Notes from Robert Kaplan’s Presentation to Rice Alumni (19-Feb-2019)

On February 19, 2019, I went to a Rice Alumni event at the Federal Reserve Bank in Dallas.  The Dallas Fed is one of twelve Federal Reserve Banks in the United States.  The CEO’s of the Fed banks meet every six weeks or so to set national monetary policy.

Robert Kaplan, the CEO of the Dallas Fed was speaking about the state of the economy.  Peter Rodriguez, the Dean of the Jones School of Business at Rice University, was asking Dr. Kaplan questions.  Late in the presentation, Rice Alumni and their guests asked questions.

Here are some key points that I took away:

  1. Business Pricing Power:  In the current market, consumers have real-time access to prices of products.  They have never had such comprehensive access before.  Because of this, price competition is extremely stiff and businesses are not able to pass on cost increases to consumers.  Dr. Kaplan specifically mentioned the recent steel and aluminum tariffs as costs that businesses are not able to pass on to consumers.
  2. The number of people in the labor force and productivity are the primary drivers of GDP growth.  More people in the labor force yields higher GDP growth.  Likewise, higher productivity yields higher GDP growth.  Technology and education drive productivity increases.  Education is a big problem for Texas because Texas lags the US in general.  And, likewise, the US lags many countries in the developed world.  (More on this below.) Texas’ growth looks positive for at least the short and medium term, however, because Texas is experiencing large population growth.  This is dampening the education disadvantage that Texas has.  Likewise, Texas’ population growth – which results in higher GDP – allows Texas to solve its education problem in the future easier than states with stagnant or declining populations.  Dr. Kaplan specifically mentioned Kansas, where he is originally from, and Illinois.Dr. Kaplan mentioned immigration as a component of population growth in Texas.  But, he did not explore the subject.
  3. Technology helps people with post-secondary educations or specialized training in the trades.  It hurts those with a high school (or less) education.  This is the biggest driver of the growing divide between the wealthy and the poor.  Dr. Kaplan mentioned STEM many times as the path to growth.
  4. Dr. Kaplan specifically mentioned Khan Academy and edX as potentially disruptive forces in the post-secondary education arena.  He stated that education delivery needs to be significantly revamped.  He believes this should be done with steps such as busting teachers’ unions, eliminating tenure for college professors, and financially separating teaching from research at the university level.
  5. The media concentrates on the U3 unemployment rate.  However, the Fed primarily looks like the U6 unemployment rate which considers people who have given up looking for work and part-time workers who would prefer to be full-time.  The U6 unemployment rate is about 8%.  This paints a much less positive picture of the economy than the U3 rate that the media reports.
  6. The US owes $54 Trillion in unfunded entitlements such as social security, medicare, and retiree pensions.  This is a ticking time bomb.  It does not show up in the deficit or national debt numbers that we hear.
  7. 2018 saw GDP grow at a rate of 3%.  That was largely due to the tax overhaul and increases in government spending.  The effects of the tax overhaul are likely over for individuals.  The effects of the tax overhaul for businesses may be longer lasting.  But, that is not clear.  The effects of increases in government spending last year are probably over.  Therefore, GDP will likely grow at 2% or less in 2019.
  8. Dr. Kaplan believes that education spending will yield productivity increases (which will yield GDP increases).  He specifically mentioned early childhood education and that 60% of children who enter 1st Grade behind will never catch up.  He also believes that college prep should have more emphasis at the high school level.
  9. Shale oil/fracking:   The petroleum yield from this kind of oil production is short-lived.  That likely means that the US’ production levels will struggle to maintain their historic high levels and that the oil industry will profit from high oil prices in the future.

Short Commentary

During the question and answer session from Rice Alumni and their guests, one gentleman told Dr. Kaplan that there is either no correlation, or negative correlation, between spending on education and educational achievement levels.  If you think about it, such an assertion is absurd because, if true, the best thing for society (including individuals) would be to spend absolutely nothing on literacy.  Obviously, Dr. Kaplan disagreed.

After the presentation, I spoke with Dr. Rodriguez, the Jones Business School Dean.  I told Dr. Rodriguez that I was surprised by this question and was also surprised that Robert Kaplan did not point out that much of the spending labeled as “education” spending really goes for athletic programs which do not increase literacy.  Dr. Rodriguez agreed and mentioned the huge high school stadium in Allen as a great example.

I told Dr. Rodriguez that I would like to understand the research about the relative effect of employment growth and productivity on GDP.  For example, immigration increases the number of workers in the workforce.  But, immigrants come with various educational levels depending on their circumstances.  So, more immigrants cause GDP to grow.  And highly educated immigrants increase productively and that causes GDP to grow too.  But, illiterate immigrants have the opposite effect on productivity – at least initially.  That means that the positive effects of increased workers are dampened if those workers have lower than average productivity.  Unfortunately, Dr. Rodriguez seemed to take this as a political question and brushed it aside.  It was not meant to be.  I am sure that the Fed has data on this question.  I would love to see it.


Economic Value Estimation

The first step to marketing is determining how products and services create value for customers. Value can vary between customers.

Value is the total savings, monetary gains, or satisfaction that a customer receives from using a product or service.

The difference between this value and what people actually pay is called “consumer surplus.”  People often won’t pay for the entire value of the product because they know that the price charged in the market is less.  The price charged in the market is called the economic value.

Reference Value is the price of the customer’s best alternative or substitute for a product or service.

Differentiation Value is the economic value placed on the difference between a product or service and its best substitute.  Remember that perceptions can be the cause of the differentiation value.  This often makes differentiation value hard to estimate since its difficult to measure the subjective value of unquantifiable benefits.

Total Economic Value
is the reference value plus the differentiation value.

Economic Value Estimation ®

Economic Value Estimation ® (EVE) is the process of measuring Total Economic Value. Graphically, the process looks like this:

(This picture was taken from

The EVE for a product is not always what the consumer perceives the value to be. Some reasons are:

  • The consumer may not know about the differentiating features of the product and doesn’t want to spend the time to find out.
  • The brand image may convince the consumer that some product is worth more than the EVE.
  • The customer may not be too picky about getting the most for her money.

Therefore, EVE only provides a good estimation of the maximum amount that can be charged for a product, assuming that consumers recognize all of the value that the product provides. If a product is under priced compared to its EVE, a good solution is to maintain or slightly raise prices while engaging in an aggressive consumer education campaign.

EVE is not the same for each consumer. That’s why price segmentation is beneficial, if possible.

The relationship between prices and economic value delivered can differ depending on circumstances. For example, new products usually must be priced below economic value to encourage people to try them. The opposite may be true for existing products with existing customers since consumers may not be motivated to switch. Or, perhaps, consumers don’t even care too much about determining economic value. This attitude of indifference toward price leads to a price premium called a regulation premium.

Its important for a firm’s sales force to use EVE so that they and the are focused on value of each part of an offering rather than on “price.” When there is price resistance, EVE can be used to present the customer with a less expensive alternative with fewer features. EVE can also be used to price segment among groups of consumers who need different bundles of features.

There are no shortcuts for estimating EVE. The steps for estimating EVE are:

  1. Study Customer Economics – Study customers’ objectives and their “next best competitive alternative.” The next best competitive alternative’s price is the reference price.
  2. Quantify Value Drivers – Customer depth interviews are the best source of information. The most important piece of information to try to obtain is the value driver algorithms. What does the consumer’s economic model say about the kinds of things that drive value?Note that its critical to do a good approximation about what drives consumer value rather than trying to do a complex calculation yielding an exact, but meaningless, number.
  3. Estimate Differentiation Value – Estimate the impact of the product on the marketplace by estimating the monetary value that consumers give to it above and beyond the value they give to the reference product. Remember that this can be positive or negative since a particular product is seldom better in all respects.Needless to say, the sum of all of the differentiation attributes must be positive in order for a product to sell at a higher price than a competing product. When trying to determine differentiation value, be sure to use equivalent units when asking the consumers to compare a product with a reference product. For example, two units of a firm’s product may replace three units of the reference product. It is important for consumers to be aware of this when their attitudes are surveyed.Use the estimate of differentiation value and the quality value drivers to build the economic value model.

A common problem in marketing communications is documenting the economic value. For example, an advertiser might look at the total circulation of a publication and purchase advertising based on cost per customer reached. In reality, she should be looking at the cost of reaching the kinds of customers that she really wants to reach, how long they spend reading the publication, etc. To convince the advertiser to purchase advertising space, the publication may have to learn a significant amount about the advertiser’s business so that the price differential between its prices and those of other magazines can be justified.

Commodity products are essentially identical products that are offered by more than one manufacturer. A good example is a cheap portable radio. There is no differentiation between products. Since there is perfect competition in commodity markets, prices will be set very close to the actual economic value of the product.

Consumer Value Modeling (CVM)

CVM relies on customers’ subjective judgments about price and attribute based performance. CVM assumes that consumers look for products that give them the most benefit for the money and time invested in using it. It rates various product strengths or weaknesses according to the weight that the consumer puts on them. Then, CVM tries to create an average linear relationship between price and perceived value for the attributes.

Consumer Value Modeling emerged from the TQM movement. Companies tried to use it to measure and deliver superior quality at a competitive price. The problem is that people may be willing to pay for a particular attribute of a product or may be willing to pay for combinations of attributes. Each consumer is different.

The biggest problem with CVM is that it underestimates the value of significantly different products for people who are willing to pay premiums for combinations of attributes. On the other hand, it also overestimates the value of products that are similar to each other.

Simple Price Concepts

All firms set prices for their products. Poor pricing is easy. But, pricing well is very difficult. Proper determination of product pricing requires knowledge, preparation, and insight. Good pricing separates top executives from the pack.

The four P’s of marketing are:

  1. Product
  2. Price
  3. Placement
  4. Promotion

Pricing is the most important. The reason is that the other 3 P’s all deal with creating value whereas pricing is method for capturing value. Bad pricing decisions decrease the effectiveness of product, placement, and promotion.

A firm’s environment costs of:

  1. Costs
  2. Demand
  3. Competition
  4. Antitrust/Legal

Slotting Allowance

Slotting Allowance is money that a firm gives to a retailer for the privilege of putting a product on the store shelf. The amount of money spent on slotting allowances alone is more than all of advertising and consumer promotion expenditures, such as coupons, combined.

Smart Cards

Many stores, especially grocery stores, use smart cards to track a customer’s purchasing behavior. A customer is encouraged to scan her cards each time she makes a purchase. The retailers collect purchasing data into a database with her name, all of the purchases she’s ever made, and what kinds of coupons she uses. This information can be used to determine price sensitivity and can be used to create targeted pricing schemes. In theory, the data can be used to charge different prices to different individuals for the same product. One supermarket chain in California is doing this. There is a kiosk in supermarket which displays customized special offers when the smart card is inserted. Another retailer has a terminal display on the shopping cart itself where a customer puts your card in the slot. The cart buzzes if it wants her attention. For example, it might tell her that she will get 25 cents off the cookies she just passed.

Profit Maximization – Raise Prices or Increase Market Share?

Consider the following situation:

A soap manufacturer has annual sales of 100000 units. The selling price is $1 per bar. It costs $30000 to set up a factory to make soap, and it costs $0.60 to make each bar.

$3000 are fixed costs and $0.60 are variable costs. Fixed costs do not change as more bars are made. But, variable costs increase each time the firm makes another bar of soap. The profit of the firm is:


Profit = (100000 bars)*($1 per bar) – $3000 – (100000 bars)*($0.60 per bar)


= $100000 – $30000 – $60000

= $10000

Would the firm be better off if sales were increased by 1% (1000 bars) or if, instead, the price were increased by 1% ($0.01)?

Profit for 1% Increase in Sales = (101000 bars)*($1 per bar) – $3000 – (101000 bars)*($0.60 per bar)

= $101000 – $30000 – $60600

= $10400

Profit for 1% Increase in Price = (100000 bars)*($1.01 per bar) – $3000 – (10000 bars)*($0.60 per bar)

= $101000 – $30000 – $60000

= $11000

This example can be extended to firms in general. A study by McKinsey and Company based on average economics showed that, on average, a 1% increase in a product’s price cases a 11.1% increase in profits. But, a 1% increase in sales, on average, only results in a 3.3% increase in the firm’s profit.

Some Easy, but Poor Ways to Set Price

Firms often use these easy techniques for setting price; but they result in foregone profits:

  • Cost-Driven Pricing

  • Customer-Driven Pricing

  • Competition-Driven Pricing

Cost-Driven Pricing

Firms engaging in cost-driven pricing set prices based on their costs and profit objectives. Cost-Driven Pricing is sometimes called “Cost Plus Pricing.”

A firm typically puts a significant amount of money upfront into product design. Then, the engineering team turns the product design over to the manufacturing team which determines how to produce the product at a cost that will be at least marginally profitable. Next, the finance team is asked for determine, based on per unit cost and markup, what the product selling price should be. Finally, the marketing and sales group is tasked with sell the product at the cost that has been predetermined. Here is an Example of Cost-Driven pricing:

A firm has a product which has a marginal cost of $3 per unit. This marginal cost is constant regardless of the volume produced. The fixed costs for setting and remaining in production are $4.5M.

The per unit cost is $3 per unit plus ($4.5M / [Number of Units Produced]). Obviously, the per unit cost decreases as the number of units produced increases.

Many companies get around the lack of a static unit cost by artificially setting a desired production rate. So, let’s assume that this firm decides it wants to sell a million units. Then, the price per unit is:

Price Per Unit = $3 + ($4.5M/ 1M) = $7.50

The firm wants to make a profit of $1.50 per unit. So, it will try to sell the product for $9.

But… Will customers really pay $9 for the product? What are competitors charging? The sales number of one million units is totally made up!

What if the firm is only able to sell 750000 units at $9 each? It will only break even. That’s obviously not the desired outcome. Does the firm raise price? Lower the price? It would need to know what the demand curve for the product looks like in order to answer these questions. Otherwise, there’s no way of knowing what the effect of changing the price will be.

The problem is that Cost-Driven Pricing gives an apparent sense of objectivity to the price. The price is not objective.

A Cost-Driven Pricing scheme ignores customers. It fails to capture customers’ additional willingness to pay. The firm has no idea about what customers are willing to pay – if they’re willing to pay anything at all!

Another problem with Cost-Driven Pricing is that it ignores competitors. Competitors could be charging a lot less for similar items.

Cost-Driven Pricing usually results in charging one price to all customers. A one price fits all philosophy is often not a good practice because the firm cannot engage in price discrimination.

There are advantages to this pricing scheme. Its easy to understand and implement. If it works, the firm will have cover all of its variable costs and, in addition, the markup should cover some of the business’ general administrative costs. A decent return on investment will result.

These disadvantages of Cost-Driven Pricing outweigh the advantages.

Customer Driven Pricing

The problems with Cost Driven Pricing can be avoided by asking what price that customer is willing to pay. Then, the firm charges the maximum price that the customer is willing to pay.

There are problems with Customer Driven Pricing too. First, Customer Driven Pricing ignores the competition. And it ignores the costs of making the product.

Customer Driven Pricing is particularly poor for pricing a new product because customers don’t know how much they like it or how much value they place on it. Lastly, if customers know this is how a firm is setting prices, why would they tell the firm what they’re willing to pay? They have no incentive to tell the truth.

Competition Driven Pricing

Competition Driven Pricing focuses on what the competition is charging.

Problems with Competition Driven Pricing:

  • Price wars can result.
  • Competition Driven Pricing ignores costs. A competitor may have a whole different cost structure which allows them to make a profit at a much lower selling price.
  • Ignores customer willingness to pay. The firm’s product may be better or worse than the competitors, making the customer willing to pay more or less for it.

Each of these strategies as positive points. But, none of them are optimal. Optimal pricing strategy takes in account costs, customers, competition, and the legal environment.

Price Elasticity of Demand

The demand for a product varies depending on the price charged.  For some products, demand changes only slightly with a large increase in price.  For other products, demand changes significantly with only a small increase in price.  The Price Elasticity of Demand is defined as follows:

  Price Elasticity of Demand = (∂Q / ∂P) * (P / Q)

Where Q is quantity demanded, P is price,  ?Q is change in quantity demanded, and ?P is change in price.

So, supposed that a family demands 20 gallons of gas per week when the price is $1.99 per gallon.  But, if the price is $2.02 per gallon, the family only demands 19.5 gallons of gas.  The price elasticity is:

 Price Elasticity of Demand for Gas = (0.5 / 0.03) * (1.99 / 20) = 1.66

The meaning of this value is that a 1% increase in price of gasoline reduces the family’s demand for gasoline by 1.66%.

Of course, price elasticity will depend on what kind of product is sold (i.e., whether its a necessity or a luxury item), the income level of the consumers, and will also depend on the locality.  For example, in developing countries, the price elasticity of demand for gasoline will probably be much larger than it is in the developed world.  Also, a product with many close substitutes is more likely to have a larger elasticity.

We can see from the above equation that a price elasticity of demand close to zero means that demand will not change significantly with price.  But, a large value indicates that the demand changes significantly with price.  Such a large price elasticity is often called a “flat demand curve.”  If the demand curve is completely flat, an unlimited quantity can be sold at a given price; but, nothing will be sold if the price is raised only slightly.

Its important to note that the price elasticity of demand is a snapshot at a certain point on the demand curve.  The 1.66% reduction in demand for a 1% increase in price of gasoline may be true for the family when gasoline is priced around $2 per gallon, but will probably not be true when the price of gasoline is $4 per gallon.  Perhaps, at $4 per gallon, the family will reduce its demand for gasoline by 3% for every 1% increase in the price of gas.  Keep this in mind when calculating the price elasticity of demand with data with large differences in price.  If such varying data is the only data available, a more accurate way to calculate the elasticity may be to average the price and demand over the range resulting in the following equation:

Price Elasticity of Demand = (ΔQ * [P1 + P2])  /  ( ΔP * [Q1 + Q2])

Price Elasticity of Demand from the Demand Curve

Suppose that it is know that a product has the following demand linear curve:

P = a – bQ

Where a and b are constants.   It can be shown using the above equations that:

Price Elasticity of Demand =  (b*P)/Q

With this linear demand curve, the price elasticity of demand approaches zero as the price approaches 0.  This makes sense if we again consider gasoline as an example.  A family will likely acquire the same amount of gasoline if the price is 1 cent per gallon as it would acquire if the price were 2 cents per gallon.

Likewise, as Q approaches 0, the price elasticity of demand approaches infinity.  Using the gasoline example:  If a family demands one gallon of gas per week if the price is $20 per gallon, a 10% increase of price to $22 per gallon might cause it to cut its consumption to half gallon per week.

Price Elasticity and Revenue Maximization

For a firm, the important question to ask is:  What price should be charged to maximize revenue?

The total amount spent by customers on a product is P*Q.   This is the firm’s total revenue.  In the simple case where price is = a – bQ:

TR = P*Q = (a-bQ)Q = aQ – bQ2

A price is considered elastic if the price elasticity of demand is > 1.  The total amount spent by customers decreases when price rises.

A price is considered inelastic if the price elasticity of demand is < 1.   So, the total amount spent by customers increases when price rises.

The equilibrium point occurs when the price elasticity of demand equals 1.  This is the price point which maximizes total revenue.

Marginal Revenue

We know that total revenue is described by the equation:

TR = P*Q = (a-bQ)Q = aQ – bQ2

The total revenue increases as the quantity increases up to a certain point and then it begins to fall.   The amount of revenue (or cost) of the final item produced is called the Marginal Revenue.  The Marginal Revenue is the first derivative of the Total Revenue:

MR = a – 2bQ

Note that the marginal revenue curve has a slope that is exactly twice the slope of the demand curve.

If marginal revenue is positive, then making extra units of the product will increase the total revenue.  If it is negative, then making extra units will decrease the total revenue.  Obviously, once marginal revenue comes equal to zero, no more units should be produced.  This is the point where price elasticity is equal to 1.

Another way to write the equation for marginal revenue is:

MR = P * (1 -[1 / Price Elasticity])

Maximizing Profit

Maximizing profit and maximizing revenue are not the same thing.  If the marginal cost of making one extra unit of a new product is $2 and the marginal revenue obtained by selling that product is $1,  producing it does not make sense.  The profit maximizing point is where marginal cost equals marginal revenue:


MC = P * (1 -[1 / Price Elasticity])

For example, if the marginal cost to product a product is $10 and the price elasticity of demand is 2,

10 = P * (1 – [1/2])

P = $20 should be the selling price

Note that, as the price elasticity increases, the optimal selling price decreases.  So, if it costs $10 to produce a product and the price elasticity of demand is 4:

10 = P * (1 – [1/4])

P = $13.33 should be the selling price

Obviously, determining the price elasticity of demand is critical for a firm when setting the price of a product.

Implementation of Organizational Strategy

After a firm develops a strategy, it has to implement it. This usually involves a difficult process of organizational transformation.

Strategy is the notion of the general direction that a firm intends to take using its current, or needed, resources. The first step to implementing a strategy is to perform gap analysis to determine what current resources the firm needs and what resources it doesn’t. This gap analysis gets converted into annual operating plans which might involve restructuring, resizing, raising additional capital, or acquiring another firm.

Strategic decisions can be divided into dimensions of time, resource allocation, and commitment. Tactical decisions are those things that describe what actions are going to take place to implement the strategy: Who is going to do what and how is it going to be done?

The biggest challenge to strategic implementation is changing intangible organizational resources. Frequently, its easier to set up a “green field” operation rather than transform an existing organization. This is the case because its hard to change what people are used to doing; the mindset of the organization must change. Change involves a deceptively simple three step process:

  1. Unfreeze the current organizational mindset and processes.
  2. Change the processes or resources to fit the strategy.
  3. Refreeze the processes and resources so that they become the accepted way that the firm does business.

Ed Shein at MIT developed this model.

Again, a green field project is often easier to implement than going through these steps. An example is General Motors. GM found change to be easier in its Saturn division, a green field project, rather than going through these steps at its existing divisions.

Implementation of organizational change can be thought of in terms of a classic three legged stool model:

  1. Decision Rights – Who has the authority to decide what measures should be taken to achieve the desired change?
  2. Performance Measures – How are the results of these actions measured?
  3. Incentives – What incentives do the decision makers have to encourage them to be most effective?

Performance is almost always measured in financial terms. But, what if it were measured in units of time? Suppose that a firm tries to minimize the time required to do something rather than cost to do it.

Zara doesn’t try to minimize cost. Clearly the small lot sizes it produces in Spain are costlier than big ones it could produce in China. Zara measures performance on the basis of time: how fast they can get information from market place, redesign, and deliver an improved product to retailers. They have changed the dimensions of performance from financial performance to time by complimenting higher development cost with lower waste. This is a different method of operation than most firms.

Large organizational shifts are rare. Most of the time, planning is linear, incremental, and non-dramatic; change is in small “leaps and hops.” The formal term for this is punctuated equilibrium. For example, one year’s plan for market share growth might be 5% more than last years. Every once in a while, there is a significant shift. Typically, significant shifts happen when some development outside of the industry forces the shift.

An example of an industry that has gone from hopping to leaping mode is the power utility industry. In the past, it was virtually impossible for a power utility to fail. The utilities were monopolies and changes occurred slowly. But today, the power industry has largely been deregulated while being subjected to more and more emissions regulations. Competition has increased and the industry is in the mist of significant restructuring.

These shifts are usually dramatic and short lived. Today, the time between the leap intervals is getting shorter and shorter because of globalization, technological shifts, and similar factors.

Dynamic Organizational Capability is a unique resource whereby a firm has the capability to respond to significant and unplanned changes. How long it takes the firm to respond to a shock compared to the next fastest responder in the industry is of utmost importance for the firm’s survival. If a firm’s response to shocks is better and faster than its competitors, dynamic organizational capability can become a sustainable competitive advantage. If its not, the firm will often die.

The importance of dynamic organizational capability has become quite obvious in the financial sector recently. Those financial institutions that have been able to quickly respond to the latest market conditions have survived. Others, like Bear Stearns and Merrill Lynch, have not. The verdict is still out on the auto industry; but the ability of manufacturers like General Motors and Ford to respond to the changing market does not look promising.

Today, more automobile brands are being manufactured in the US than at any time in the last 100 years. Japanese and European firms are prospering by manufacturing in the US. At the same time, Chrysler is very sick. GM is not as sick. Ford is not as sick as GM. But, all three are on the verge of bankruptcy. The difference between the Big Three and their competitors, who also make cars in the United States, is the cost of labor contracts. Bankruptcy is likely the best solution (as opposed to a bailout) for these manufacturers because reorganization under bankruptcy can allow a judge to get rid of the burdensome labor contracts. Somewhat positive results have occurred in the past in the airline industry through Chapter 11 reorganization.

Creating a Focus of Activity to Deal with Change

One way to create a focus of activity for dealing with leaps and hops is to introduce a new product design. This allows a firm to focus its resources and to communicate to stakeholders outside of the firm the direction that its going.

Another way to create a focus of activity is to exploit right to left information flow (flow of information from consumers to the firm) and data mining. In the US in particular, supply chain management is becoming much more important than manufacturing. Organizational boundaries are becoming more fuzzy as more and more pieces of the supply chain are outsourced. Time to market for most products is rapidly shrinking. The need for right to left information flow necessitates efficient distribution channel alignment with the firm’s strategy.

An example of the importance of distribution channel alignment is the competition in the PC industry between Dell and HP. Dell triumphed over HP for many years because its direct marketing strategy allowed it to glean critical information from its customer base and to act on that information. HP, on the other hand, has been stifled by poorer information flow due friction in its distribution network.

A firm must be able to use right to left information flow to fit its existing capabilities into the needs of the market. They must also be adept at stretching resources to meet the market. This stretching requires development of new capabilities. But, developing new capabilities is inherently risky. Often, organizations, especially small ones, can find themselves stretching too far. So, there must be a balance between appropriate reactions to market forces and what is possible (and reasonable) given the firm’s history and limited resources.

A new company doesn’t initially have as much of a stretch/fit problem since it often has better focus. But, as time goes on, new opportunities arise and the firm is tempted to chase them. Small companies get in trouble by continuing to focus solely on the customer (in a Market Based View) rather than on its unique capabilities. Suddenly, the firm may find itself trying to satisfy a myriad of customers. – Remember that “strategy” tells a firm whom it wants to serve as well as whom it doesn’t want to serve. If a firm tries to be everything to everyone, it has no strategy.

Of course, at some point, a firm might decide to stop serving one group and pursue opportunities serving another. But, if it tries to serve everyone, it has stretched too far.

As stated in a previous post, the Resource Based View of the firm is usually more important than the Market Based View. A firm should start by looking at its unique resources and then build on them to form a strategy. It may find that it makes sense to serve many different customers. That’s acceptable as long as it has a focus on building a unique resource. For example, Honda makes many varieties of power equipment: motorcycles, cars, leaf blowers, and lawn mowers. But, its focused on products that contain motors. Motors are its core competency.

For organizational change to be successful, organizational leaders (a subset of managers) must guide the firm to develop unique resources to allow the firm to compete. Unique resources should not be confused with essential resources. For example, in the case of Zara, its unique resources include the capability to quickly meet changing market conditions in the fashion industry. That’s its focus. An essential resource for Zara is production equipment such as sewing machines. While maintaining its unique resources is essential, it may and should obtain essential resources such as sewing machines from other sources rather than developing them internally.

The Venetian Blind Effect

Allocating resources over multidivisional operations and projects presents a challenge for a firm – particularly when there is consistent under performance. This often leads to the Venetian Blind Effect:

In organizations experiencing the Venetian Blind Effect, projections of future growth are made which show that the product development or market will start off slowly and then suddenly take off at a rapid rate at some point in the future, such as later in the fiscal year. When the fiscal year comes to a close, the firm is either still in the slow growth phase or the rapid growth phase has not taken off nearly as fast as expected. Yet, projections for the next period are made based on the current status of the project and the same faulty assumptions are made over and over again:

Startup businesses and venture capital businesses see this all the time. The problem occurs when overly optimistic projects become a recurring event in the organization. When this happens across an organization and management attempts to deal with it, stretch targets begin to become par for the course. Management acceptance of failure breeds an organizational habit of failure and the expectation of failure becomes a self fulfilling prophesy. This leads to a real organization sickness. The firm has built a scheme where its not being honest with itself and doesn’t know how to effectively allocate resources.

In reality, only 63% of strategic forecasts are realized in most firms.

A case in point is Kodak in 1982. Kodak was going through tough times and its stock was not doing well. Kodak kept estimating its target stock price based on strategic plans. Yet, the stock price was 1/3 lower than they thought it should be. In 1984, they looked at how well they had met their strategic plan. They missed the strategic plans by 1/3; in retrospect, that’s why the market valued the stock the way it did.

When examining why strategic forecasts often fail to pan out, one has to ask whether the failure was due to poor strategy or poor implementation. The answer is usually not obvious. Perhaps there are external factors that the firm misses when developing the strategy. Perhaps resources within the firm are misallocated. In other cases, the market is simply delayed; the firm has precisely estimated what the market is, but its timing is off by a year or two.

One reason for market delays may be a delay in the availability of complementary products. An example of this appears to be electric automobiles. There appears to be a large demand for electric cars. But, a complementary product (batteries) just is not ready. So, the introduction of viable electric vehicles is slow and not exciting as some had imagined because of lack of good battery technology.

Resource Allocation

As mentioned above, implementation depends on resource allocation. Assume for a moment that a project manager has agreed to lead a very important project. She has identified resources and developed a reasonable schedule. She’s given the go ahead to commence development, but then she realizes that she needs the talents of a particular individual. Unfortunately, her supervisor says “Wait until he’s done with his present project in 6 weeks.” Now, the project manager does not have the resources to get started.

On short projects, delayed resources like this put a project manager in great jeopardy. Her manager will remember that she promised to deliver but didn’t. The lack of resources will be totally forgotten and only the failure will be remembered. So, a project manager must strive to get the necessary resources lined up before making a delivery commitment.

From a personal standpoint, a manager should try to work on one of two kinds of projects:

  • Very good, successful, projects.
  • Projects that are great but in trouble.

Senior management spends its time with projects that are in trouble. So, a project manager who can successfully bring a troubled project to completion will stand out. A leader of a fairly trouble-free, successful, project will also stand out. However, a leader who works on a so-so project is unlikely to be noticed.

Changing Strategy At the Right Time

Often, the need for strategic change is not obvious. When David Kearns was CEO at Xerox in the 1980’s, he realized that, if Xerox didn’t make some significant changes, the company would be in bankruptcy in a couple of years. This was an astute observation because, at the time, Xerox was quite profitable. Kearns addressed this issue by starting the quality program at Xerox. The quality program created a sense of urgency and formed a focal point that the company could rally around.

Unfortunately, Kearns also bought insurance companies. His reasoning was that Xerox was in a cyclical business. He noticed that insurance industry was counter-cyclical. He felt that level earnings would help with analysts’ recommendations. It turned out that he didn’t know anything about running an insurance business; so the experiment failed.

Besides creating a sense of urgency and a rallying point, its important that a management executing strategic change form a powerful coalition. She needs a group of people who understand and are supportive of what she’s trying to do. When thinking of the players needed to form such a coalition, we usually start by looking at the players on the firm’s organizational chart. But, typically, the influential leaders are not on the organizational chart. For example, in a company like Xerox, they might be an senior inventors. Or they might include a loner or eccentric employee who is very insightful and comes up with many new successful things. Or, perhaps, there are people in the marketing organization that understand trends. People turn to them and value their judgment. The new strategy must be created and communicated and leaders should be delegated to carry out the new vision.

In carrying out a new vision, its important to plan and create short term “wins.” Typically, strategy is long term. But, people tend to focus on short term results. Short term successes to keep people focused.

Implementing Change

The most important part of implementing change is to “keep it simple” and to link the firm’s operating plan to its strategy. As mentioned, first look at the firm’s resource gaps and then determine if new implementations address the gaps. Al Simone, the President Emeritus of the Rochester Institute of Technology, did this well. In the early 1990’s, he put together in a notebook describing the university’s strategy. When people came in with proposals, he ask them to show him where it was in the strategy. If it was there, it was easier to convince him. If it was not in the strategy notebook, he could still be convinced to implement the proposal; but, would be hard. Within a year, people recognized that they had to be aligned with the strategy in order to get something done in the university.

As mentioned in Coordinating a Global Brand Strategy, its important to develop a common language and analysis framework across an organization. This is particularly important because it is a prerequisite to effective performance measurement of identified metrics and priorities. If a firm does not measure its performance, it will not improve. If it does, it will. Once performance is weighed against the metrics and priorities, resources can be allocated based on performance.

When you get into uncertainty, debate the assumptions and not the forecasts. Forecasts can always been tweaked if assumptions are correct. But, incorrect assumptions can never be used to create valid forecasts.

Of course, assumptions can be proven incorrect. This makes robust adaption to changing circumstances imperative. Sometimes the external environment changes. Sometimes it just looks hard to go the direction the firm is going and it needs to reevaluate its strategy. Flexibility and recovery are valuable management capabilities. But, leaders must be careful not to merely cop out of a tough situation.

Finally, postmortem project analysis is important if a firm is to learn from its mistakes. Yet, very few companies conduct postmortems. The general tendency is not to do a postmortem and just start again with a new project. The reason is that postmortem analysis is uncomfortable because the manager is associated with failure.

Private Labels

There are 800 categories of Private Labels. These categories include medications, vitamins, pet foods, apparel, and grocery items among others. Private label products are a large part of many stores’ products: 55% at Sears. 20% at Kohls.

Private label products are typically positioned as cheap, generic, substitutes for other products. They generally have similar quality and lower price.

The following are typical characteristics of Private Label Brands:

  • Mimic brand name packaging.
  • Products similar to major brands – including quality.
  • Associated with a particular store.
  • The actual manufacturer is hidden from the end consumer.

The actual manufacturer is usually hidden from the consumer to prevent cannibalization of the name brand. For example, assume that Kelloggs is producing a store brand for Wegmans. Consumers won’t see any reference to Kelloggs on the box; if consumers knew that Wegmans and Kelloggs cereals were identical, they would never buy the higher priced Kelloggs brands.

Of course, not all private labels share the above characteristics. For example, Marks and Spencer has the store brand St. Michaels. Until recently, their products were not sold as a “national brand” in other stores. However, Marks and Spencer products are medium to high priced; they are not inexpensive knockoffs of major brands. St. Michael is an example of a Premium Private Label. Premium Private Labels have superior standards. They are most often seen in the apparel industry; but they can be seen in the packaged goods industry as well.

Packaged goods are the place where private labels create the most havoc. In retailing, a “detailer” is a person who works for a national brand whose job entails stocking shelves in retailers. The detailers ensure that the national brands gets its products to the location or aisle where it will do best. Such positioning is extremely important for national brands. The most valuable spots are at the end of the aisles. Its also critical that a brand be placed at the customers’ eye level. By having detailers stock the shelves, national brands are more able to control where private label competitors are positioned relative to them in stores.

Of course, the retail establishment has a competing interest if it sells private labels. The retail establishment’s strategy might be to get consumers hooked on a private label with the store name. Then, the person feels she has to go to that store to get the product she wants. This can be a double edged sword because the brand reflects the store and the store reflects the brand. A brand with a bad reputation reflects badly on the retailer. Likewise, a good product carrying the label of a retailer with a bad reputation is likely to be poorly perceived. Yet, such a product can be effectively used to build up the retailer’s reputation.

Given current growth rates, improving quality, and lower prices, private label products are likely to continue gaining market share in the future. However, national brands, arguably, keep product categories alive since they provide category awareness through advertising.

In some cases, private labels have actually become the dominant product. A case in point is generic drugs. In some cases, its not even obvious that a particular drug is a generic version of a brand name drug. Today, there is a whole set of prescription drugs now sold only under their generic names. HMO’s will typically insist on generics once patent protection expires.

Supplying Both Brand Name and Private Label Equivalents

When a firm supplies or manufactures both brand name products and private label equivalents, its quite important (as stated above) that it keep secret the fact that both products are the same.

Another thing to be concerned about is maintaining a strict price premium. This becomes increasingly difficult in cases of fierce private label competition. An example is Coke and Pepsi versus grocery store brand soft drinks. At any given time, Coke or Pepsi seem to be on sale. The sale price is similar to the price of the grocery store brand. Unfortunately for Coke and Pepsi, such regular promotions erode the perception of added value for their brands. After all, if Coke/Pepsi sells for the same as a brand like W-Pop every two weeks, many customers will not consider it to have higher quality or market position than W-Pop.

The problem is that, once a national brand starts such a cycle of promotions, its difficult for it to break out. Customers will wait to purchase the products until they go on sale.

Advantages for the Retailer to Sell Private Labels

Margins on private labels are better for the retailer. Typical margins for private labels are 35% compared to 25% for national brands. But, comparing these two numbers directly is not possible because national brands significantly contribute to the overall market for a category through advertising.

When a retailer sells private labels, it is able to increase its bargaining power with national brands. As a purchaser, the retailer can threaten national brands by either introducing private labels or promoting them more heavily.

Private labels can be used to differentiate a retailer from its competition. For example, W-Pop is only available at Wegmans. Competing grocery stores do not sell W-Pop.

Finally, private labels can be used effectively to reposition a retailer in the market. This repositioning is most often seen when premium private labels are used to promote the store as an exclusive outlet. In addition, private labels can be promoted through other channels (for example, President’s Choice is promoted through many retailers as is Safeway’s organic brand, “O”.) In the case of President’s Choice chocolate chips cookies, the private label brand has repositioned the retailer as a seller of high quality food items.

From suppliers’ point of view, there are real advantages to private labels.

One advantage is Economies of Scale. Making another brand of corn flakes imposes very low extra cost to the producer. By not making private label, a firm may very well be giving business to a competitor who is welling to make it.

The big problem, though, is that cannibalization of the national brand can occur even if the private label agreement is secret. The reason is that a successful private label will effect the pricing of national brand.

Concept of a “Fighting Brand”

A “Fighting Brand” is new brand that’s positioned half way between a firm’s national brand, a private label, or another brand. Fighting brands are often used when it’s difficult to differentiate between the attributes of various brands. Fighting brands can provide a buffer between brands, but often lead to brand cannibalization.

A firm must be very careful with introduction of a fighting brand because the linkage between fighting brand and flagship brand is hard to protect. When word gets out, a substitute has been created with the flagship brand at a lower price.

A good illustration of this is Kodak in its fight for market share of film with Fuji in US. Fuji’s film was not quite as good when they first began selling it in the US market. But, it was fairly low cost and Fuji had 10% market share. Kodak had 80% margin on its consumer film products. Kodak began asking itself how it should deal with Fuji. Kodak talked about making a fighting brand. But, what would happen if people found out that Kodak was making the fighting brand? Customers would know that the product would be high quality because it came from Kodak. The debate went on within Kodak for a decade.

Another big problem for a firm supplying both brand name and private label products is distraction and inadequate economic analysis of the true cost of supplying the private label. Too often, firms simply look at the low marginal cost of supplying the private label and, based on that, decide to produce the private labels. For example, a firm might say, “Our factory is operating at 75% of capacity. We can produce produce private labels at marginal cost to bring the factory up to full capacity.”

The problem with this approach is that, over time, the firm will have to add or replace capacity with capital investment. When that happens, the capital investment involved in continuing to produce the private labels can be substantial. Yet, firms often just look at the capital investment in relation to the national brand. They make the investment. Then, they have even more excess capacity which is used to produce even more private labels. So, when making a decision about adding or replacing production capability, its imperative that the firm analyze the trade-off between yet more capability and just giving up private label production altogether.

Another problem for suppliers producing private labels is that it is difficult to take price action on a customer; raising the price charged for a private label may cause the retail to find an alternate supplier for the private label product. So, suppliers lose bargaining power with retailers. Not only do they lose bargaining power with private label, they also lose bargaining power for their name brands. For example, if Kelloggs produces private label cereal for Safeway, Safeway can demand a reduction in the price it pays for name brand cereals or, else, the private label contract will go to General Mills. In an extreme case, the supplier becomes a commodity supplier and most of the bargaining power goes to the intermediary (the retailer.)

Private label management can also take up a significant amount of senior management time. Senior management time is one of the most scarce resources in a firm, but its use rarely shows up in the accounting/economic analysis of private labels.

Private Labels in Recessionary Economies
The market penetration of private labels goes up and down with the economic situation. Private label penetration does not change at a constant rate. As private labels get better, however, substitution improves. The key for a private label is to try to get customers to try it. This is especially true for packaged goods since packaged goods are high experience products. At every downturn in the economy, more people try private labels. When the economy improves, some consumers stick with the private labels. So, over the long run, economic downturns are good for private labels.

What is a “Brand”?

Brand is a name. Brand is a shape. Brand is a design. Brand is a logo. Brand is a color. — All of these aspects of a brand are trademarked and are fiercely protected.

Think of the generic attributes of a product:

  • Search
  • Experience
  • Credence

“Brand” is a shorthand for all of them and provides a notion of the characteristics of the product. Of these generic attributes, brand tells us the most about the experience and credence attributes. The importance of the brand with respect to each of the attributes depends somewhat on the product. For Coke, brand tells us about experience. For Apple, it tells about experience and maybe credence.

A few years ago, Microsoft had a glitch in a new version of Windows whereby the calculator which didn’t always give the correct answer to simple arithmetic. Microsoft tried to assure its users that the glitch didn’t occur often. However, people were up in arms! The Microsoft brand is largely about credence. So, a rare problem with the reliability of the calculator function destroyed some of the credence in the Microsoft brand name; consumers couldn’t be 100% sure that the calculator issue was really as rare as Microsoft said it was. In addition, perhaps there were other things wrong with Windows that hadn’t been discovered…

Since brand is an asset, it can appreciate over time if it is invested in. And it can depreciate over time if investment in it is neglected. Brand value is usually built over a long period of time and is a unique resource that creates value as long as it either exists or is perceived to exist. This perception is very important because a brand can continue to convey a desired message about a product that is no longer really up to standards whereas marketing communication (such as advertising) is only a way of communicating what the characteristics of a product actually are. The same idea holds true for differences between products. Whereas marketing efforts cannot describe a product as being different from another if there really isn’t any difference, the brand name can be a powerful differentiator for a very long time after the differences goes away.

An example is of this is Coke. In a variety of blind taste tests, consumers don’t really prefer Coke over other cola soft drinks. But, when the labels are visibile during taste tests, people usually prefer Coke. That means that the Coke brand is valuable and that there’s brand equity.

Coordinating a Global Brand Strategy

A global brand should have a global marketing strategy and set of standards for the brand. But, not all details of implementation should be dictated centrally. There needs to be some local flexibility in the marketing, advertising, and perhaps product customization. At the same time, individual country managers or regional managers should communicate with one another so that best practices discovered in one country can be shared with managers in another country.

Its easy to discount brand strategy ideas and say that they will never work in a certain country. But, sometimes fresh, unexpected, strategies can work well. By communicating effectively in working groups, success stories can be shared and new ideas can be tried in other places.

Local brand management efforts have to be coordinated somehow. One way is by having a global brand manager. Another way is having a global brand champion within the company. Or, perhaps a firm can have a global brand team with some authority. Each of these people/teams should also have specific responsibilities other than working on global brand management so that they have practical experience and credibility. The responsibility of this person/group needs to be harmonizing global brand strategies with country specific brand strategies.

Another idea is that the country managers of a global brand need to speak the same “language.” In other words, they need to use the same terminology when describing ideas. They should examine the same things such as the target segments, brand identity or vision, brand equity goals and measures, analysis of customers and competitors, and methods of success measurement.

Brands Serve Customers; Customers Don’t Serve Brands

Brands are created to serve customers; customers are not there to serve brands. Brands should do try to change themselves to fit customers’ needs and wants. A brand strategy should not be created and then segments found to fit the strategy; rather customer segments with large lifetime value (customer equity) should be found and then brands should be created to fit their needs.

Companies tend to view brands as encompassing of large segments. However, the proper trend is to create narrower brands in response to more narrow customer segments. In this way, the brands’ strategies can be better tailored to be a better fit to the needs of the segment served.

Remember this: If a brand strategy does not address which customers that it does not want to serve, then its not segmentized!

Implementing this idea of consumer segment driven brand formation is difficult. One reason is that brand managers have their brand turf to protect. Implementing a consumer segment driven brand strategy is only effective when there is top down commitment to it so that the idea permeates company culture.

One way to implement it is to have consumer segment groups and managers within the company that hold the purse strings of the brand managers. Again, remember that the brand is there to serve the customers; the customers are not there to serve the brand.

Also remember that the value of a brand depends on the customer. So, averaging the value of a particular aspect of a brand across a wide range of customers creates an artificial situation where the actions taken in response do not adequately address the feelings of hardly anyone within the customer segment.

Companies can have different brands in the company to appeal to different segments. Instead of trying to keep a changing customer in a certain segment, a company should strive to hand off the customer to another brand within the organization when the customer outgrows the segment. For example, if a person is a loyal customer to Fairfield Inn and then starts becoming a frequent business traveler, it could be time to hand that customer off to a more business oriented member of the Marriott Hotel family; and it may not be the best thing to try to keep him as a customer of the Fairfield Inn brand.

Product Distribution

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 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.