in receiving; 40 hours for stocking product; 20 hours for rotating and managing inventory; and 10 to 12 hours spent on reordering.

Annually, this translates into 125 million to 150 million labor hours for the retail trade—a figure that can mean $1 billion to $2 billion cost avoidance or profit enhancement. On another level, it would be extremely difficult to replace experienced DSD reps in today's labor-short market.

DSD reps are not only highly trained and motivated, but offer high service frequency and specialized equipment. This level of service is essential for such DSD mainstays as salty snacks/crackers, bread, beer and carbonated soft drinks, all of which have unique product characteristics. These include:

Shorter shelf life

Higher SKU velocity

High demand variability driven by promotional intensity

Lower value density

Merchandising difficulty due to the weight or fragile nature of the product

Getting into specifics, BCG notes that DSD products including carbonated soft drinks, beer, bread, salty snacks, cookies and crackers, have an average shelf life of 70 days, and as little as 30 days for bread. This compares with 390 days for the average warehoused category. Additionally, DSD items turn an average of 12 units per store per week, compared with an average of nine for warehoused categories. Shelf life and velocity both require higher call frequencies.

"If you just look at short shelf life, high SKU velocity and demand variability, they all drive the need for frequent service to keep the shelves stocked or to keep product from getting stale. Typically, this means smaller, more frequent deliveries," BCG officials said.

Demand variability is measured by the standard error or the standard deviation divided by the mean velocity. The standard error is more than 50% for DSD categories, according to BCG, meaning there's a 50% probability that velocity will be one standard deviation above or below the mean in any week. This means that a retailer running a lot of frequent promotions for products like salty snacks, soft drinks and beer has a lot of variability in demand.

"If you just look at short shelf life, high SKU velocity and demand variability, they all drive the need for frequent service to keep the shelves stocked or to keep product from getting stale. Typically, this means smaller, more frequent deliveries," BCG officials said. "These factors also drive the need for expert merchandising. "The 16-year-old stock boy is not doing the same forecasting, tracking out of stocks or making sure the beans don't crush the chips as someone who's trained to handle the product."

DDS products are also more difficult to merchandise and the fragile nature of the product or the weight of soft drinks and beer means that special equipment might be needed to get product onto the shelves. DSD items also have a much lower value density—$27 per cubic foot vs. $110 per cubic foot for warehoused items. This is measured as the price of the product divided by how much space it takes up. "Think about distribution economics. Trucks and warehouses are the major costs. If you have a product with a low-value density, it has a high cost as a percentage of sales," a BCG official notes. "You may be cubing out the trucks, but sales value of the product is low."

BCG concedes that some large retailers benefit from economies of scale and have lower fixed costs per unit because they warehouse and deliver more products and have larger drop sizes. But they also understand that focused customized DSD systems reduce out-of-stocks, provide fresher, more appealing products, result in fewer unsaleables and stales and greater efficiency in warehousing, delivery, handling and merchandising.

As the store manager of one chain put it: "The systems are entirely different. I'm working every day to balance my load and streamline the distribution center and fleet network. I can't worry about the beans crushing the chips. If we handled fast-moving DSD categories, we'd end up shorting out because we can't deliver daily or handle their peaks and valleys. "

The buyer for one leading mass merchandiser told BCG that the company has considerable trouble moving many private label DSD items through the warehouse system. "Initially, private label chips look good on gross margin, but they cost a lot more after we move them because they require a lot of hands. We can barely do a good enough job with service twice a week. We can't provide the seven-day a week service we get from our DSD vendor."

Again, BCG notes that gross margins—even dead-net gross margins after trade support—are inadequate for tracking real profitability. In fact, retailers might think they are making more on warehoused items if they look at just gross margins. However, in playing out the data for the beer category, BCG compared the numbers for DSD and warehouse-delivered brand. After taking into account direct and incremental costs, including that of the distribution center, delivery, in-store labor and the administrative costs of receiving and invoicing, the contribution margin for the DSD product is 18% higher than the warehouse-delivered brand.

In other categories, gross and contribution margins are both higher for DSD items than warehouse-delivered ones. This was the case in salty snacks where the "dead net" gross margins are 10% higher for the leading DSD brand. Furthermore, the contribution margin for the DSD brand was more than 70% higher than for the warehouse-delivered item.

DSD items are among the most profitable food categories in the store. The higher contribution profit from DSD categories has been corroborated by numerous studies that have measured ABC costs for grocery retailers, according to BCG, which made note of work done by Milton Merl Associates showing the average contribution margin for DSD items at 16% compared with 3.6% for mixed distribution categories.