The effect of foreign off-brands on industrial manufacturers and distributors

by Scott Benfield and Steve Griffith

Some two decades ago, a seminal article by Jim Anderson and Jim Narus in the Harvard Business Review entreated manufacturers to “turn their distributors into partners.”¹ The article was from a working Distribution Research and Education Foundation² monograph entitled “Managing Working Partnerships Between Wholesaler-Distributors and Manufacturers.” The idea, in a nutshell, is that manufacturers and distributors should focus on common ground wherever possible, and the most common ground was serving the end customer and delivering value and reaping profits from joint marketing and sales activities. From this work blossomed a number of young business school graduates, seminars and lectures about how manufacturers and distributors should work together on market issues.

One of the authors of this article (Scott Benfield) was a graduate business student under the instruction of Jim Narus in the late 1980s, who subsequently went to work for a Fortune 100 manufacturer developing the distribution partnering efforts across North America. Some 20 years ago, when manufacturing was largely domestic, Narus and Anderson’s advice worked quite well. Today, however, we would advise manufacturers to rethink partnerships as many, if not most, of their distributor partners are turning into competitors.

Kissed by the Express Train³
Globalization is upon us and the changes, while often difficult to predict, are immense and affect all parts of established channels including distributors, manufacturers, associations, independent reps, and service firms. Why? Our research Disruption in the Channel,⁴ takes a comprehensive view of the importation of foreign off-brands by distributors. (Note: We define off-brand as an unrecognized brand, typically not manufactured on domestic shores. We define domestic brands as the incumbent brand(s) that can be manufactured in North America or a foreign country.)

The research is based on the responses of 200 durable goods distributors. Approximately 70 percent were executives. The research shows a significant increase in imports of foreign off-brands by domestic distributors. How big is the increase? Looking at Figure 1 below, when we asked distributors how much of their current inventory is in off-brands, we learned the following:

• 40% of distributors buy less than 10% of their purchases in off-brands

• 30% of distributors buy 10% to 19% of their purchases in off-brands

• 10% of distributors buy 20% to 29% of their purchases in off-brands

• 20% of distributors buy 30% or more of their purchases in off-brands

Using a weighted average of the mid-range of each group, we find that a whopping 20 percent of all durable goods channel inventory is composed of off-brand products. Hence, we liken the coming tide of foreign off-brands, for existing channel members, to be like “kissing the express train.” The obvious questions to us are: Why is 20 percent of channel inventory in off-brands and why has there not been more research and information about a trend that, to us, is the biggest thing to happen to industrial channels in the past 25 years?

It’s About Economic Survival
The explosion of off-brands is due to a confluence of events including the rapid expansion of foreign manufacturing, the use of the Internet to search and find foreign suppliers, the increase in the channel of importers and global master distributors to source off-brands, and the sheer price advantage of foreign manufactured items. We asked distributors why they purchase off-brands and found: (Question allowed for multiple responses)

• 92% of the respondents said price was the reason for sourcing off-brands

• 13% said quality was the reason for sourcing off-brands

• 15% said control over distribution rights was the reason for sourcing off-brands

• 27% said the chance to private label these products was the reason for sourcing off-brands (Note: There has been recent research on “private labeling” and its increase in distribution channels. However, private labeling has been a part of distribution for the last century. Private labeling is a distributor branding strategy and is largely a misnomer for the attractiveness of off-brands brought about by globalization. The difference in meaning is illustrated by the response to the question as distributors readily differentiate between the terms.)

• 13% said a trouble free relationship was the reason for sourcing off-brands

From the responses, it was clear that price or product cost was the main reason for purchasing off-brands. How much price advantage? Figure 2 below gives insight into the price disparity between off-brands and domestic brands.

From the exhibit, some 33 percent of distributors get a 21 percent to 30 percent price advantage from off-brands; 25 percent of distributors get a 31 percent to 40 percent price advantage from off-brands, and nearly 15 percent get a 40 percent or more price advantage from off-brands. Using the mid-range of the groupings and a weighted average of responses, the off-brand price advantage nears 30 percent over domestic brands. And, in our interviews, we found that many distributors buy commodities at a 60 percent discount to off-brands, which would make the greater than 40 percent less class more significant, and from which we have pegged the average price advantage from purchasing off-brands at 35 percent!

The idea that a distributor can be 35 percent out of the market unless they buy off-brands makes the decision to purchase them a near necessity and explains the fact that 92 percent of the respondents said price was the primary reason for buying off-brands. In Figure 3 below, we looked at the effect of differing levels of off-brand purchases on distributor income using an average distributor income statement in Scenario 1, and subsequent levels of purchases in Scenarios 2-4. The averages are taken from our work with distributors over the last decade inclusive of industry accounting ratios compiled by many associations. Averages including income and expense categories are expressed as a percent of sales. In Scenario 2, 10 percent of purchases are off-brands, and distributor net income increases from 2 percent of sales to 5 percent of sales. In Scenarios 3 and 4, the purchase volume goes from 20 percent to 30 percent of off-brands, and net income moves from 8 percent to 10 percent of sales. Of course, we don’t find too many distributors that make 8 percent to 10 percent return on pretax sales, and our interviews found that, after a few years, most off-brand price advantage makes its way to the customer. However, the point is clear that distribution is a thin margin business and, since the cost of goods are the majority of expenses incurred for the distribution firm, the distributor literally cannot afford to be without competitive purchases which are, in this case, off-brands.

The closing of this section leaves us with some irrefutable evidence that foreign off-brands are here to stay and are a necessity for distributor survival. The price advantage of 35 percent over domestic brands and effect on distributor profitability clearly point out this fact.

Old Habits Die Hard but They are No Match for Globalization
The network of powerful manufacturers and their distributors across industrial markets is supported by a number of vertical market associations. In all, there are over four dozen vertical markets and distributor/dealer associations for North American durable goods. These associations bring manufacturers and distributors together for common benefit and provide a host of services for their membership, including knowledge-based learning and research. These associations get significant financial support from vendor membership or associate membership fees, vendor exhibitor fees for meetings, and sales of vendor-sponsored educational material. Hence, the link between domestic manufacturers, associations, and distributors is financial and strong. The networks have been nurtured over years, are relationship-based, and form a tight-knit community. However, the relationships are largely North American-based, which is why we think there is negligible research on foreign brands. In short, the knowledge is too upsetting and disruptive to existing relationships and channel establishments. Acknowledging this and being empathetic toward these relationships is important but trying to ignore or stymie the knowledge of the effects of globalization is a losing battle. The horse has long left the barn and is running free and gaining speed.

The globalization of manufacturing, increase in distributor size from consolidation, increased quality of manufactured goods, 24/7 availability of foreign sources, and increase in information flow from the Internet have all combined to assure the growth of off-brands. Ergo, we entreat distributors, their manufacturers, and associations to explore, in earnest and post-haste, this issue. Off-brands are, more literally than metaphorically, the express train that won’t be stopped. The world is changing and is indeed a flat world where there are fewer places for inefficiency to hide. We also believe that national platforms for associations will begin to change. In essence, globalization will force many associations to go international or risk obsolescence.

In future installments we will dig into the research and answer the questions of quality of off-brands versus domestic brands, support services of off-brands versus domestic brands, and distributor estimates of the trend toward off-brand purchases.

1 Narus, J. and Anderson, J., Turn Your Industrial Distributors Into Partners,
   Harvard Business Review, 1986 and found in harvardbusinessonline.
2 DREF changed its name in recent history to the NAW Institute for
   Distribution Excellence.
3 Paraphrased from the Movie “Rocky Balboa.” 2006.
4 Benfield S., Griffith S., Disruption in the Channel, 2008, Power Publishing.
   See at www.disruptioninthechannel.com.

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