Operational efficiency: A clear path to outperformance in distribution

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Many distributors are finding it difficult to grow revenues and maintain margins while meeting the rising expectations of customers. Hiring and retention challenges, sharp demand variability, uncertain supply lead times, shortages, and inflationary pressures may seem like the new normal.

But opportunities abound for those who know where to look: distributors can meaningfully improve operational excellence to create more value for shareholders, customers, and suppliers.

In our inaugural survey of operations leaders in more than 80 North American distributors across more than a dozen subsectors, we identified many operations shortfalls—along with improvements that are helping about one in ten distributors outperform the industry by wide margins. Since 2019, these “transformers” have improved returns on invested capital by almost 30 percent and revenues by an average of almost 9 percent annually, boosted profits by around five percentage points, and expanded EBITDA margins by nearly seven percentage points. 1Lessons from transformers: How some distributors reset and won,” McKinsey, February 21, 2023.

Distribution leaders recognize that operational excellence can be a promising path to profitable growth in these uncertain times. In this article, we outline the steps leading distributors are taking in operations to overcome their toughest challenges—and prepare for new ones.

The labor market has eased overall but is still a top concern

Labor shortages have eased since the pandemic, but more than a fifth of survey respondents still consider worker turnover their biggest operational gap (Exhibit 1). Labor mismatches are unlikely to fully dissipate on their own due to structural shifts such as early retirements and relocations. As one operations executive at an electronics distributor told us, “Prepandemic labor for warehousing and transportation was tight, and during the pandemic it became absurdly hard to recruit and retain people from the front line all the way to senior VP level. The situation is cooling, but labor is still a top priority.” Many distributors continue to face difficulties recruiting in select regions or for specific roles, such as commercial drivers and warehouse workers.

Workforce turnover remains a major operational issue for distributors.

Nearly all respondents said they were hiring externally to meet talent needs, and most are offering more compensation or other benefits (Exhibit 2). But barely four in ten are helping current employees master new skills. Those companies that are upskilling may be gaining an edge: training can boost organizational agility in a more volatile marketplace, and career development and advancement can reduce turnover because they matter more to workers today. 2Money can’t buy your employees’ loyalty,” McKinsey, March 28, 2022.

Most distributors are investing heavily in attracting external talent.

In conversations, leaders discussed a wide range of approaches they are taking to improve operations and the employee experience. An operations leader at a building supplies distributor credited his company’s lean operations system with giving workers more control over how they do their work and increasing their job satisfaction. He added that targeted infrastructure improvements, such as remodeling the break room and improving the air-conditioning system, increased retention. A food service distributor has introduced more flexible schedules, including a part-time work option, five eight-hour shift options, four ten-hour shift options, and extended operating hours to accommodate more flexible schedules. Another operations executive has made equipment and operations bilingual, expanding the pool of potential talent to include Spanish speakers. Some distributors are also employing flexible labor, such as contract workers, to plug labor gaps. While these workers can be more expensive, they’re not as costly as productivity losses or declines in service levels caused by staffing shortfalls.

Many distributors continue to face difficulties recruiting in select regions or for specific roles, such as commercial drivers and warehouse workers.

Technology is also playing a much larger role in retention. We spoke with leaders at a distribution company who used advanced analytics to understand what was driving attrition. Based on what they learned, they redesigned the daily routines of frontline roles. Improvements included more accurate delivery scheduling that reduced driver idle time, along with significant reductions in downtime and overstaffing in distribution centers. Retention rose by approximately 15 percent.

Low digital adoption has slowed the pace of operational improvement

By definition, every big distributor is a master of complexity—it may source, stock, price, and distribute half a million SKUs to meet customers’ needs—but many leaders have yet to harness basic digital tools, such as planning processes or systems, to manage that complexity. As one auto parts distribution executive put it, “Compared to our peers, we rank at six or seven out of ten on digital capabilities, but the industry as a whole is 20 years behind.” Some distributors are discouraged by the costs of purchasing, ROI, and building on legacy systems, but evolving software-as-a-service offerings are changing the equation and presenting an opportunity to leapfrog digital solutions. The time for upgrades has arrived.

Nearly half of our respondents said they had not invested in core building blocks of digital supply chain consistently across their networks, such as advanced planning systems (APS), warehouse management systems (WMS), or transportation management systems (TMS). About 14 percent still rely on manual spreadsheets for planning, while other sectors, from retail to advanced industries, are driving operational efficiency by using APS in pursuit of autonomous planning. Half of respondents have no warehouse robotics or automation—and no plans to adopt them (Exhibit 3).

Most distributors have been slow to adopt digital tools.

Almost half of survey respondents said they had accelerated their implementation of advanced analytics to respond to recent supply chain challenges, but progress has been difficult in many cases—data scattered across different systems is the most common pain point. Other challenges include perceived high investment costs and slow implementation and adoption, with steep learning curves, across acquired subsidiaries. One senior leader in the chemicals sector told us that some software had been “home runs” in terms of value, some had not met expectations, and some had simply never been used.

Inventory and network strategies are increasingly important in today’s more volatile marketplace

As supply constraints ease, more distributors are getting back to basics, such as improving the customer experience. Their success will depend heavily on strategies that make inventory available across networks in more efficient ways, particularly for traditional distributors aiming to provide high service levels to retain high margins. Many distributors are building capacity to stay closer to customers, for example, by offering larger selections of SKUs and exceeding service-level expectations to boost customer acquisition and retention.

More than six in ten survey respondents say they have reassessed inventory strategy to maintain higher service levels, including faster deliveries and higher fill rates, and now hold larger stocks of critical SKUs. Many are finding ways to expand warehouse capacity to accommodate a larger and wider selection of inventory. In fact, nearly a third of survey respondents expect to make major investments in capacity and automation in the next three to five years—roughly the same share as those who anticipate investments in digital (Exhibit 4). Some operations leaders are getting more value from the space they already have, such as by investing in retrieval systems that maximize the use of vertical space per square foot. As distributors focus on driving growth, network strategy will play an increasingly critical role, especially as revenues continue to shift to online channels and e-commerce.

Investments in network capacity could match those in digital.

Recent disruptions revealed the high costs of complex organization design

The ability to make the right decisions quickly in response to changing market conditions is more important than ever as major disruptions become more frequent. But we find that many distributors become less agile as they grow—for example by adopting inconsistent systems and processes in different areas of their business. This is particularly the case for those who rely heavily on M&A to bolster the top line but don’t fully integrate the companies they acquire.

Without standard tools and approaches to make organization-wide decisions and gain synergies, distributors are likely to miss opportunities to drive sourcing efficiency, optimize pricing, and respond quickly to shifting customer demand. They also tend to spend more on multiple solutions that do not integrate well with one another. A leader in energy and mining equipment distribution explained that too many levels of management created lengthy chains of approvals, causing delays in procurement and quote changes from suppliers and logistics vendors, raising the share of expedited shipments.

Meanwhile, without central oversight, complex reporting lines and approval processes can slow strategic decision making and obscure accountability. Two-thirds of survey respondents said their companies had not centralized core functions or had duplicate and noncore functionality in IT, network planning, supplier management, or other areas. As one senior food services operations leader put it, “The duplication in our business adds costs and impedes our ability to move quickly.”

A value-back operations transformation can set up a distributor for success

Given the complexity of transforming operations, distributors should use a “value back” strategy to prioritize initiatives based on expected business impact, feasibility, and the time and cost to scale. Without a value-back approach, organizations risk pursuing projects that won’t deliver the maximum impact or investing in “must have” digital solutions that remain underutilized and fail to deliver adequate returns—making future investments even more difficult to justify.

Only half of our survey respondents said their investments in digital technology met or exceeded expectations. Some of the biggest shortfalls in ROI arise from failures to link technology upgrades closely to process and organization changes. We have seen some companies delay digital journeys while they wait to compile “perfect” master data, but starting with a few use cases and then gathering relevant data can yield results far more quickly. Another key to progress in most digital transformations is tapping talent with the right experience to complement the knowledge of those who understand distribution. As one executive that is focusing on bringing in external talent said, “You are one good person from success in any given organization.”

Transformation can seem daunting, but business as usual is a losing strategy in a volatile marketplace where competitors are raising their game. A value-back approach applied across functions and subsidiaries helps distributors set, execute, and modify strategy in response to almost any challenge, from economic and geopolitical disruption to sudden shifts in customer needs and expectations.

In today’s tight labor market, for example, some distributors using value-back strategies are piloting physical automation. A global healthcare distributor has reduced its reliance on manual labor by using autonomous, maneuverable robots in distribution centers and is reportedly testing autonomous floor sweepers and scrubbers—specific use cases that deliver solid returns on investment. Some are also adopting labor planning systems that allow managers to identify areas with excess labor, make intraweek and even intraday labor adjustments, and build flex capacity to account for absenteeism—all of which can ease the impact of labor shortages and rising wages.

In our experience serving distributors across sectors around the world, we have found that digital advances underpin nearly every transformation. Most find that a first-rate warehouse management system improves labor management, for example. This is likely one reason why a majority of survey respondents without a WMS are considering implementing one (Exhibit 5).

Distributors are investing heavily in supply chain technologies.

Distributors with up-to-date tech stacks and access to mountains of data from public, private, and internal sources will get more value from advanced analytics, including demand-and-supply planning, predictive inventory replenishment, machine-learning-based inventory forecasting, and a digital control tower.

The pace and scope of any transformation are vitally important. Achieving results and exciting stakeholders requires striking the right balance between thinking too big—an enterprise-wide transformation across multiple domains, for example—and thinking too small, such as pursuing only individual use cases to demonstrate material impact.

It’s time to act

As systemic supply disruptions ease in an inflationary and increasingly transparent market, distributors who improve operational efficiency to offer better service, responsiveness, and capabilities could gain considerable competitive advantages and limit margin compression.

We expect the delta between leaders and laggards to expand in the years ahead. Based on our analysis, we believe that as much as one to two percentage points of EBITA margin could be up for grabs across the distribution market—a significant improvement given an industry average EBITA margin of just 8 percent.

A few players could seize a larger share of that growth: the masters of operational excellence.

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