THE JOURNAL REPORT: BUSINESS INSIGHT

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Marketing

The Distribution Trap

It's every manufacturer's dream to get on the shelves of Wal-Mart and other megaretailers. Too often, it turns into a nightmare.
By !D"#W ". T$%M & and TIM%T$' (. WI)*I!&%!
September 15, 2007

For many companies, the lure of partnering with a mega-retailer is irresistible: Giants like WalMart &tores Inc. and $ome Depot Inc. can put products in front of hundreds of millions of customers -- and potentially bring in huge gains in sales and market share. But behind those high hopes may be a faulty premise -- one that can lead to disaster for many companies. Whether out of nai et!, arrogance or greed, manufacturers e"pect that the big retailers will care about the success of their products as much as they do. VIDEO
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%ndrew Thomas tal&s' with the (ournal)s *rin +hite about how the ,nternet has changed the balance of power between retailers and manufacturers.

What companies forget -- or ignore -- is that the retailers# business model depends on mass marketing, low price and olume. $aturally, the retailers use their tremendous le erage to dictate tough terms to manufacturers. %hey insist on e er-greater price reductions and force companies to redesign products to better suit their needs. &nd in the end, many companies disco er that all the blood, sweat, tears and money they# e poured into their products has been wasted: %heir hard-won creations ha e been turned into commodities with ra'or-thin profit margins. Lost in the Crowd %his is particularly damaging for companies with inno ati e products. In a mega-store, shel es are packed with competing products from multiple manufacturers. &n inno ati e product loses its luster when it#s surrounded by a slew of potential substitutes, many of which are cheap knockoffs. $umerous companies e en agree to make copies of their own brands for the retailer. (ompounding the problem: (lerks at the store often recei e little or no training on the specifics of the products on display. )mployees may know only where a

product is located, not what makes it stand out. *a ing created the process and product, and in ested time and money, why would companies turn the final stage of the operation o er to a third party+ %o a oid this outcome, companies must control their own distribution. THE JOURNAL REPORT
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Round-the-cloc& operations. aren)t just for call centers anymore. !lus, to win mar&et share, don)t try to influence/ what brand of product people buy. 0hange how they use the product in the first place.

ee the complete 1usiness ,nsight2 report.

%his may mean selling directly to customers online or through company-owned retail stores. ,r it may mean striking strong deals with distributors -- and a oiding partners who won#t agree to those terms. ,f course, going it alone often means less olume, but the ad antages of doing so are likely to make up for it. (ompanies that keep a tight rein on distribution ha e a greater ability to control pricing, customer ser ice and after-sales ser ice. %hey can also build stronger, longer-lasting relationships with their customers. Below, we#ll e"plore how the lopsided relationship between manufacturers and retailers e ol ed and show the disastrous conse-uences it has had for some companies. %hen we#ll look at how other companies ha e a oided the distribution trap -- and are doing the .ob right. Core Con erns /anufacturers began surrendering control to retailers se eral decades ago. &t the time, many academics and business gurus were urging manufacturers to focus e"clusi ely on their core competencies and outsource e erything else -- including sales and distribution. In the short term, the strategy worked. (ompanies were able to lower transaction costs, boost efficiency and liberate themsel es from .obs that weren#t essential to their business operations. But there was an unforeseen conse-uence. 0etail chains and mass discounters began to take on tremendous power. By the beginning of the 12st century, what we call mega-distributors, or megas for short, were dominant players in the &merican economy. %hey could demand lower prices from endors, insist upon product alterations and e en dictate changes in manufacturers# internal operations -- such as demanding that suppliers begin using new merchandise-tracking systems. %he mega-distributors insist that such a shift has been beneficial for the economy as a whole, and customers in particular. For instance, Wal-/art spokeswoman 3inda Blakley says the company#s 4aim is simple.4 %he retailer is 4looking out for the customers# best interests and working hard to sa e them money on the items they want to buy. We know thousands of suppliers see the benefit of that, too, and don#t buy the argument that we ought to li e in a world where prices should be

higher and items harder to find.4 A BIG !ISTA"E#

The Ho$e: 3any companies see deals with mega-retailers as a great way to boost sales and mar&et share. The Re%&it': 3ega-retailers live by high volume and low prices -- so they use their powerful leverage to demand price cuts and other concessions from their suppliers. 0ompanies end up with thin profit margins, and their innovative products are often treated as little more than commodities. The So&(tion: 0ompanies must control their own distribution -- whether that means driving hard bargains with retailers, e4ecuting a direct-mar&eting strategy or even opening their own outlets.

5till, for many suppliers, the outcome is not so happy. %he saga of toy maker 3ittle %ikes shows what happens when manufacturers gi e up control o er distribution. First, some background. 6uring the 2789s, the strategy of large retailers was to identify the most popular items from toy makers and use them as loss leaders to draw in parents. %his created a chain reaction. 5maller stores were forced to lower their prices, too, and thereby endure unacceptable profit margins. %he smaller stores then put pressure on wholesalers, who demanded lower prices from the toy makers -- who in turn were forced to lower product -uality and make cheaper toys. 3ittle %ikes founder %homas G. /urdough :r. was unhappy with the poorly made toys flooding the market. *e belie ed that he could a oid the deep discounting and low product -uality of other manufacturers by keeping tight control o er distribution. When he founded the company in 27;9, he de eloped toys using a technology called rotational molding. Borrowed from methods used to produce large agricultural and chemical containers, the process allowed /r. /urdough to mold plastic toys that were more durable than others on the market. When it came time to bring his toys to the public, he focused on creating word-of-mouth among parents and building effecti e relationships with independent distributors. %he company did sell through large chains, but instituted a firm pricing plan. 3ittle %ikes offered its retail partners a <= ad ertising discount on products -- but they would lose that discount if they sold the products below a minimum ad ertised price. In addition, 3ittle %ikes only selecti ely released new, inno ati e products -- the lifeblood of the company -- to mass retailers. %he combined strategy of cutting-edge inno ation and control o er sales and distribution was an o erwhelming success. In 27>?, /r. /urdough sold his company to 0ubbermaid for @A9 million, but stayed on as president. 0ubbermaid officials placed pressure on /r. /urdough to distribute more new 3ittle %ikes products through mass retailers. Frustrated, /r. /urdough resigned in 27>7. 0ubbermaid dropped the selecti e-distribution and discount policies. 5ales temporarily skyrocketed. But problems were brewing. %he perception of e"clusi ity that had been the brand#s hallmark was lost in the .umble of neighboring and ine"pensi e (hinese toys. While the firm kept inno ating, its products no longer seemed special. Bltimately, the 3ittle %ikes name came to be

associated with deeply discounted toys sold on the mass market. &nd retailers, who had been slashing prices on the toys, reali'ed they weren#t making any money -- destroying their incenti e to carry the products. %he mo e into megas, coupled with generally slowing demand and higher materials costs, pro ed disastrous. In 199A, 3ittle %ikes had sales of around @1A9 million, @19 million less than in 27>7. In 1998, !e+ell "ubbermaid Inc. sold 3ittle %ikes to /G& )ntertainment Inc. $ewell 0ubbermaid spokesman 6a id 6oolittle says, 4&s markets change, business strategies must e ol e, and we managed 3ittle %ikes in line with the shifting dynamics of the toy market.4 Isaac 3arian, chief e"ecuti e of /G& )ntertainment, says, 4%he 3ittle %ikes brand remains ery powerful and positi e with consumers. 3ittle %ikes is often rated as the most trusted, durable, safe and fun brand in the market segments in which it competes.4 )OR )URTHER READING
These related articles from 3,T loan 3anagement Review can be accessed online The *+ Di,,erent W%'s ,or Co-$%nies to Inno.%te By Mohanbir Sawhney, Robert C. Wolcott and Inigo Arroniz (Spring 200 ! Twelve dimensions of innovation can be displayed in a new framewor& called the 5innovation radar,5 which companies can use to manage the increasingly comple4 business systems through which they add value. http:66sloanreview.mit.edu6smr6issue6'7726spring6$.68 Red( in/ the Ris0s o, New Prod( t De.e&o$-ent By S"#"$" %gawa and &ran' (. )iller (Winter 200 ! 9ew products suffer from notoriously high failure rates. 3any new products fail not because of technical shortcomings but because they simply have no mar&et. http:66sloanreview.mit.edu6smr6issue6'7726winter6$.6 : The Er% o, O$en Inno.%tion By *enry W. Che#bro"gh (Spring 200+! The way companies generate ideas and bring them to mar&et has been undergoing a fundamental change. http:66sloanreview.mit.edu6smr6issue6'77-6spring6/6; The New Pr% ti e o, G&o1%& Prod( t De.e&o$-ent By Ste,en -. .ppinger and Anil R. Chit'ara (S"$$er 200 ! <rowth and innovation can now be much more effective if manufacturers tie their decentrali=ed development organi=ations into a cohesive, unified global product-development operation. http:66sloanreview.mit.edu6smr6issue6'7726summer67:6 $7 How !%n%/e-ent Inno.%tion H%$$ens By /"lian Bir'in#haw and Michael Mol (S"$$er 200 ! "espite the importance of management innovation, it is poorly understood and usually not systematically fostered. http:66sloanreview.mit.edu6smr6issue6'7726summer6$/6 $$

A Di,,erent Ro%d For another stark e"ample of the megas# power, consider the case of car companies and dealerships. Bntil the 27>9s, auto retailing consisted largely of independent dealerships that relied mainly on selling one brand for their li elihood. %hese dealers, which could not match the economic power of ,ord Motor (o., -eneral Motors (orp. or (hrysler (orp., had to follow the dictates of managers in 6etroit. %he large auto makers had the power to make life ery easy or ery hard for these distributors. %hen foreign competition -- especially from :apan -- became a ma.or threat to the Big %hree car makers. 5o they took a drastic step to boost flagging sales. Beginning in the late 27;9s,

manufacturers permitted their dealers to sell other brands if those brands didn#t constitute direct competition. For instance, a lu"ury-car dealer would probably be allowed to sell another manufacturer#s economy cars. In time, this eroded the manufacturers# power o er their dealers -- and more and more dealers basically began selling e erything. 6etroit had only two options: drop the dealers and create a completely new sales and distribution network or learn to get along with the new power structure. $ot wanting to start o er, 6etroit chose to stay with the e"isting dealer network. %he result+ 6etroit now finds itself dealing with nationwide chains of mega-dealers. For these retailers, the only brand that matters is the one ser ing their purposes at a particular moment. If there#s a new model at Ford that the buying public doesn#t like, a dealer can seamlessly shift to selling 4better4 (he rolets, 6odges or *yundais. For the mega, it#s no problem. (ustomers will still buy, re enue will continue to come in, and the dealership will continue to grow. But what about Ford+ %he company has borne the risk of de eloping new products, dealt with the lawyers and go ernment safety inspectors, spent tens of millions on engineering tests and designs, conducted thousands of hours of costly market research, sourced new parts from suppliers and retooled its manufacturing processes. But because Ford can#t influence its big distributors in a meaningful way, it has no margin for error in anticipating customer tastes. If it brings out a car that isn#t popular, it can#t force the dealer network to carry the car and try to sell it. Ford says that the dealership picture is more comple" than presented here. %he current system e ol ed, the company says, because of a number of factors -- dri en by car companies, dealers and state laws. /oreo er, the company notes, dealers who are awarded a Ford, 3incoln or /ercury franchise offer a full line of the brand#s merchandise in their showrooms as part of their franchising agreement. %he company also argues that it is being aggressi e about deli ering 4more of the products customers really want, including new cars, crosso ers and trucks that feature ad ancements in safety, -uality, en ironmental inno ation and design.4 St%'in/ in Contro& *ow do manufacturers a oid the distribution trap+ Follow the e"ample of companies such as $arley-Davidson Inc. and .aterpillar Inc., which ha e recogni'ed the critical importance of controlling what happens to their products throughout the sales and distribution chain. &nd that means they ha e used the creati e energy of their employees to benefit their own stakeholders, rather than those of the mass marketers. ,ne way for a growing company to a oid the influence of the megas is through smart ac-uisitions. Instead of placing products in a big retailer to boost olume, a company could ac-uire other businesses that ha e strong ties to independent distributors. %hat way, e en if the

company#s core business must work with the megas, its other product lines can grow outside their influence. 5till, controlling distribution doesn#t necessarily mean a oiding big distributors entirely. If companies must deal with retail giants, they should push for fa orable terms -- ideally, working with them as truly e-ual partners. %ake !i/e Inc.#s relationship with the big athletic retailer ,oot )oc/er Inc. %he companies are teaming up to launch a network of specialty basketball stores called *ouse of *oops by Foot 3ocker, which will sell only $ike products. %he mo e ser ed $ike#s larger strategy of targeting core consumer segments. Finally, controlling distribution may mean selling directly to customers. %his can take a number of forms. %he most e"pensi e -- and risky -- is setting up proprietary outlets. $ike, for instance, operates a ariety of company stores along with *ouse of *oops. ,f course, most companies won#t ha e the means to create retail stores. Fortunately, the Internet and other technologies ha e made it simple to sell directly to customers. Stri0in/ % B%&%n e (onsider 5tep1 (o., a maker of toddler and preschool play products and home-and-garden products that /r. /urdough founded after lea ing 3ittle %ikes. For years, the toy maker has been striking a delicate balance between selling through the megas and selling directly to customers. %he company, owned by pri ate-e-uity firm 3iberty Cartners, sells many products through mass retailers, which helps build brand awareness. But 5tep1 keeps its newest inno ations close to the est. It often offers them e"clusi ely through the company#s Web site and independent retailers that support the complete line. ,nly much later -- after the products# no elty alue has worn off -- does 5tep1 offer them through outside retailers. For instance, the company launched the 3ife5tyle 6elu"e Ditchen and 3ife5tyle Grand Walk-In Ditchen play sets as e"clusi es on the Web. &fter a year or so, they mo ed into wider release. In conclusion, selling through the megas is almost irresistible for most firms. But before producers fall into the arms of the mass marketers, they should consider whether the benefits outweigh the risk of losing control o er their products, processes and internal operations.
--Dr. Thomas is associate director of the Taylor Institute for Direct Mar/eting and assistant professor of mar/eting and international business at the 0niversity of /ron .ollege of Business. Dr. Wil/inson is associate professor of mar/eting at the Montana &tate 0niversity, Billings, .ollege of Business. They can be reached at re$orts2ws34 o-12.
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