Leveling the playing field

Manufacturers should tread carefully before implementing functional discounts

by Tom Halpin

If you are an independent distributor or a manufacturer selling through distribution, you have most likely read about functional discount structures. Functional discount structures greatly contrast today’s most common form of manufacturer discount, the single discount structure. In the single discount structure, manufacturers typically don’t recognize distributors for their functional differences and extend all distributors the same discount off of manufacturer list price. A high-performing distributor that offers far more value than another distributor would earn the same discount.

Functional discount structures attempt to reward distributors according to the value they provide. The manufacturer builds a matrix that supports its business and then grades the distributor accordingly. The example below demonstrates a simple matrix.

What you see below is a partial example of a functional discount structure, where the manufacturer assigned 40 percent of the total value available to ownership and possession and customer service. Additional activities would raise the total to 100 percent, which would then become the multiplier of the manufacturer’s maximum discount on a given product.

The rationale behind the movement toward a functional discount structure is understandable. Manufacturers are searching for ways to reward distributors that offer more value than others. However, having been involved in the unsuccessful implementation of a functional discount program, there are some lessons that I’d like to share with those considering a similar move.

First, distributors don’t like to be told how to run their businesses. And functional discount structures have the potential to foster that kind of relationship, because they require suppliers to grade their distributors. That’s not a big deal if you are 3M, have lots of new product in the pipeline and end-user demand is bursting at the seams. However, small to medium-sized manufacturers with products on the downward slope of the product life cycle curve (see graph), may want to consider an intermediate program to bridge their current single-discount structure to the functional discount structure they envision for the future.

For example, an intermediate program could have three components making up the total discount, such as 1) stocking position, 2) point of sale information and 3) average days to pay requirements. In this situation, the manufacturer weighs each component according to its priorities. What’s good about this approach is that it starts to change the rules from single discount structure to functional, but in a manner more reasonable to the manufacturer’s distribution partners. 

Which types of distributors are better positioned to adapt to a functional discount model?  Without question, larger distributors look better on paper compared to traditional distributors in a functional discount structure. Their logistics network and overall sophistication allow them to offer more inventory and marketing support to manufacturers. However, larger distributors tend to fall short when it comes to engaging with manufacturers to create demand at the end-user level. Advantage traditional distributor. Specifically, the traditional distributor has the edge when the manufacturer has new, technical products that require missionary selling during the introduction phase of the product life cycle. Larger distributors have trouble giving up that much mind share and prefer to be mass merchandisers of product than to invest in a longer, technical sale.

My final advice to manufacturers considering a functional discount structure is to take stock of their value proposition, relationships with key distribution partners and their overall objective in implementing a functional discount structure. If they take a rigid stance without creating buy-in from key distribution partners on the front-end, implementation will be difficult.

Manufacturers with a distributor council should solicit their input on the framework of the functional discount structure and implementation of the program. Distributors that are involved in the decision-making process will be more apt to buy in over the long term. A functional discount structure inherently culls out low-performing distribution partners, making it an ideal mechanism for rationalizing a manufacturer’s distributor base.

Finally, I suspect many manufacturers will roll out functional discount programs in the coming months and years. This is a good thing. However, manufacturers that do not have a succinct channel strategy, have tenuous relationships with their distribution base and a mature product line need to go slow, consider an intermediate approach and poll key distribution partners up front. Failing to do so will be damaging to their distribution network.

This article originally appeared in the November/December 2004 issue of Progressive Distributor. Copyright 2004.