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  • Freakonomic Based Real Life Story

    Posted by Dan from Madison on July 25th, 2008 (All posts by )

    I am a middle man.  I run a business that sells HVAC products and equipment to contractors.  We do not do any retail.

    In my world, it is common for the manufacturer of the equipment that I am selling to set up factory direct stores that welcome contractor business.  It makes it interesting, to say the least.  Imagine you are doing your best you can to sell a company’s products, then they set up a store down the street a few blocks and sell directly to your customers.  It may sound weird to some, but it happens all the time in my industry.

    We sell service, delivery, no damage, taking care of problems, and basically do everything that the factory direct stores can’t, or won’t.  The relationship is more complex than this, but for this post that is all I need to explain about it, as that is the nuts and bolts of it. 

    The huge problem with this situation is that as a reseller, you are obviously at a price disadvantage to the factory direct store.  There is only so far you will go with this line.  That is fine with me, you either take it or leave it.  But something interesting happened a few weeks ago.  I received a call that this particular manufacturer was shutting down its operations in my state.  That is awesome news for me.

    For whatever reason, a disgruntled employee from the factory store came over and gave me a handful of price sheets and told me which customers were on what sheets.  This is great news as well.  I thought.

    As I began calling these customers, most of which I already had relationships with from selling them other things, I quickly realized that this wouldn’t be as easy as I had hoped.  Is anything easy anymore?

    This factory store had a blizzard of different price sheets on the street, and the information that I received from the disgruntled employee was about half right.  Many of the contractors had not received current pricing.  Imagine my surprise when I was told by some contractors that they had not had a price increase in several YEARS.  Have you seen what raw materials have been doing?  The trend is UP, to say the least.  What is an air conditioner or furnace?  A bunch of copper, steel, and other raw materials bent, soldered and welded into a usable form. 

    On top of all of this, most of the contractors were not getting invoiced correctly from the factory store according to their (not current) price sheets.  Many times it was lower, or higher, depending on the employee that worked there that day, apparently.  I heard rumors of the factory store dealing units out the back door for cash, opening side companies, sub distributors, and kickback schemes.  It is incredible.  I have filled almost a complete legal pad full of stories that I have been told.

    As an added bonus, many contractors were being sold products AT COST.  No kidding.

    I have many more things to add to this list of nonsense, but you get the drift.  It is no surprise that the manufacturer pulled the plug on this operation, because they weren’t making ANY MONEY.

    It is at times like this that I think of Freakonomics by Steven Levitt.  Much of that book is and has been argued, but one thing that really sticks out in my head is the concept of incentives.  Of course Levitt didn’t invent the concept, but he explained it very well in his book.  It is clear that the employees of this operation had zero incentive to make money.  I wish I had the information, but I would guess that the manufacturer paid the employees by the number of boxes that passed through the place rather than the amount of profit that they made, which is a huge mistake imho.  This would partly explain the low margins on many accounts (some zero) and the general lack of any perceivable plan on their part to present themselves as professional business persons.  This whole episode really kicks in at the end of the month when the factory store officially closes, and it will be insane at my place, in a good way. 

    It has been quite an eye opener.

     

    12 Responses to “Freakonomic Based Real Life Story”

    1. Ralf Goergens Says:

      Interesting, and congratulations!

      PS: On the other hand, you will have to tell the factory store’s former customers that they were undercharged all along and that they can’t hope to get equipment at such low prices from now on. At the very least, they’ll try to haggle.

    2. Dan from Madison Says:

      Yes, Ralf that is exactly what is going on. I have done it so many times now, that I have all the answers.

    3. David Foster Says:

      I think companies often look at the margin they are “giving up” to their channel partners and develop the idea that they could save a big chunk of this if they sold it themselves. Sometimes this is true, but often it is a matter of wishful thinking by people who underestimate the cost of running a sales operation and overestimate their brand value.

      In any event, it is crazy to embark on a factory-direct effort without putting tight contribution-margin measurements on the people who are running it; ie: revenue minus cost of goods sold minus cost of store operations & administration. Sounds like this wasn’t done in this case.

    4. Dan from Madison Says:

      David Foster – we always have a saying in distribution that goes something like “if the manufacturer could avoid us, they would”. But it seems in this case they eventually realized that they couldn’t.

    5. Mitch Says:

      One company where I did a consulting engagement made its sales commissions based on gross sales, period, and the sales force had a good deal of discretion in pricing. That practically guaranteed that their margins went south in a hurry, and returned goods (no adjustment to individual sales records) went in the opposite direction. Oops.

      The agency problem is really what management is all about. People everywhere respond to incentives, so you had better make sure you are rewarding the right behavior.

    6. Mrs. Davis Says:

      The lesson here is that there is a certain portion of the market that wants price and not all the other services you bundle into your product sale for “free”. The manufacturer, however poorly, was serving this portion of the market. You might take advantage of their exit to set up a low cost “competitor” to compete against your current company before a real competitor does. At least that way you’d know when your customers got your consulting services for free and not let them take you twice.

    7. Dan from Madison Says:

      Mrs. Davis – upon the exit of the company owned store, the manufacturer immediately opened up another distributor of their products (an independent), which was not a surprising move. I can handle that, at least the playing field is more level now.

    8. BOB JONES Says:

      Why in the world would you support a company like this? I know of a number of manufactures that do not and will not do that to their customer, the wholesaler. I’ve seen it in my area with Goodman and it boggles my mind why a legitimate wholesaler would allow their supplier to screw them on a daily basis. I’ll make a prediction, as soon as you get the territory back to speed and some of YOUR accounts are doing well, they’ll be back. In our area Goodman takes away an account as soon as it becomes a certain volume no matter who their wholesaler customer is and how well he’s doing.

    9. virgil xenophon Says:

      Everyone wants to eliminate the middleman–they just haven’t figured out how to eliminate the middleman’s costs…..

    10. Dan from Madison Says:

      Bob Jones – “Why in the world would you support a company like this?” The world of HVAC is very regionalized. Many times there are literally no other options for a wholesaler. In one market a company may go strictly with independent distribution, and others they may have only a factory outlet – or both, as was my case until recently.

      Don’t pick on Goodman either. In Indiana a loyal Trane wholesaler who had the line for some thirty plus years (and did a GREAT job with it) was rewarded recently by having the line taken away and replaced by a factory direct Trane store. They didn’t even have the option of selling the product anymore. There are many other markets where this has happened with several different manufacturers. I really don’t want to get into a brand p*ssing match though because they are ALL guilty of doing it to some extent.

      I will give you one more example. I see from your website that you represent Allied Air, which is owned by Lennox. In my neck of the woods the Lennox products are distributed exclusively by factory direct stores, where the Armstrong products are distributed by an independent. It may differ in your region, but like I said, I really don’t want to pick on any one manufacturer since they are all guilty in one fashion or another.

    11. Carl from Chicago Says:

      The factory direct store is similar to what happens in large condo buildings when the management is run by an outside firm. These outside firms are known for taking kickbacks and the like while delivering shoddy service, since the only “check” on their behavior is the condo board and that isn’t much of a check usually. If you find a semi-decent outside manager you should hang on to them for your life.

      Costs are poorly understood by many large, integrated enterprises. Often there are incentives, like the factory boss gets paid on volume but all the markdowns hit someone elses’ budget. Then there is also the fact that the time horizon for many people at corporate can be measured in months, while your time horizon (as an independent) may be measured in decades. If you want to hit a quarterly target and push stuff out the door regardless of what happens later and take your $ that may be a perfectly rational activity for YOU to do, even if it stinks for your company.

      Glad that guy is shutting down, though, sounds like he was at the least causing havoc in your neighborhood. I do like the employee giving you price sheets – what was his incentive to do that? Probably just to stick it to his own crappy company, while he prepares to high-tail it out of there.

    12. Dan from Madison Says:

      Carl – Besides making a dent in my potential volume, the factory store was causing TOTAL havoc in the marketplace – not just for me, but for my competitors too. I received a call from my rep the other day who somehow got that factory stores numbers and he FINALLY understood why I have been griping and bitching for the last decade or so – he said that he had literally never seen anything like it. I almost snapped on him, but held my tongue.

      I have no idea why that ex employee came in and spilled the beans to me. There was literally zero benefit for him to do so. I think he wanted to stick it to someone and dind’t know how. The sheets have been somewhat helpful, but so many pieces to the puzzle are missing still. The extent of the nonsense will never be fully unraveled, but the fact that they are gone, and replaced by another independent makes the playing field much more level. I can handle competition all day, but not when the game is fixed.