The changing economics of industrial channels

According to the author, there is currently underway a significant change in the economics of industrial channels. These economic effects are the result of globalization, consolidation, and the ability to conduct business 7/24 with immediate information on price and availability. Industrial Channel Members should be cautious in their investments in their channels as historical models may not be appropriate.

by Scott Benfield

With the advent of industrial channels some 100 years ago, manufacturers and distributors developed channel supports and funded them to drive products to market. Many of these supports were monies dedicated to the relaying of product knowledge, branding, advertising, sales promotion, product literature, and outside sales to ensure the growth of the brand. Also, many smaller wholesalers began to band together and form buying groups, co-operatives, and require volume rebates and price concessions from Domestic Brands. Today, these channel supports can cost millions of dollars for sizable manufacturers and many are not valued by the distribution base.1  Also, the changing economics of manufacturing may not allow Domestic Brands the ability to fund these programs in the long-term. The purpose of this article is to examine the traditional channel supports and what, based on current research, is most likely to transpire. Many supports will need to change as they are no longer of value or affordable by Domestic Brands.

Cost of Channels
While there are few axioms in business, the predominant truism in industrial (b to b) markets is that the low cost producer wins. Typically, cost is researched at the product level including direct labor, direct material and direct overhead. However, a substantial part of the cost of the product to the end user is in channel supports. Typically, it takes 30% to 50% of the product’s final cost to get the product to the end user. Today, the research shows that the cost of channel supports is becoming an increasingly fertile area to get excess cost out and the traditional channel supports that have existed for generations may not last. Our research in industrial markets across some 40 verticals and some 200 distributor executives finds that the key drivers of obsolete channel supports are consolidation and foreign manufacturing.2  These two trends are increasing at an increasing rate and the result will be more cost efficient channels with larger players and better prices for end users.

Consolidation of the Distribution Base
Consolidation in distribution has been the rage for many years with strategic studies predicting significant consolidation over the past decade and well into the future.3  Consolidation has long term effects on channel structures including:

• The larger players hire better educated and experienced executives and managers and management goes from running a lifestyle business to a business run for earnings and outside shareholders.

• Larger companies use their larger purchases to negotiate better prices putting considerable “back pressure” on existing vendors. Also, larger wholesalers rely less on co-operatives and buying groups. They can secure sufficient volume in proprietary purchases to drive a competitive price.

• Larger distribution companies are more likely to go overseas and source off-brands which have been shown to have a 35% landed cost advantage over domestic brands which can be made in foreign countries also but have significant domestic overhead costs including the funding of redundant channel supports.4

• Consolidation has tremendous effects on associations and industry events. In a recent association meeting, the manufacturers outnumbered the distributors by a 2.5:1 ratio. The question, among the manufacturers, was why fund the industry event heavily when the number of wholesalers is falling? This is probably why a recent association sponsored trade show was cancelled costing the association significant funds. In mature markets with shrinking numbers of players, the need for trade shows diminishes at an increasing rate.

How pervasive and powerful is consolidation? In the electrical industry vertical market of five years ago, the top 200 distributors counted for approximately 49% of industry sales. Today, the top 200 distributors count for 60% of industry sales5 and all indications are that acquisition will increase at an increasing rate.
In summation, consolidation puts considerable cost pressure on the channel and manufacturers who heavily fund channel supports. The estimate is for the manufacturer funding for these supports to decline as channel pressures increase.

Foreign Manufacturing and Off-Brands
In our research study, Disruption in the Channel, we chronicled the importing of foreign off-brands by the distribution base. Distributors, on average, were getting 20% of their products from off-shore, the average landed cost advantage was 35% over domestic brands, and the quality of off-brands was on par with domestic brands.

In the research, we reviewed service quality of 16 service variables that supported industrial products through the channel. We found that off-brands performed as well or better than domestic brands on all services except: product literature, technical support, EDI capabilities, product application training, field sales, and marketing programs. These services were not provided or provided only sparingly by off-brands. Distributors placed a low value on these services. Why? Our take is that these traditional services are needed for new products but, since some 75% of distribution markets are made of commodity materials, there is an historic and significant bias by domestic manufacturers to fund services that add little value.

Financial modeling of a typical distributor’s income statement finds that, at the current landed cost advantage and 20% of channel inventory in off-brands, distributors literally cannot afford to forego purchasing these products. Our further research found six distinct channel entrants who provided these products to distributors outside of a direct relationship.

Globalization of manufacturing has a significant effect on channel supports. The traditional top-down producer led channel is under siege. As brands mature, off-brands appear at less cost and consolidated distributors take advantage of the global environment to reduce costs for strategic advantage. In a recent review of four electrical distributors in the sales range of 4-5 billion dollars annually, we found that those who admitted to sourcing offshore had a return on sales that was 2.5 to 3 times greater than the firm who admitted loyalty to domestic brands. As acceptance of off-brands increases, domestic brands will simply be at a financial cross-roads of whether or not to fund traditional channel supports. Much of this support will decrease as they fund services that add questionable value. The next section reviews these channel supports and the likely outcomes.

Trimming Down Channel Supports
Not all channel supports are redundant or obsolete. Much of what manufacturers do is valued and will continue to be so. The following observations for channel supports is taken from our research and is our best estimate as to what will happen to the traditional supports including:

• Expect co-op dollars to fall or be challenged by manufacturers. Co-op expenditures will be scrutinized and approved in a much more detailed fashion and many co-op budgets will be trimmed.

• Volume rebates by domestic manufacturers will be under pressure. Currently, some industries have rebates that are larger than their distribution’s net income as a percent of sales. Expect volume rebates to fall and domestic brands to compete on upfront price with off-brands. Or, expect domestic brands to substantially cut other programs to continue funding of year end rebates.

• Sales literature, sales promotion, and marketing collateral will be trimmed significantly. Again, the maturity of products and the consolidation of distributors will render these expenditures suspect and many of the funds for these events will be trimmed.

• Association funding by domestic brands will decrease. Manufacturers often outnumber distributors at association events. This will only increase as consolidation will shrink the distribution base. Many associations get significant funds from their manufacturers but this will decrease as domestic brands will need available funds to fight off-brands. Expect associations to get smaller, combine with manufacturers to create an industry wide association, or combine with like industries and create a cross industry platform.

• Trade shows where manufacturers and distributors get together will die out unless they demonstrate significant value. In mature markets with declining numbers of firms and where world-wide communication is instantaneous, the number of trade show attendees, who pay significant sums to exhibit their products, are going the way of the dinosaur.

• Outside and inside sellers will increasingly be replaced by e-commerce models with customer service back-up. Sellers will be used will be in non-traditional sales roles of enterprise, functional, or consultative models.

Manufacturers and distributors are advised to review their channel supports and work diligently to assess the value of these programs to the channel. If the value proposition is questionable, then a plan to reduce funding these programs is recommended. The economics of industrial channels, in the next decade, favors substantial cost reduction in channel supports and delivering better value in the form of a lower price to the end user.

1 Benfield,S, Griffith, S, Disruption in the Channel, pg. 57, Power Publishing, 2008.

2 Ibid, pg. 14-15.

3 Fein, Adam, Shakeout and Consolidation in Wholesale Distribution, Abstract, Penn Libraries, 1997 at http://repository.upenn.edu/dissertations/AAI9814840/

4 Benfield S, Griffith S., Disruption in the Channel, pg 30, Power Publishing, 2008.

5 Lucy, J., The Top 200: Electrical Wholesaling, pg. 31, June 2008, Vol. 89, No. 6.

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