Sheltered income: the battle continues

Foodservice distributors and manufacturers recognize the role played by sheltered income. Sheltered income contributes 100 to 300% of a distributor’s tax profit, therefore spelling the difference between a distributor’s survival and shutdown. Manufacturers have come to accept the necessity of shelter and view it as the cost of getting involved in the distribution game. Although many believe that sheltered income is here to stay, methods can still be employed to make them more manageable.

Only three statements can be made with certainty about sheltered income. First, it is the single most abrasive component in the food-service distributor-manufacturer relationship. Second, it is a topic of such exquisite sensitivity that, however passionate the commentator, whether distributor or manufacturer, all observations are off the record. Finally, all agree that sheltered income has become a tiger so big that, as one distributor notes, “it is impossible to put a rope around it.”

Even definitions vary. Some manufacturers consider promotional funds allocated to distributors a component of shelter. Others have separate promotional funds. Cash discounts can be considered a form of shelter. So can manufacturer growth programs with distributor customers.

But, there are a seemingly infinite number of other forms of shelter for which distributors reach out to their vendors. They include fees for access to their sales forces, charges for participating in sales meetings, trade shows, and slotting allowances, to name but a few.

Whatever its form, though, shelter has become an all but indispensable component of distributor margins. In many, if not most cases, it is the lifeline to survival. If it were not for the existence of shelter, foodservice distribution would be decimated.

Knowledgeable observers of the scene estimate that sheltered income contributes from 100 to 300 percent of a typical distributor’s pretax profit, with the average contribution falling in the middle of this range.

No distributor questioned on this estimate disagrees. Translated into the simplest language, this means that if it weren’t for the availability of shelter, the average distributor would, at best, break even. Many would sink.

One real-life example points up the reality. Although, for obvious reasons, dollars-and-cents figures cannot be revealed, the story can be told in terms of percentages. At the beginning of his most recent fiscal, a Top-50 distributor projected his company’s pretax profits for the year. Shelter comprised approximately 120 percent of this bottom-line projection.

Year-end came. The bottom line ended up 50 percent under plan, this despite the fact that shelter dollars ended up 125 percent over those that had been projected.

Thus, contrary to what many vendors contend, what may seem like increasingly strident demands for sheltered income are stimulated by much more than an attempt to fatten bottom lines. Like it or not, it has become fact that for the average independent distributor, shelter is the bottom line. It spells survival.

THE WELLSPRINGS RUN DEEP

At this point, when so much emotion is connected with the issue, it is difficult to pinpoint exactly when the distributor battle for shelter first began to roil the waters in relationships with vendors. In retrospect, it was probably the early to mid-1980s, when the giant corporate distributors began to exert their purchasing clout and fearful independents sought avenues to match it.

However, this is, at best, a simplification, for there are other factors as well. While the whole subject of shelter is customarily thought of as a manufacturer-distributor issue, it is at least as much a distributor-operator issue.

Put most simply, operators–particularly those in the multiunit sector–have their own margin pressures. With their eyes focused on price and in their quest for the lowest conceivable cost-plus deals, they have put the squeeze on distributors. Distributors, in turn, have inevitably moved this margin pressure one rung further up the ladder to the manufacturer.

In the 1970s, when cost-plus business first began to loom high in the broadline-distributor customer mix, cost plus 12 was a generally accepted standard. True, even then, there were some who were quoting cost plus 10, but this was considered dangerously low unless there were alleviating factors. Today, cost plus eight is common and even cost-plus-seven deals abound.

Such arrangements can be profitable to systems distributors whose total operations have been geared to service operator chains. Customarily, they deliver to a limited number of customers through carefully controlled programs, are not burdened with an excessive number of line items, and can achieve high inventory and money turnover rates. Low cost-plus arrangements make sense for them. For a typical broadliner, they do not.

How, then, does the latter manage to ring up a bottom line with cost-plus-eight or even cost-plus seven programs? The answer is simple. He rarely does. Not really.

As one distributor puts it, “We are not using numbers reflecting our actual margins. Any distributor knows that he needs a 17-percent margin to realize any sort of bottom line. The only conceivable way a distributor could execute cost-plus-seven chain programs and achieve this essential 17 percent would be to realize 27 percent with street customers. We know this isn’t the case.”

What is happening too often takes on the appearance of a game played with smoke and mirrors. It is shelter, which is not generally included as part of “cost,” that makes up the missing margin component. In short, “cost” has lost any meaning it might once have had.

However, while there is undoubtedly much legerdemain involved in defining cost, this largely results from the fact that any distributor who reveals his true costs will find himself wedged between the proverbial rock and hard place. Imagine, for example, this far-from-hypothetical situation.

Distributor A goes to a prospective chain, reveals his true costs, and offers a cost-plus-12 program. His competitor, distributor B, is less candid and says that he can do the job as cost plus seven or eight. Almost inevitably, the contract will go to distributor B, although actual dollar costs to the chain could be less on the plus-12 program where costs are accurately defined.

Nonetheless, operator pressure on margins is far from the only stimulus for the onward march of the shelter concept. It is noteworthy that many of the vendors whose cries about sheltered income are the loudest are frequently the very ones who offer ever-broader financial incentives in their eagerness to obtain additional distribution for their lines.

As one astute observer of the distributor scene notes, “The majority of the responsibility lies on manufacturer shoulders. They look for ways to endear themselves to foodservice distributors. They have aligned themselves with distributors through shelter rather than through systems and marketing goals.

“On new products, for example, they will offer so many dollars off per case even before a price point has been established. Naturally, as they come to the door with such new-product introductory offers, the distributors build them into their profit margins.

“Shelter is the easiest road for a manufacturer to take to capture a distributor’s share of mind.”

MANUFACTURER VIEWPOINT

It is safe to say that most manufacturers, like it or not, have come to accept the necessity for shelter as a fact of life in working with distributors. It is the relentless pressure for more as well as how the funds are used that concerns them.

As one major manufacturer puts it, “We consider sheltered income as green fees, the cost of getting in and playing the game. What bothers us is the magnitude of the fee we have to pay. If a competitor offers $1.00, do we have to pay $1.50 to play?

“Cash discounts are fine with us,” he continues. “They speed our cash flow, and, not incidentally, also serve as credit checks on customers. We will give rebates on a pay-as-you-go basis, but won’t pay up front. And we will participate in growth programs.”

However, another vendor, who looks at shelters as “insurance programs,” contends that “the industry is in a self-destruct mode. Manufacturers are expected to make up lacking margins resulting from operators putting the squeeze on distributors. Too often, manufacturer-distributor partnerships are relationships where we end up bleeding together.”

Whatever the degree of acceptance of the distributor need for shelter, manufacturer animosity centers on what they see as strong-arming and the mounting demand for what the distributors term unique programs, but the vendors consider run-of-the-mill approaches that fail to expand the market.

“Pounding at the manufacturer doesn’t build volume,” one vendor notes. “A DSR goes to an operator and finds that a competitor is selling a product at $2 a case less. He goes back to his management and gets them to meet the price. This doesn’t build volume. Too many operators are working the distributor. Distributors have to take a stand. We do.”

Many manufacturers recognize the mutual benefits of growth programs. But, they say, distributors in increasing number are demanding guarantees. “They don’t recognize that I have growth objectives, too,” one says.

Still another manufacturer complains that “now instead of talking growth programs, distributors are asking for shelters that begin with case No. 1. During the recession, many of us restructured our growth programs so that the increments which formerly began at 100 percent of goal began to come in at 95 percent. Now it’s forget the 95 percent.”

And as manufacturers, particularly those with strong brands, point out, they have their margin pressures, too. They are locked in on prices. If they raise them, they will no longer be competitive with distributor private labels.

THE DISTRIBUTOR CASE

While at least a considerable number of distributors acknowledge that the crying need for shelter is hardly a symptom of industry health, it would be difficult to find any distributors who find the principle itself either illogical or unjustifiable.

One leading independent puts it this way: “As an industry, distributors market and channel the manufacturer’s product to operators. If we weren’t here to perform this function, the manufacturer would have to take on our distribution costs.

“Basically, the manufacturer pays us to market his goods. He does this through promotions, by participating in our food shows and, in cases where our volume is sufficient on his line, by keeping one of his people on our staff to work with our sales force. Basically, he is paying us to perform a marketing function for him.

“These are all forms of shelter which help us bolster our margins. In return, the vendor benefits by getting more business.”

Another distributor, one of the pioneers in developing shelter programs with vendors, says, “All our deals are based on growth programs. We put all our eggs in one basket, consolidating as much as possible with selected suppliers. If we grow, they will.”

“Shelter is not extortion,” says one distributor. “Manufacturers have been playing with the concept for 15 years or more. They have adjusted their prices. The margins of public companies haven’t shrunk.”

Such distributors, of course, endeavor to give vendors a bang for the bucks they provide in the way of shelter. There are others, though, who just take. But, it is pointed out, manufacturers bear at least some of the responsibility for this.

“Manufacturers no longer ask how many of the requests they get for shelter return value to them. They don’t ask themselves how the value they receive can be translated into dollars or who they can afford not to give shelter to,” one distributor observes.

Meanwhile, as they buttress their position, distributors point to the practice by at least some manufacturers of setting up contract pricing directly with operator chains. Such deviated prices put distributors in a squeeze position.

As a major distributor told manufacturers at an industry forum not long ago, “There are two kinds of customers, our customers and your customers, and for your customers, you set special pricing at less than we can buy for.”

Manufacturers are also accused of sharing distributor price lists with multiunit-operator customers. If that is the case, a question of ethics arises, distributors contend. After all, they maintain, they pay for the products and they own them.

Also promising to further intensify the distributor need for shelter is the fact that major multiunit operators are beginning to call for and get it themselves. When chains are beneficiaries of such deals, it is a rare instance when they allow their distributors to raise the “plus” percentage on their cost-plus programs.

CAN THE TIGER BE ROPED?

It seems unlikely at this juncture that the beast can be tamed completely. Who started the ball rolling is no longer a question. Shelter has become part of the distributor-manufacturer operating cycle.

Also no longer of particular interest is whose fault it all is. Both parties–distributor and vendor–share responsibility. Distributors have abjectly failed to educate operators in the true costs of distribution, choosing to taking the seemingly easier approach of seeing if they can sell for less. Manufacturers, too, shoulder a percentage of the responsibility by offering shelter, sometimes helter-skelter, as an avenue to expanded distribution.

However, while it is doubtful that the tiger can be completely tamed, it could be made more manageable. There are signs of light at the end of the well-known tunnel which offer a glimmer of hope that, even if distributor demands for shelter continue to echo–as they most certainly will–manufacturers will get a better return on their investments.

Consolidation of vendors by both distributor marketing groups and individual companies has become a major trend in distribution. This provides the opportunity for both manufacturer and distributor to develop joint programs to increase market awareness, to provide at least sustained volume for existing products and growth for new ones.

What seems required above all is to call an end to the smoke-and-mirrors.

Distributors should level with their customers and explain to them that the costs of distribution extend beyond that of product.

Manufacturers should stop running scared and concentrate their programs with distributors who return value that can be expressed in dollars. As a former First Lady observed, “You can always say no.”

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