Distribution Channels
Distribution channels are managed by mapping, searching, and finding ways to match a set of offers to a set of consumers.
Once a firm has developed a strategy, it must figure out how to determine who the target customers are and how to reach them. In addition, it must develop a methodology to extract information about its customers from its distribution channels. This is often underrecognized, but very important.
When considering how to appropriate value along the distribution channel and what the bargaining power between the producer/channel and from the channel/customer is there are several points to consider:
When thinking about a distribution channel, its important to consider efficiency vs. speed. Previously, it was thought that efficiency was the same as cost. But, today, efficiency is usually described in terms of speed. In the indirect channel systems, a firm needs to get information flowing from R to L (customer to supplier) quickly and fully. However, there are incentives for the indirect channels not to share information completely and accurately with suppliers. Technology helps facilitate R to L information flow. Technology increases the velocity, magnitude, and integrity of information flow. But, technology is poor about addressing the question of tacit information flow. The tacit information flow issue is a problem that marketing professionals haven’t really solved.
The marketing function in firms has become a strongly analytical function. Marketing is in the transition phase from an intuitive part of the business to a quantifiable part of business. Marketing today is where finance was 30 years ago. Its going toward being analytical like finance.
Consider the distribution channel for a knowledge based firm like a university. A university is a keeper, generator, and distributor of knowledge. Historically, universities have had a direct distribution channel with no intermediaries. But, there are alternative models. For example, the University of Phoenix is an indirect conveyence of information via an online channel. Their business model is similar to mail order courses 100 years ago. Principle is the same. Indirect channels are just as valid for knowledge based providers.
Its said that a firm can only take monopoly profit once. In the simplest since, if a firm is a monopolist in a value chain, it may be tempted to forward integrate to take over the distribution channels so as to raise its margins. However, a true monopolist excising complete monopoly power allocates all profits to itself. None of the profits are allocated to distribution channels in a monopoly relationship. So, distributors of a monopolists’ product should have no producer surplus. Therefore, acquisition of distribution channels by a true monopolist does not increase its producer surplus and is doomed to failure. Its important to remember, however, that there are not many true monopolies. But, when there is a true monopoly, the monopolist can capture all value and there is nothing left for the distribution channel. So, integrating forward is worthless.
An example of this concept is Texas Instruments. In the early days of digital watches and calculators, TI basically had a monopoly. Yet, TI decided to integrate forward by opening up a whole series of stores to sell their watches and calculators, thereby eliminating distributors. TI escaped, but the venture almost put them out of business.
The vast majority of our products are moved to consumers through intermediaries (distribution channels.) Very little is sold direct.
Let’s examine the question of why distribution channels even exist. The answer is that they improve efficiency. Distributors add efficiency because they buffer and aggregate. Frequently when a consumer buys something from a distributor, the distributor has aggregated products across classes and provides it to retailers or customers in some convenient form. A simple example is a grocery store. Imagine going to a different store to buy canned goods, a different store to buy eggs and milk, and a different store to buy fresh produce…
Distributors facilitate the search process for the consumer. Searching for products is expensive for both buyer and seller. Consider the example of an entrepreneur starting a high tech company for medical related products. The new firm has a product concept in mind that works. But, they need to know “who wants it?” How a firm connects to the customers that really want it frequently turns out to be an overwhelming problem for startups. (The other overwhelming problem is acquiring capital resources, of course.)
Distributors also often provide an augmented product. Perhaps the distributor provides financing, government relations, warranties, or after sale service. Note that, recently, there are some distribution channels where distributors no longer takes responsibility for these kinds of things. Instead, some manufacturers are asking people to return problem products directly to the m. The feasibility of this is increased by technology, communications, and transportation improvements.
Distribution channels can add friction, such as addition cost and communication inefficiencies, to the delivery of a product to a customer. If suppliers and distributors bear the costs, the costs become part of the total price of delivery. On the flip side, if the consumer bears some of the costs, the supplier never sees any of that in the price. A simple example is transportation for a loaf of bread. If a firm bakes bread and has to send it off to a store far away, it will cost the firm money. But, at the same time, the customer might have to drive an hour to get to the store that distribute breads. Driving involves time and expenditure. So, both transportation costs from the supplier to the distributor and from the distributor to the customer increase the cost of product.
But, suppliers don’t see the customers’ costs in getting to the store. In general, both supplier and consumers have friction involved. Both kinds of costs are kinds of friction that have been introduced into the supply chain. The friction process shifts the supply/demand curves and moves the equilibrium point to the left. In other words, the price of the good increases and the quantity demanded decreases. Getting rid of friction makes the supply process more efficient.
One might ask how much it really costs to transport one loaf of bread in truck. The answer, of course, is that it costs very little. But, all of the small additions of friction in a supply chain quickly add up. Consider retailers like Best Buy, Macy’s or Lowes. The traditional markup between producers and retailers depends on the products involved. Diamonds are a couple 100%. Food is relatively low. But, markup can be around 50% for many products. That’s a huge amount. There must be more to these costs than just transportation of the product to the store; obviously, retailers are not netting huge profits.
Distribution of a product directly from the producer to the consumer is the simpliest channel of distribution. Sometimes a firm can sell a service directly. Yet, often, it is more expensive to perform distribution functions in-house as opposed to outsourcing distribution functions.
Consider an industry where there are the 3 producers of similar goods and there are 5 consumers. In a direct distribution channel, each of these 3 producers has to interface with all 5 consumers. There are 15 connections that have to be made in order to get products to their final destinations.
Now, insert a distributor into this distribution channel. 3 producers connect with 1 distributor. The distributor then connects with 5 consumers. Now, there are only 8 connections between the producer and the final consumer. This is how cost is reduced by aggregation provided by a distributor. Of course, the distributor can also add additional value through something like providing the consumer with product financing.
The 3 producers/5 consumers example can be expanded by considering the amount of connections needed in a direct distribution channel between 100 producers and 10000 consumers. Perhaps, as the number of players grows, additional benefits of reduced number of transactions can be achieved by introducing yet another intermediary to further increase efficiency.
Note: One type of distributor is an “agent.” An agent is typically the only player in the distribution chain who doesn’t take title of the goods as they pass through her hands. She usually gets a small fixed percentage of the sales, but, she never really takes ownership.
Today, many products that used to be distributed by indirect channels are being distributed by direct channels. The reason is that for some products, like text preparation, computers have allowed people to be eliminated and replaced by machines. This drastically reduces the cost of employing direct channels. Another similar idea is that travel agencies have essentially been eliminated by the internet; the cost to the airlines of selling tickets directly through the internet is so low that there is no longer a need for travel agents to act as intermediaries.
Let’s say that a new channel comes along that appears more efficient (e.g., Travelocity.) Supplier, such as airlines, can choose to stay with the old travel agent channel, use the new channel, or use both. In many industries, firms choose to use both the new and the old distribution channels simultaneously. The reason has to do with the firm’s attempt to capture as much value (producer surplus) as possible.
For the travel industry, using older distribution channels, such as travel agents, as well as newer distribution channels such as Travelocity and even direct sales are an attempt to implement multi-part pricing.
Some people want more services when they book travel than others do. A business traveler’s time might be used more efficiently by just calling travel agent and telling her where you want to go, when, and when you want to come back. The travel agent can call back a hour later with everything arranged. But, with Travelocity, the business traveler often spends a significant amount of time searching for the lowest price only to find that the price has changed before the purchase is complete. This might merely irritate the leisure traveler who just starts over. But, for the business traveler, the lost time can add up to a significant loss. In other words, the travel agency is an indirect channel that adds value. The agent exists to augment the product so that it appeals to a different group of people. By segmenting demand and having alternative channels that add value, as needed, for different customer segments, the airline is able to capture more surplus.
Of course, using a travel agency costs more than buying airline tickets directly from the airlines. So, its possible to observe that, for exactly the same primary product, cost is different in different channels because people want more or different services to go along with the product.
There are different levels of distribution, depending on the type of product involved:
- Intensive Distribution — If a firm is selling a product (toothpaste, for example), it wants it available everywhere. This is intensive distribution. Walmart is an example of an intensive distribution channel.
- Selective Distribution — A somewhat augmented product is distributed in fewer locations to impart a bit of exclusivity. Macys and Kohls are examples of selective distribution channels.
- Exclusive Distribution — A firm has a single dealer for each geographic market. Exclusive distribution is typically used for luxury goods, specialty goods, or business products. Neiman Marcus is an example of an exclusive distribution channel.
Often, products are differentiated by the type of distribution chain employed. They are also differentiated using different product models for different distribution chains. For example, a consumer might buy Model 25 of a washing machine from Lowes or a Model 26 from a local appliance store. Neither store carries the other model. So, there are overlapping geographic areas for distribution of the firms products, but different models are sold depending on the retailer. Consumer can’t compare two products easily in this case. Another example is that models in BJs or Sams are different than in a specialty electronic store. But, the products might be exactly the same product with a different model number.
The choice of the kind of distribution channel has an impact on the brand: A firm should choose the distribution channel appropriate to the kind of brand that it wants to have.
Distribution Channel Conflict
Conflict incurrs in the distribution chain between the suppliers and the distributors. There are often overlaps in the distribution components that service end users. There can also be gaps in the distribution system. And there can be exclusive agreements that prohibit entry of additional distributors.
Distribution agreements can impose geographic restrictions, and restrictions on other products or services that a distributor can provide. Its important to think about the inevitable growth in the number of in distributors in any given market area. If a product has too many distributors and not so many customers, prices will increase. The reason is that each distributor starts selling less products when the distribution market gets saturated. This tends to happen for a variety of reasons over time. Distributors want to expand product range, so they start selling more products. Firms find themselves from time to time trying to straighten up the distribution channels. That’s tough and often guarantees lawsuits. But, its a necessary thing. The lesson is that a firm has to be very careful about how it lets the distribution channels grow because its hard to clean up bloated distribution channels.
Grey Market
A grey market is an unsanctioned, unwanted, Parallel Import Channel. The grey market provides a secondary market for products. Prescription drugs that are exported to Canada and then re-imported into the United States is an example of a grey market channel. Grey market channels disturb and undermine regular distribution channels.
Another example of a grey market channel is Kodak 35mm film. Kodak used to manufacture 35mm film to sell in China. Film is a high margin product; so, Kodak was able to price it according to the available purchasing power of the Chinese market. What Kodak found was that, suddenly grey market film from China began showing up in the United States. The film was exactly the same as the film sold through US distributors. But, the grey market importers were able to undercut the distributers’ selling price by 20%.
The same thing happened to Kodak with X-Ray film. X-Ray film used to be sold under “tender” — price cost only deal — only to governments in most countries. This was especially true for sales to developing countries. However, problems arose because the genuine Kodak X-Ray film was re-imported to the US and sold to US hospitals at half the price of US distributors.
The grey market can be thought of as just another way to achieve multi-part pricing – if firms could control it. Typically, grey market imports are illegal because they violate distribution contracts. For example, if Kodak sells film in India, they have a contractual agreement allowing the distributor to only resell it in India. But, still, companies have little control over the grey market.
The way Kodak solved problems with grey market film was by eliminating English from film packaging in China. By making Chinese the only language on the package, re-importation was not nearly as lucrative.
Reverse Distribution
Reverse distribution is a notion that’s come to the forefront only in the last 2 years or so. Products are beginning to be recycled and traded in for alternative uses; products that have been sold for a purpose are being recycled into a channel where there is a new use for the product. This is happening with electronics, soda cans, and even automobiles.
Reverse distribution arises from the notion of sustainable economics. Sustainable economics is a concept that has not really received the kind of focus that its going to receive in the future. The wave of sustainable economics is the future. Its only going to grow and is a real business opportunity.
Empathetic Design
Another new concept for product development is called empathetic design. It involves getting customers directly engaged in the development of new products. Neiman Marcus does this. Empathetic design turns out to be a great way to design new products, especially when style or tacit information is important. Frequently, firms’ attempts at empathetic design are disturbed by indirect distribution channels. Firms end up developing their own separate paths to reach customers. For example, one company takes its highest value customers to Bermuda for a week. Part of their day is spent on new product design. Knowledgeable consumers have a better idea than designers about what is coming next. Of course, empathetic design works best with incremental product development. Cutting edge product design is not as conducive to this method. For example, asking electronics customers in 1975 to brainstorm ideas for developing the internet probably would not have worked well.
Franchising
Franchising is a means of collaborative product distribution. Franchising is a large, and growing, business model. There are currently 4500 franchisers and 600000 franchisees worldwide. A new franchise opens every 6.5 minutes and almost half of retail sales are done through franchising.
A franchise is allowing an outsider to pay a fee to copy a retail model. Often, franchise agreements are specific to a geographic location. A franchise contract provides a brand, knowledge, sometimes capital, training, and a set of regulations/restrictions on how the business is run. The franchisee provides capital, becomes part owner, agrees to operate within the franchise agreement. She pays a significant upfront cost to the franchise and has onerous restrictions on her ability to get out of the business. In exchange, the franchise takes a percentage of revenue while the franchisee is the residual claimant to the revenue left over.
Franchising works best for multi-unit enterprises which are easily duplicated and rely on the brand equity of the franchise. Examples are: Stores, service areas, dental clinics, pharmacies and Business-to-Business (B2B) franchises.
First, from the point of view of the franchise, the franchising system saves the hassle of doing the end to end distribution. Franchising allows for increased revenue without as much increased expense to the franchiser. A franchise is really selling the idea of its business to a certain extent.
The franchisee has a vested interest to see that the enterprise works out. This vested interest limits agency costs because the principal (the franchise) and the franchisees have the same objectives since the owner/agent is also a principal (owner.)
From the point of view of the franchisee, she can be a successful late entrant into a business. She has less need to worry about first mover advantage. Late entrants into a business are almost never as profitable as first movers. But, as a franchisee, a viable business can still be established.
Franchising is a popular business model in the US and Europe as well as for US and European firms operating outside of their home countries. Its also very popular with Japanese firms. It may not be as popular of a model in India with Indian companies or in China. But, with the advantages of franchising, its popularity is likely to grow.
Note that many franchises are owned by corporate group, creating somewhat of an aggregation of franchisees.
Franchising in expanding companies addresses the problem of the franchise not being familiar with new markets. For example, McDonalds in France might serve wine for lunch. The McDonalds parent company in the US might not have thought of that a priori.
Advantages of franchising include:
- Name recognition.
- Training/management assistance. The franchise works with its franchisees to train employees to do a good job. Its easy to damage a reputation; so the franchise has an interest in creating homogeneity among the franchisees.
- Pooled marketing and purchasing. Typically, the franchisee has no choice about whether or not to participate.
- Corporate level financial assistance.
- Quicker startup with a cookie cutting design. Multiple units are very similar. The corporate franchise knows how to get the new business up and running.
- Risk is quite low; lower failure rate.
Disadvantages of Franchising:
- Fees are frequently quite high to start the business.
- The franchisee is constrained in many ways including marketing and image, being forced to make purchases from the franchise (to ensure homogeneous product).
- Typically involves geographic restrictions; so a franchise’s growth is limited.
- Territory infringement. There may be issues with the scope of the geographic areas so that too many franchises are allowed to open in a small geographic area.
- The franchise often imposes restrictions of how a franchise can be sold. A franchisee might have only the option to sell her business back to the franchise for a defined price.
The Internet as a Distribution Channel
The Internet can be an efficient distribution channel. But, although the internet disintermediates, it can also create new intermediaries like Travelocity or Ebay.
80% of new car buyers do research online before buying a vehicle. But, very few people are buying cars online. People collect information online and then go someplace to look at the products. This is a free-rider problem. Another example of the free-rider problem is customers who go to a high end electronic store and get complete information about available products. Then, they go to Best Buy and buy the item at the lowest price. Yet another example is calling a full service stock broker to get information, analysis, and recommendation about a stock and then going to E-Trade to buy the stock for the lowest commission.
The internet has had a significant role in globalization. Customers have more power today than they have had in the past because they have more information. The cost of search is lower.
Communication speed really hasn’t increased since the telegraph; electrons on a wire still move at near the speed of light. But, the bandwidth has increased significantly. So, in fact, communication is much faster.
Transportation is another significant factor behind globalization. Today, airplanes and not just ships and trains are used to transport people and goods worldwide. This enables companies like Zara to sell Spanish made products all over the world quickly through air shipments.
Containerized shipping allows firms to ship huge quantities of goods cheaply. The per-product cost of shipping something across the ocean is analogous to the small price of shipping one loaf of bread on an 18 wheeler.
Adding together the changes in the transportation structure and the internet creates a situation where globalization can have a huge impact on trade. The rate of improvement in transportation and information technology has picked up considerable steam in the last 10 to 20 years and promises to continue making the world a smaller place.
What does transportation and information technology improvements have to do with distribution channels? Consider global brands. A firm would be foolish to blindly start peddling goods in markets that it doesn’t know anything about; its extremely difficult to enter an unknown market in a location where the local culture may be quite different than what the firm is used to.
The notion of “distance” has been developed at Harvard. — If firms can ship things from one place to another economically, why does it matter if things are made down the street or across the world? Michael Porter posed this question a few years ago. He came to the conclusion that geographic distance matters more today than before.
Porter’s conclusion was that, with growth in communication, we can share information pretty uniformly around the world at any one time. The advantages of being in one place or another are lost. Yet, there is clearly a difference between doing business in one part of the world (or country, for that matter) and another.
The difference is the ability to communicate tacit information. Tacit information is skill building. Its hands on experience – like riding a bicycle. Its hard to share some kinds of information. What Porter found is that tacit information flows in tight geographical places. Examples: Hollywood or Bollywood makes movies; Silicon Valley and Bangalore are hubs of information businesses. In other words, many industries are clustered in specific geographic locations. The reason is that clusters improve the flow of tacit information.
Cage distance: Distance is cultural, administrative, geographic, and economic. Each of these is a “distance.” Cage distance is the modern way of thinking about distance between people or between firms. Distributors help reduce cage distance because they can eliminate a significant amount of cultural, administrative, geographic, and economic gaps and help firms do business in new places. The larger the cage distance, the more a distribution partner is needed.
Note that clusters can move over time. This is especially true if one firm is “the cluster.”
The internet is becoming just another channel of distribution. Its not a special case anymore. Its a channel of distribution like all others. It is becoming a alternative, parallel, distribution channel for many products such as medical tourism, shopping for books online, etc.
The internet will likely have the largest impact on developing countries. The reason becomes apparent when we look at other new technologies such as cellular phones. For example, in China, consumers are adopting cellular phones at a rapid place in locations where it wouldn’t be worth putting in a wired infrastructure. The phones can reach people in mountainous regions and other inaccessible places.
This is the case in many countries; developing countries will likely have few landlands ever.
Likewise, the internet is likely going to provide a new distribution channel in developing countries. The legacy/parallel distribution channels in Western countries many never develop in the developing world.
Use of the internet as a new distribution channel is evidence in India’s eChoupal network. With eChoupal, farmers get direct access to information flow. Other indirect channels have never developed.
An interesting book about the opportunity of using technology and capitalism to improve the plight of the poor in the developing world is “The Fortune at the Bottom of the Pyramid: Eradicating Poverty Through Profits” by C.K. Prahalad. I highly recommend this book.
There is a significant experience attribute involved in products like automobiles. The experience attribute is one of the reasons that most people go to dealers to make a car purchase. The issue is, as we look at the classes of products, we need to figure out which ones are efficient to distribute via the internet.
Software is just as complex as automobiles, but consumers buy software on the internet. They also buys books online and sometimes medicines. What class of products are best distributed on the internet?
The augmented product and freerider problem only exist as long as there are alternative channels. At some point, if the alternative channel disappears, the augmented product and freerider problem go away.
Will car sales become an online business? Is it that people are more experienced with computers (Dell does OK online) than with cars? … Maybe the reason is that the car is not as easy to return. But, say that a local dealer handles the kind of car that you want to buy. Maybe it would be in their best interest to deliver the car that a dealer in Texas would be willing to sell you for a better price. Or maybe its in their best interest to sell it to you themselves for the same price as the Texas guy without having to charge all of the shipping. In addition, they could say that they are giving you service. Shipping price from Texas would be a deadweight loss in the distribution channel. — Guess: Trend is one way. Car dealers in the next 10 years are likely to be more service dealers which provide delivery. Some segment may exist to purchase in the traditional way. But, just like there are still people who want to purchase from travel agents, there will likely be people who want to use the traditional channel. This is a multi-price segmentation with an augmented product. However, likely, most people will want to purchase more through electronic means like the internet.