BUILDING FOR THE FUTURE

B Y C L A R K C O LV I N

How Building Material Retailers Can Adapt to Changing Industry

Who will be the winners and losers in the revolution that is radically reshaping the marketing, distribution and selling of building materials? Will the expansive dealer networks, which are broken into literally thousands of independent retail suppliers, be able to overcome years of inertia to pioneer and execute new concepts that will strengthen and extend the value and scope of their businesses? Or will nimbler, more imaginative retailers get there first?
The transformation of the business of selling building materials to professional contractors is happening before our eyes at an incredible pace promising to change forever an industry that has long been noted for low margins, poor economies of scale and extremely fragmented service providers. Building material suppliers have competed fiercely among themselves to drive down prices and meet consumer needs for lower-cost building supplies. Now the survivors face new threats from outside the industry that might thwart all their well-conceived plans in building strong, lasting relationships with their customers. Financial acquirers of building material suppliers have dissected the costvalue equation and come up with new retail concepts. Their stories have attracted interest in the public equity investment world. The end result has been to persuade dozens of fiercely independent suppliers to sell out, forcing a financial-oriented consolidation upon the industry. This pattern is consistent with revolutions in other consumer durables markets that effectively transferred market power from manu38 DOITYOURSELF RETAILING/DECEMBER 2001

facturers and distributors to a financial savvy type of retailer. This also insures that the retailer becomes the caller of shots over the contractor customer, instead of the other way around.

FORCES OF CHANGE
From the early decades of the 20th century, the building materials industry has been based on a supply-push philosophya strong bias toward filling the stores to cover the distribution and warehousing costs of the distributors. The building material retail network (that is still in place today) was largely created as a logical extension of the supply-push model. The retailers were designed to hold inventory, leverage their own private capital (without threatening the wholesale distributors control) and service and support what still is a commodity-based, maintenanceintensive line of products and services. These retail lumber and hardware stores were built from the ground up by entrepreneurs who focused on a defined geographic area, selling a large array of both construction and hardware lines, catering to both contractor and the walk-in consumer.

This distribution retail model has been remarkably resistant to change. Building material retailers have become ingrained over time by a web of informal habits and long-established customer and vendor contacts. Despite its longevity, the building material supplier channel leaves some retailers unhappy. High customer acquisition costs motivate retailers to convert store traffic to sales by merchandising a multitude of products that extract differential margins based on customers willingness to pay. Taking numerous bids and sticker wars have taught contractors to be excessively cost sensitive and negotiate from cost up, rather than from bid down. As a result, retailers often find themselves competing against a similar supplier across town. This acute competition has almost wiped away retailer profit on the sale of lumber and other commodity-oriented building materials. So, lumber companies often make their profits in areas other than lumber. The decline in profits on building materials has forced construction, lumber and hardware suppliers to make up the margin shortfall by looking at what many only considered filler businesses

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before: cottage manufacturing units, installed sales programs, etc. The problem is that a conventional building material supplier is not necessarily positioned well to conduct all of these businesses because of their different economics, knowledge of direct costs, bases of competition and consumer purchasing patterns. Some suppliers, for example, have purchased a truss manufacturing or a pre-hung door assembly facility only to shut down those same factories a year or two later. They go into these ventures lured by the perception of high margins only to find out they were ill-fitted in terms of cost control and management to handle such laborintensive operations.

of scale evolution and look at the lessons they learned. Most consumer-durable industries have undergone a substantial distribution and service evolution resulting from changes in economics, competition or technologies. Each one has unique circumstances, but we can see three relatively common, distinct stages in these economies of scale restructurings:

ic customer segments through the rationalization of logistical support services. Functions are unbundled and restructured into more efficient or more appealing profit and cost centers and formats for defined groups of customers. Customer value is further enhanced through lower prices for select product lines, better service or greater variety.

Stage One:
This first stage is marked by major improvements in value delivered, mostly reductions in cost. Usually the cost reductions stem from strategic-

Stage Three:
The final stage brings dramatic new paradigms not just for the sale and distribution of products but for the entire value chain. 1. Multiple profit centers and formats will coexist to satisfy different market segments. Profit centers are distinct paths between a retailer and a customer through similar economic entities, such as contractors vis--vis retail customers, vis--vis commercial customers. Formats are distinct combinations of points of sale, service offerings and business processes within a general profit center definition. We expect much more variation in profit, cost centers and formats in both an accounting and in a physical sense and more distinct positioning in terms of the purchase experience they provide, thus shifting the basis of competition from products to services. 2. The separate businesses under the roof of the traditional retailer will be unbundled. Different operational structures will be required to serve a variety of customer needs and economics. 3. The cost of distributing and marketing building materials will be cut significantly. New formats will instill discipline in the current system to drive out non-value-adding cost. Supplier consolidations may unlock substantial economies of scale in back-office functions and purchasing leverage. Much larger savings are possible, however, by driving out obsolete and excessive inventories; reducing investment in brick-and-mortar, equipment and real estate, and optimizing the delivery of services.
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RETAILERS STILL PART OF EQUATION

No one is suggesting, though, that construction-oriented building material dealers will disappear. Ironically, changes in building materials themselves are making retailers more important. Customer satisfaction has become a much more critical competitive differentiator and a greater influence than the materials themselves. And it is the retailer that controls these levers today. This explains the intense efforts many building material retailers have made to increase standards for customer satisfaction. As a result of the low-margin, highsatisfaction proposition provided by the traditional retailer in general, the successful strategy will be to capitalize on horizontal cost-reduction opportunities afforded by improving the retailer economies of scale equation by trying to reduce costs in administration, advertising and service.

Customer satisfaction has become a much more critical competitive differentiator and a greater influence than the materials themselves.
oriented consolidations and rationalizations in the value chain as better concepts or bigger players drive out marginal or small players. The objective is the bigger players use their cost advantage to reduce prices and often to improve service, variety and convenience. In practice, however, these strategic consolidators focus mainly on increasing market share rather than the profitability of each acquired entity.

VISION FOR THE FUTURE

Now that we see cracks in the walls protecting the traditional building material construction supply industry, what will the future bring? Both the underlying drivers of change in building material retailing and trends already under way help answer that question. In addition, it is helpful to compare with other industries that have experience in economies

Stage Two:
The second stage is marked by companies becoming more focused on achieving economies of scale of specif-

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4. Marketing and distribution will concentrate on establishing durable customer relationships. Since customer acquisition costs are high and going higher, it is logical for retailers to work harder to hold on to the customers they have. We see these relationships developing on two axes: follow the product and follow the customer. The follow the product axis will make manufacturers and distributors more active in the value chain. We see this axis as counterproductive, actually driving down margins as well as depleting necessary cash flows for the retail suppliers. The follow the customer axis means building more direct relationships with a targeted set of customers to define their needs, develop tailored marketing programs and stake out unique positions. Identifying these customers and keeping them happy will require substantial investments in market-understanding capabilities that go far beyond the functional and demographic information that most retailers rely on today. We see this axis as the correct point of strategic realignment of customer service. Retailers will seek and attain much closer contacts with consumers. We have no doubt that someone will figure out the riddle of consumers needs, aspirations and experiences as they relate to building materials; the tenuous part of this prediction is that retailers must get there first. However, retailers today are surprisinglyif not shockinglycut off from their consumers. Undoubtedly, Internet technology will enable more effective and efficient direct contact between retailers and their customers, as both become more comfortable with this new type of POS. If, however, retailers fail to exploit technologies to establish meaningful relationships with consumers, more powerful intermediaries may gain the upper hand and end up providing material direct to both the contractor and retail consumer end-user. These transformations will not be easy, and many of todays players will fight them aggressively. But the revo40 DOITYOURSELF RETAILING/DECEMBER 2001

lution in building material retailing has begun, and now that it is underway, it will be impossible to stop and nearly as difficult to contain.

FORMING A STRATEGIC RESPONSE

What, then, should a building material retailer do? Appropriate responses are to some extent situation dependent, of course, but we believe the three stages of economy of scale evolution observed in other industries provide valuable insight into what will be required to prevail in the retail building material industry.

sue functional, as well as, profit center improvement, such as operational cost savings and high margins of the existing product lines. 2. Develop a vision of a desired endgame sales strategy and begin making progress toward that vision, taking care to achieve consistency between the longterm vision and short-term functional improvement agendas. 3. Build the means to create and capture much more of the downstream value associated with building materialsand, in so doing, strive to

In fact, first-stage economy-of-scale evolution activities are already rampant in building material retailing in the United States, and second-stage changes are gradually being accepted by a handful of retailers at this time. We expect that participants who fall behind in this evolutionary process will suffer severely, particularly as more and more of the value creation and consolidation in the industry occurs downstream. The future winners in the building material industry likely will be the ones that drive thirdstage evolution. Accordingly, we recommend the following strategic responses consistent with the three stages of economies of scale evolution and the future of the building material supplier vision described above: 1. Aggressively and systematically pur-

innovate game-changing approaches to the business.

FUNCTIONAL IMPROVEMENTS
In the conventional building material retailer network, tremendous improvement opportunities exist along two basic functional paths: reducing operational costs and raising customer satisfaction. Most retailers are jumping at the latter, forgoing the former. For example, these players tend to select a limited number of high acquisition specific programs, and they typically concentrate on single functional improvements independently or on a single functional path. For example, thinking that a kitchen and bath department is the cure-all for companywide lagging sales, or that focusing solely on contractor sales will enable the com-

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pany to rid itself of unnecessary people and product lines. A better approach is to systematically address the whole realm of possibilities with an integrated view of benefits within and across specific functions. This is not easy. Even programs with moderate scope and ambition typically require reforming entrenched business philosophies; coordinating several organizational groups with individualized incentives; managing complex and imposing logistics, and facing up to customers resistant to change. But retailers must recognize that new players unencumbered by these constraints are raising the bar and traditional players must reach higher or fall behind. Based on our experiences and analysis, we estimate that cost reductions, though easy to execute, will be one of the hardest things to accomplish. There are three reasons: 1. The consolidation and rationalization of activities to achieve economies of scale and eliminate inefficient operations is unpopular. Large numbers of small competing suppliers operate as mom and pop operations. 2. The unbundling of profit center businesses, for instance, is largely unknown to unsophisticated business people. To date, a retailers profit center is often viewed as a location, not a customer type or manufacturing process. 3. Given the wide variation and the resulting large differences in efficiency and effectiveness in operations among retailers, the application of best practices for the industry is substandard. In other words, working toward the industry standard creates a continuing downward spiral in industry-wide performance. Here are some examples of potential functional improvements: Reduce inventory costs. Retailers can cooperate among their different locations to pool inventory in regional centers. Also, analytical methodologies, information-systems tools and best practices can be used to evaluate the retailer-level sales history to determine the best amount and mix of materials

to hold in inventory. Finally, to improve future demand visibility and forecasting accuracy, retailers can use improved information systems and marketing techniques to track customer and sales-promotion information, marketing campaigns and historical data on sales-promotion effectiveness. Leverage purchasing power. Retailers can also capitalize on purchasing economies of scale. The economies result from lower costs in areas such as financing, advertising, management personnel, payroll handling, insurance, supplies, administrative functions and, of course, material purchases. The reported cost savings from these economies alone can be as high as 20 percent of a retailers cost. Use best management practices to sell building materials. The traditional selling approach for building materials is loaded with cost (and effectiveness) opportunities that are not taken advantage of. Sales management is often the missing ingredient. In our opinion, the understanding of management, as applied to sales personnel, is one of the largest problems of most building material retailers today. Align manpower requirements with profit and cost center activity. Generally speaking, even the most efficient retailers dont separate manpower requirements within individual profit and cost centers, correctly understood. Often a simple ratiopayroll to company salesdefines the standard manpower productivity level. Such oversimplification of personnel efficiencies disguises the contribution margin of the separate profit-generating parts of a company. Increase customer satisfaction. Customer satisfaction and loyalty are rich veins of potential functional improvement. Good performers end up getting paid for what they are already doing well, and the poor performers undertake short-lived, superficial steps to manage the measurement. Customer service in building material retailing is mostly about executing the basics

wellkeeping delivery commitments and offering conveniences. Service advisors and computer-driven followup calls will not regain ground lost to sloppy execution.

DISTRIBUTION STRATEGY
Cost and customer-service improvements are necessary but not sufficient enough to transform the building material retailing industry. Realizing the full potential of these programs is not possible without a reasonable view of the different customer segments that should be targetedthe appropriate mix and level of marketing functions needed for each segment, and the best means of distribution. Just as specific groups of customers have their own product requirements, different consumer segments have their own requirements for the purchase experience. These requirements can be effectively targeted with package variations such as service contracts, financing, sales incentives and different pricing matrixes. Ultimately, the consumer-segment requirements will drive the service requirements and in turn help determine the best cost and operating structure for the specific distribution format and customer-value proposition of each customer type. Creating the purchase experiences to meet the needs of specific consumers has two other significant implications. First is the need for parallel accounting and profit centers in a given region, each with its own pricing and bundle of product offerings. Parallel sales profit centers range from the traditional contractor to the commercial customer to consumer overthe-counter sales. The second implication of serving multiple, service-based customer profit center segments is the need to avoid cannibalizationin other words, the robbing of contractor sales to beef up retail consumer sales, and vice versa. Here the accurate tracking of sales, margins and expenses are necessary. Unfortunately, most accounting software programs in (Continued on page 51)
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(Continued from page 41) the industry are not set up to track information by profit centers.

dominant force in the industry; forever changing a century of habits and practices. Clark Colvin, managing general partner at CSC Capital Partners, Ltd. is an expert in the restructuring of building material retailers. He has personally restructured more than 50 building mate-

DOWNSTREAM VALUE CREATION

The biggest winners in the building material economy of scale evolution will be those that drive substantial value improvements by creating real innovation in the retailing of building materials. In many other industries, retailers have driven and benefited from economy of scale evolution at the expense of manufacturers and/or distributors. The cost-reduction potential in the building material retailing industry is huge. Innovative ideas that tap this potential may well dominate the future of the building material industry. Such innovations can be achieved by recognizing the real drivers of value and the linkages among them. This new lifecycle value paradigm represents one way that a building material company might approach the problem of creating value through its marketing and distribution activities.

rial dealers across the United States, conducting the restructuring often as interim ceo. CSC Capital Partners is a leading corporate restructuring, turnaround and private investment firm in the industry. Visit CSC Capital Partners at www.csccapital.com for more information or call (503) 540-0888.

ANTICIPATED CHANGES
Change and innovation are the lifeblood of all retail businesses, but the building material supplier industry has been remarkably resistant to transformation. As a result, the industry suffers from an outdated, inefficient and expensive way of doing business. This situation will change. Building material retailing is beginning to evolve. At one level the future implications are clear. These include multiple alternative profit centers or a greater unbundling of the retailers business; increased value through economies of scale; more emphasis on life-cycle relationships, and probably tighter relationships between retailers and their customers. Specifically who will win and lose is much less clear. To win, the established retailer must shake off old habits and practices and then visualize and implement revolutionary ways to sell building materials. However, if the established retailers cannot or refuse to change, the financial acquirers will be the new

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