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IT distributors: The only people adding value to the world economy

More than just middlemen...

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Why distributors? More specifically, why electronics distributors? Why have these intermediaries in the markets at all?

Yes, obviously, someone somewhere has to have pieces of kit on a shelf somewhere for when a customer wants to make an order. Someone has to crate it up and ship it off too: but why do we still have distributors as independent companies performing these functions? It's the sort of thing we might have expected to see being disintermediated away over the years as communications became cheaper, as information became ever easier to keep track and as delivery itself became both easier and cheaper.

It's entirely possible to think of ways in which that gap between the manufacturer and the final retailer should have closed, killing the space in which distribution is done. Wal-Mart's logistics system is reputed to have done just that. Wal-Mart systems know that someone's just bought an extra jar of veggie pasta sauce and it's not long before this is aggregated with other store information to tell the manufacturers of said pasta sauce to get busy shipping some more: or indeed making it.

However, this gap hasn't shrunk. In large part the industry still works on manufacturer to distributor to retailer or VAR/reseller. Some firms have gone direct, Dell being an obvious example, but this hasn't become the standard across the industry despite what might seem to be obvious benefits of such a model.

There are reasonable financial reasons why this extra step might not be worthwhile as well: depreciation of value being one of them. It rather shocked me when I first heard it said that electronics are about as perishable as chocolate. While they are sitting on a shelf their value (as an average, of course) goes down by some 1 per cent a week, or 50 odd per cent a year. This means an extra step – where the goods hang about in a warehouse gathering dust – seems like something people would like to cut out. And certainly, it would be brave people who take on the risk of being the ones watching the expensive stock depreciate.

So I've done a little bit of digging around in the accounts of the industry to see what I might be able to find. Please do understand that I am looking at this as an economist would: not at all from the industry point of view. You might well know how distributors make your life easier (or more difficult) in the business, but I'm interested in the existence of the very sector. Simply, do electronics distributors add value to the economy in the way that an economist thinks about that?

Economists are funny birds and tend to think of things quite differently from engineers or even accountants. Most importantly an economist is always (or damn well should be) aware of opportunity costs: the cost of doing something is not in fact solely the amount of money you have spent doing it. It's really giving up all of the other things that you could have done with that money. That last £4 on a Friday night can be spent on another pint, or a burger to lesson the hangover from the pints you've already downed. The cost of the pint is the loss of the burger, the cost of the burger the loss of that last pint. Weird, but someone's got to think this way.

Which means that when we think about adding value we don't in fact look at the margins that a business is making. They're interesting but not really relevant to our question. A margin of 1 per cent is obviously smaller than one of 10 per cent: but whether you've got a viable business there depends more on your fixed costs and the volume that you're getting that margin on than it does on the size of the margin. A hedge fund making 2 per cent on a few billion when overheads are 1 per cent is going better than someone with a 30 per cent margin on £1m with £400k of overheads.

So operating at thin margins might be something a business worries about: thin margins leave less room for mistakes for a start. But that's not what an economist would worry about.

Similarly, profits are important to all sorts of people. A loss is indeed the universe's way of telling you to be doing something different. But simply making a profit isn't enough, because of this opportunity/cost thing that economists like to bang on about.

Yes, a profit is a start, it's a move in the right direction. However, capital has a cost and capital has to be employed within a business. So what an economist wants to see is that a company is making a profit over and above that cost of capital. Only then can it be said to be adding value to the economy as a whole. For if it isn't, then perhaps the business should be closed down, the capital deployed to do something else that does in fact earn that average cost of capital: something pretty close to the average return to capital in that economy in fact. Accountants and business people ought to be concerned with this number too, but they tend not to be quite as much as they should be.

All we need now is a guess at that cost of capital, some distribution company accounts and we can have a look. A reasonable guess is 8 per cent. That's what companies often use to judge internal rates of return on projects at least and we might as well use that same return to measure companies as a whole. There are reasons (like current low interest rates) to think that this is a high hurdle to use, but we have to use something so why not?

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