Power shift in the channel

Distributors and the purchasing of "off brands"

by Scott Benfield

For more than 100 years, North American Distribution earned value by sourcing and reselling various goods manufactured in the U.S. economy. Distribution’s primary value add has been the ability to break bulk from different manufacturers and aggregate disparate products into a value-added bundle for the end user.

An example is the plumbing distributor who breaks bulk from fixture, pipe, valve and accessory vendors, warehouses these goods, and aggregates them into shipments for plumbing contractors.

In essence, a shipment  includes parts from each of the vendor groups. In this way, distributors across 100 economic sectors carved out a value niche in the U.S. economy. Today, distribution passes approximately 25 percent of the U.S. GDP through its numerous warehouses and purchases from tens of thousands of manufacturers.

There is, however, a fundamental change going on within these mature and slow moving industrial channels. Initially, domestic manufacturers developed brands and these brands became recognized and identified with distributors and industries. In the early history of distribution, these brands were new technologies and carried prestige for the distributor. Fast forward to today and many of these technologies are considered commodities. Their value is not in a changing technology, but in which manufacturer can make an acceptable level of quality at the lowest price.

Many of these commodities are part of extensive product lines and sizable manufacturers. 

Consider a stainless steel fitting for a high purity system that is core product for a division of a leading Fortune 250 company. The company has been around for more than 100 years and has sales in the billions of dollars. The fitting, although a tiny part of the company’s overall sales, is strategically aligned with the industries of the parent company and fits within other products manufactured by other divisions.

The fitting, however, is a mature technology and the parent company has moved the manufacturing to foreign shores in the last decade. 

The reason for this move is twofold: The first is to get the labor cost out of the product, and the second is to capture growth markets in the quickly industrializing nations of the world. The fundamental change happens, however, when a foreign company takes the fitting design and manufactures it, at reasonable quality levels, and makes it available to the U.S. distributor at 30 percent to 40 percent less than the branded item.

At this “discount”, and for a distributor who is fortunate to make 2 percent of sales income before taxes, the temptation to buy the “off brand” is too great. If the distributor buys the fitting, sells it to industrial customers who don’t seem to care if it is an off brand, then the sales erosion of the domestic brand begins.

And, instead of the 100-year-old vaunted brand controlling the power in the channel, the distributor now has the chance to control the power by their ability to source from a much less expensive, but equal in quality, foreign supplier.

In the past decade, we have noticed this scenario being played out dozens of times in the distribution base of North America.  Some examples from our work will illustrate the pervasiveness of the problem:

• A cooperative of non-competing U.S. wholesalers sets up a central warehousing facility and purchases foreign items, by the container, for the cleaning industry. The goods are distributed to member warehouses as needed. Almost overnight, two leading U.S. manufacturers are out of business.

• A flooring distributor, tired of manufacturing glitches and ongoing conflict with a major supplier, takes raw material from U.S. and Canadian mills, ships it to China where it is cut and finished into flooring that is significantly less expensive and better in quality than the domestic product. The distributor sells the product under a proprietary brand name.

• An electrical distributor, out of curiosity, purchases switches, switch plates and outlet boxes from a Chinese manufacturer. The products are almost identical to those made in the same country by a branded, U.S. based parent company more than 100 years old. The distributor mixes a container of the off brand products in the warehouse bins with the branded product. The off brand products are sold to electrical contractors without a hitch. The price paid is 40 percent less than the branded product.

In dozens of vertical markets, we have witnessed stories like these where off brand products are being sold by distributors with great success. And, none of these relationships used traditional manufacturer representatives, buying groups or cooperatives.

In essence, the assault on powerful brands, by off brand manufacturers has begun. And, the power of the longstanding brand is being diminished by the distributor who once identified with the branded supplier. Too often, the branded manufacturer is, almost overnight, left out of a 100-year-old relationship and established channel.

The distributor, who has often been at the mercy of the powerful branded manufacturer now has the ability to control the power in the channel by sourcing off brands. In essence, the product has reached commodity status and the brand is of nominal value.  What matters is that the product is of a reasonable quality and the source of supply is reliable; the distributor can do the rest.

A rising tide or a blip on the radar?
The seminal question on the minds of manufacturers, reps, cooperatives and distributors in industrial channels, is whether off brands are a way of the future or a short-term event? We believe the sourcing of off brands is a rising tide that will help redefine channel relationships, channel structures and channel power in the coming decades. Those who understand this power shift can react to it and some can prosper greatly from it. Those who simply go about business as usual may not have the usual business in the foreseeable future.

The primary source of off brands will be China. But, as the Chinese economy matures, other global sources will spring up.  To understand how much investment has flowed into China, primarily for manufacturing, one needs only to understand the growth of investment and flow of goods to and from the rapidly industrializing country.

Since 1979 when China and the U.S. established formal diplomatic relations, the trade volume has grown from $2.5 billion to $150 billion per year. As of the end of 2004, there were 45,000 U.S. investments in China totaling $48 billion.1 

In addition to impressive growth in U.S. trade and investment, U.S. companies buy only a fraction of the goods they could buy from China. In a recent survey of 39 U.S. companies, “respondents estimated that these companies buy only 30 percent of the goods they could buy…” from China. Furthermore, the estimate is that “the figure will rise to 50 percent three years from now.”2  

Because of the investment and belief that more U.S. companies will source an increasing amount of materials from China, the likelihood that there will be a greater influx of Chinese and foreign off brands is assured. If China and other foreign countries as a source of supply are secure, there will be significant changes in established channel relationships. These changes are, as of yet, unknown but they can be approximated given the nascent trends in industrial markets.

Decline of traditional channel supports
As off brands grow, their purchase supplants many of the traditional roles in the industrial channel. In the past 10 years, we have witnessed a merger and general decline in independent manufacturer’s representatives. While this observation is not empirically validated, it is our experience that, as companies moved manufacturing offshore and began pursuit of foreign markets, they were less willing and able to pay traditional fees to manufacturer’s representatives to sell into mature domestic markets.

As the first foreign off brands arrived, the domestic brand was under extreme price pressure. The expendable costs in the channel were often independent representatives. And, there have been any number of rep firms who have consolidated simply to survive. Sales support hasn’t been the only casualty of the foreign supply of off brands. Cooperatives and buying groups are often left out of the picture.

Because off brand manufacturers are not part of established channels, they initially seek sales through any means possible.  Often these sales are to master distributors or large distributors who have the ability to purchase container loads of products and set up agreements.

As these companies become established, they do not always seek relationships with cooperatives and buying groups. Because the companies compete on price and have scant marketing budgets, they are reticent to give 2 percent to 5 percent of the product price to marketing groups or reps and prefer to deal directly with the wholesale buyer.

The impact on cooperatives and buying groups from off brand manufacturers is unknown, but the potential impact on these channel intermediaries could be substantial. Also, working against the established channels is the consolidation in the wholesale sector that is expected to remain strong.

There are approximately 220,000 wholesale firms in durable goods markets in the U.S.3 There is also a general decline in the number of firms at a rate of approximately 1 percent to 2 percent per year.4 

The distribution of revenue size of wholesale firms  favors off brand manufacturers. Depending on the industry, the vast majority of wholesale firms are small and less than $10 million in sales.

However, it is not unusual to find the top 5 percent of firms in revenue size to have more than 60 percent of a sector’s sales, and the top firms are often those where consolidation is the most active.

And, the larger firms are those with the expertise, size and wherewithal to source direct from the foreign manufacturer. In essence, the dynamics of size and consolidation in the distribution base favor the off brand manufacturer when the large are literally getting larger and have more of a propensity to source direct.

Why can’t domestic companies compete?
It is a foregone conclusion that manufacturing has moved offshore primarily because of the huge disparity in wages. U.S. manufacturing wages hover around $17 5 per hour while the average wage is $2.50 per hour in Mexico and 88 cents per hour in China.6

It is not unusual to find many industrial goods with traditional U.S. brand names made in foreign countries. The question that begs asking is: Why, if U.S. companies have operations in foreign countries, do their products cost 30 percent or more than off brands made in the same countries?

A contributing factor to the price disparity, are the managerial and executive wages of U.S. manufacturers. Many domestic manufacturers, while moving plants to foreign shores, still have R&D and other corporate functions stateside. R&D and product management for industrial products are traditionally done by engineers. Salaries for U.S. engineers can be 40 percent to 80 percent higher than for qualified engineers in other countries.7 

In addition, salaries for U.S. executives are astronomical compared to their counterparts in other countries. In one survey, the top tier of American CEOs earns 475 times the wage of the average employee. By comparison, in other industrialized nations, this ratio is 24 to 13 times the average employee wage.8  

The so-called “marketing organization” where manufacturing moved offshore but marketing, R&D and executives remained stateside may be in trouble. With the disparity in engineering costs, excessive executive pay and emerging growth markets that have unique R&D needs, the marketing organization concept is appearing less substantial over time.

While U.S. companies have moved manufacturing offshore, their employees in engineering and executive roles may prove too costly. This is a contributing factor to the inability to compete in the more mature parts of their product offerings.

Increasingly, domestic manufacturers, while having moved plants to low wage countries, may be pressed to add value in unique ways or may find themselves in trouble. 

What’s a branded manufacturer to do?
The field of industrial marketing has progressed from product-focused to supply chain to wrap-around services in the past two decades.

From our perspective, the product-driven model began to fade sometime in the 1990s and was replaced by the supply chain model. From the supply chain perspective, 40 percent or more of a product’s cost resided in moving it through the channel.

EDI, channel streamlining, information sharing and better planning with distribution were the means to drive these costs out.

Recently, we have seen evidence of service bundling with mature industrial products as a means to combat low cost off brands. For example, instead of selling paint, PPG Industries moved forward in the channel and offers painted parts.9  The idea is that industrial companies need to redefine their value add and wrap services around their products.

Much of this comes from Lou Gerstner’s successful turnaround of IBM, launching it as a service provider as opposed to a hardware company.

While wrap-around services have intellectual appeal, there are many industrial products that simply don’t need them. Looking at the commodity products common to distribution including copper and steel fittings, electrical outlet boxes and switch plates, basic plumbing fixtures, spring-loaded gauges, and so forth, there is little room for these products to undergo a radical redefinition and/or absorb wrap-around services.

If this is true, then domestic brand manufacturers who depend on these staples to absorb their manufacturing costs and contribute to their marketing organizations may be in trouble. 

And, this troubling situation will likely grow as off brands find their way to distributor shelves. 

The extent of off brands supplanting domestic brands is unknown but, from our work with distributors across numerous vertical markets, we believe it is an emerging trend. Distributors, who were once dependent on powerful brands, may well inherit the balance of power in the industrial channel by being able to choose “off brands” from foreign manufacturers.

In doing this, the larger distributor who can develop international relationships, buy container loads of product and private label them where appropriate has the upper hand.

To the extent that distributors recognize the hand they are dealt will determine how they grasp the power shift. For many domestic brands with high costs, cooperatives dependent on domestic brands and smaller distributors dependent on cooperatives, the future may not be as bright unless they make significant changes.

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