Sizing up: managers need to measure costs and revenue to gauge the importance of size and scale in distribution.

The recent step-up in mergers and acquisitions activity highlights the importance of scale in the distribution business. Size clearly matters in determining the distributor's bargaining power to obtain favorable allowances and special wholesaling support from a product manufacturer; in building brand awareness and a consumer market franchise for a career agency system; or in affording a sophisticated technology platform to support financial planning.

Yet, unless management clearly understands the cost structure of its distribution operation, the distribution revenue embedded in the products being sold and, in particular, the economic leverage inherent in the distribution operation, bigger is not necessarily better.

To truly enhance distribution profitability, management should focus its scale-building efforts to ensure that the nature and cost of the infrastructure necessary to attract, retain and develop producers are aligned with the mix and volume of sales necessary to pay for it. This requires that distribution management understand two things:

* The "fixed" cost inherent in its distribution operation--i.e., those costs that do not vary directly with sales. At least in the very short run, rent, sales management, technology, health and welfare benefits, licensing, compliance/supervision, marketing, training and wholesaling support are fixed costs. A company's distribution strategy and operating model define the functions and resources that are critical to building competitive advantage, and thus define the economic scale requirements and leverage opportunities.

* The revenue that distribution will earn by selling different products. To instill management discipline, the gross dealer concession or total distribution allowance priced into each product sold should be allocated to different elements of the distribution operation. For example, of the distribution revenue earned by the sale of a universal life product, 65% might be allocated to cover purely variable, contractual costs (commissions, overrides, etc.), 15% might be allocated to cover the fixed costs of agencies, branches or wholesaling, and 20% might be allocated to cover the fixed costs of home office-based management, marketing and sales support.

The combination of fixed cost and revenue perspectives helps to define the minimum scale required for each element of a company's distribution operation to break even. It also suggests the potential to enhance profits after fixed costs are covered, so additional revenue contributes to the bottom line. Such insights enable management to establish performance standards, budgets and strategic goals and focus efforts to close performance gaps through acquisition, change in operating model and cost structure, or other strategic investment. To illustrate:

* The Marketing and Sales Department spends 530 million to provide essential management and support. If 20% of total distribution revenue is earmarked to cover these fixed costs, then the minimum scale required to break even is distribution revenue of $150 million (roughly $75 million of first-year commissions).

* A career agency has $1 million in fixed cost, based on the services and resources provided to attract, retain and develop agents. If 15% of distribution revenue is earmarked to cover these fixed costs, then the minimum scale required to break even is distribution revenue of $6.7 million (roughly $3.4 million of first-year commissions).

* A brokerage arrangement with a group of producers could impose 540,000 in fixed costs on a company--such as basic relationship management (share of regional vice president fixed costs, travel, home office oversight), share of product wholesaling fixed costs and compliance/risk exposure. If 8% of distribution revenue is earmarked to cover these fixed costs, then the brokerage relationship would need to generate revenue of $500,000 (roughly $250,000 of first-year commissions) to pay for itself.

Building scale in the right areas can create material advantage. We observe from our own studies, for example, that companies selling $4 billion or more of annuities enjoy a 35 to 70 basis point distribution cost advantage over smaller competitors--which may translate into a 1% to 2% improvement in return on equity. And we have seen companies refocus their agency acquisition and management efforts to target larger agencies, as they seek to build scale that produces leverage rather than compounding the losses inherent in chasing low revenue, high-cost field operations.

Yes, size does matter, providing management understands and acts on the underlying economics of its distribution business.

Richard K. Berry, a Best's Review columnist, is a Towers Perrin principal and consultant for the firm's Tillinghast business. He can be reached at [e-mail].