Merton Industries

Bill Locke
July 28, 2008
Situation Audit

Merton Industries is a small manufacturer of premium carpeting. During the summer of

2000, Merton began to evaluate the idea of opening its own distribution center.

During times of economic growth, sales grow more quickly. This may be due to more

homes being purchased, and homeowners having more disposable income to spend on their

homes. The price of raw materials is positively correlated with the cost of floor coverings; when

the price of materials increases, so does the cost. Advances in technology have allowed

development in new types of synthetic materials used in products to meet consumer needs. As

styles and tastes change within the industry, different types of floor covering will see a growth or

decline in sales. A legal issue that many manufacturers need to be aware of is that the synthetic

materials should be flame-retardant, preventing a fire from quickly spreading over the floor.

The carpet and rug sales industry, which consists of approximately 100 manufacturers,

had sales of almost $12 billion and $18 billion at manufacturer’s and retailer’s prices,

respectively in 1999. Sales increased 7% over the past year, which was segmented between

contractors and retailers. Retailers currently account for 74% of sales. The top ten companies

within the industry produce 91% of sales, while the top three dominated the industry, amassing

85% in sales. The largest companies are Shaw Industries, Mohawk Industries and Beaulieu of

America; Shaw is currently the worldwide leader in sales. Shaw consumes 22% of the market

alone, while Mohawk lags slightly behind at 17%. Some competitors have an advantage by

selling their products directly to retailers to cut costs, while others sell through floorcovering

wholesalers. Several manufacturers sell other floor coverings other than carpeting, allowing

them to hedge some of their costs. During the 1990s, Shaw began operating its own retailer to

compete with other companies. The initiative failed, due to other retailers and wholesalers
switching brands as Shaw tried to increase competition. Carpeting is seen as a commodity

product, so there is little differentiation between manufacturers.

The industry sells its product predominantly through wholesalers and retail distributors.

Since the 1980s, manufacturers have shifted their focus from selling their products through

wholesalers directly to retailers. Purchases typically are based on price, with many retailers

forming buying groups in order to obtain price discounts by combining their purchases. Buying

groups have managed to obtain a lot of buying power, forcing wholesalers and manufacturers to

sell their carpeting at lower prices. The three largest buying groups, CarpetMax, Carpet One and

Abbey Carpets, accounted for $3 billion in sales. CarpetMax, Carpet One and Home Depot

registered 45% of all floorcovering sales by 1999. The market has consolidated considerably,

where 40% of the retailers are members of a buying group, a mass merchandise retailer, or home

center chain.

Merton sells premium priced carpeting primarily to the wealthier residential segment of

the industry. Merton specializes in having durable, soil resistant carpeting that has a long

lifespan. Under the names Chesterton and Masterton, the company’s sales were $75 million in

2000, 72% of which were attributed to residential markets. The company amassed a net profit

before tax of $3 million, while only accounting for 0.4% of the market. Merton distributes its

line through seven floorcovering wholesalers, who supply 4000 different retail accounts. The

wholesalers are spread across the Midwest, as well as the East and West Coasts. Half of the

company’s retail accounts provide 80% of overall sales. The company has strong relationships

among its wholesalers, many of which have served the company for more than 20 years. Merton

currently employs two regional salespeople to work with the wholesalers, assisting in advertising

and managing accounts. Merton primarily advertises its products through shelter magazines and
newspapers, where it focuses on the qualities and features of its carpeting. The company has

also had much success with retailers through its cooperative advertising program.

Currently, Merton has an opportunity to change its distribution methods. The company

could drop some of its wholesalers and begin selling directly to retailers. Merton, however,

would be late to enter this market, since most of the larger companies already have direct

distribution. The company has healthy relationships with its wholesalers, who are very loyal to

Merton carpeting. Though carpeting and rugs dominate the floorcovering industry, sales have

been declining for the past six years. Other types of floorcovering, including hardwood and

ceramic tile, have seen an increase in sales over the same time period. Critics have evaluated

that due to the lack of marketing of new innovations, the industry has suffered in sales. Since

price has become the determinant in most purchases, buying groups and retailers have squeezed

profit margins from manufacturers and wholesalers. Though margins are thinning, dollar sales

have risen as a result of manufacturers focused on cost reduction. As larger markets and

economies of scale open, companies have an opportunity to bypass their wholesalers and sell

directly to retailers in order to cut costs.

An assumption can be made that carpet and rug sales will continue to decline within the

floorcovering industry. Since Shaw had significant losses due to its venture in opening its own

retailers, it would also be reasonable to assume that other manufacturers do not have their own

retail stores.

Problem/Decision Statement

As retailers become more price-conscientious, Merton has seen slow growth in sales with

its premium-priced carpeting. Wholesalers have had declining profit margins due to the pressure

from buyer groups, which in turn has caused Merton to have lower sales. Merton has struggled
to cut costs, since wholesaler expenses account for 6% of sales. Sales representatives were

devoting only 40% of each of their sales calls to sell Merton’s products, while spending the rest

of the time selling noncompeting products. Inventory costs are rising as well, since inventory

turnovers are at fiver per year, while management feels that four per year is sufficient.

Identification of Alternatives

Merton has contemplated the idea of selling its products directly to retailers in order to

decrease costs. The company would need to open seven warehouses to maintain all 4000 of its

accounts, as well as hire more salespeople. By cutting its ties with its wholesalers, Merton could

distribute directly to retailers and possibly increase its market exposure. Instead of opening its

own distribution center, Merton could reduce its prices to wholesalers to ease pressures from

buyer groups. These savings would then be reflected in the price to consumers to increase sales.

Criteria

In order for Merton to make a decision, the company must look at the potential costs.

Merton also needs to analyze how its decision will impact its relationship with its current

wholesalers. Should Merton become a direct distributor, the company would have to consider

how its retail accounts will respond by communicating directly through Merton instead of its

wholesalers.

Analysis

If Merton decided to shed its wholesalers, the company will have several costs associated

with starting their own distribution center. The company would need to hire 31 salespeople and

four managers to handle all retail accounts (see Appendix A.) This will increase expenses by

almost $2.5 million. Merton would also incur $700,000 in fixed operations costs for each of its

seven distribution centers. Transportation, inventory and accounts receivable costs would amass
almost $16.3 million in additional expenses throughout the seven warehouses. Total expenses

would be $39.3 million, a 50% increase from the 2000 fiscal year (see Appendix C.) Inventory

turnover would decrease from 5 to 4.28, which would be more favorable to company executives.

These costs are based on the assumption that Merton would inherit the direct sales from its

wholesalers. To account for changes in distribution methods, sales would decrease by 30% due

to a decrease in prices. Merton cannot continue charging the same price to retailers as its

wholesalers did. By decreasing costs, the company could still compete with other wholesalers

while keeping a significant amount of its retailers. Merton would most likely lose many of its

accounts due to the changing distribution method. Merton may lose as many as 20% of its

accounts from the switch, decreasing its projected sales and cost of goods sold. According to

Appendix B, 30% of the company’s retailers are in buying groups, so there is potential for a

significant percentage of the buying groups drop Merton carpeting.

Merton would realize a gross profit margin of 46% by creating its own distribution

warehouses. Cost of goods would decrease due to the lost accounts, creating a larger profit

margin for the company. The net profit margin would decrease to 2%, a 50% decline from 2000.

This decline would be caused by the additional costs incurred by Merton. If the company does

not need all 31 employees due to the lost accounts, it could generate a larger profit margin from

the layoffs. It is important to note that although the number of retail accounts may decline, all

employee costs should be within the budget to account for unforeseen changes. Merton would

be able to meet the minimum of wholesale sales of $7 million within each of its warehouses.

The $7 million sales volume would be economically viable, allowing Merton to continue

operations. The average sales of more than $11 million in each distribution center would be

more than enough for the company to operate smoothly.

 A shift to using direct distribution would harm Merton’s relationship among its

wholesalers. The wholesalers are negotiating with competitors, awaiting a mass withdraw if

Merton decides to drop its wholesalers. A mass exodus would leave Merton unable to distribute

its products to retailers. Since many of the wholesalers have done business with Merton for

more than 20 years, Merton may receive a very negative reputation among other wholesalers and

buying groups. This ill-will could be detrimental to Merton’s sales, with the company losing

many accounts. Merton’s wholesalers may create a worse scenario by enticing retailers not to

purchase from Merton. In order for Merton to retain its accounts, it must avoid create hostility

with its retailers. Retailers may also switch brands of carpeting, thus in turn dropping all

advertising done with Merton. Since 50% of Merton’s retail accounts represent 80% of

residential sales, Merton could potentially lose more than $54 million. This is a significant risk

to the company, which in turn could foreclose on all business.

Recommendation

Merton should not open its own distribution warehouses. Though the company would be

able to cut its cost of goods sold and increase its gross profit, Merton would lose more than $1.5

million from operations. Too many unknown costs exist from opening distribution centers,

including how retailers will react. Retailers will more likely be swayed by wholesalers, who

would be able to provide retailers in buying groups steeper discounts. The buying groups may

lose a significant amount of buying power when dealing exclusively with Merton, while may

lead to a loss of sales from the groups. Merton would lose its cooperative advertising campaign

with many of its retailers, forcing the company to spend an additional $300,000 annually (see

Appendix D.) Merton would put itself into a similar position as Shaw when they tried opening

their own retail stores, and could potentially lose all of its business if it bypassed its wholesalers.