Saturday, September 22, 2007

The Distribution Trap

BoSacks Speaks Out: I thought this was a great read. It is thought provoking and insightful. It is not exactly focused on our industry, but then again, the parallels are fully and clearly evident.

"A farmer who had a quarrelsome family called his sons and told them to lay a bunch of sticks before him. Then, after laying the sticks parallel to one another and binding them, he challenged his sons, one after one, to pick up the bundle and break it. They all tried, but in vain. Then, untying the bundle, he gave them the sticks to break one by one. This they did with the greatest ease. Then said the father, Thus, my sons, as long as you remain united, you are a match for anything, but differ and separate, and you are undone."

Aesop quotes (Ancient Greek Fabulist and Author of a collection of Greek fables. 620 BC-560 BC)

The Distribution Trap
September 15, 2007; Page R8

It's every manufacturer's dream to get on the shelves of Wal-Mart and other mega-retailers. Too often, it turns into a nightmare

For many companies, the lure of partnering with a mega-retailer is irresistible: Giants like Wal-Mart Stores Inc. and Home 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 naiveté, arrogance or greed, manufacturers expect that the big retailers will care about the success of their products as much as they do.

And in the end, many companies discover that all the blood, sweat, tears and money they've poured into their products has been wasted: Their hard-won creations have been turned into commodities with razor-thin profit margins.

Lost in the Crowd

This is particularly damaging for companies with innovative products. In a mega-store, shelves are packed with competing products from multiple manufacturers.

An innovative product loses its luster when it's surrounded by a slew of potential substitutes, many of which are cheap knockoffs. Numerous companies even agree to make copies of their own brands for the retailer. Compounding the problem: Clerks at the store often receive little or no training on the specifics of the products on display. Employees may know only where a product is located, not what makes it stand out.

Having created the process and product, and invested time and money, why would companies turn the final stage of the operation over to a third party? To avoid this outcome, companies must control their own distribution.

Of course, going it alone often means less volume, but the advantages of doing so are likely to make up for it. Companies that keep a tight rein on distribution have a greater ability to control pricing, customer service and after-sales service. They can also build stronger, longer-lasting relationships with their customers.

Below, we'll explore how the lopsided relationship between manufacturers and retailers evolved and show the disastrous consequences it has had for some companies. Then we'll look at how other companies have avoided the distribution trap -- and are doing the job right.

Core Concerns

Manufacturers began surrendering control to retailers several decades ago. At the time, many academics and business gurus were urging manufacturers to focus exclusively on their core competencies and outsource everything else -- including sales and distribution.

In the short term, the strategy worked. Companies were able to lower transaction costs, boost efficiency and liberate themselves from jobs that weren't essential to their business operations.

But there was an unforeseen consequence. Retail chains and mass discounters began to take on tremendous power. By the beginning of the 21st century, what we call mega-distributors, or megas for short, were dominant players in the American economy. They could demand lower prices from vendors, insist upon product alterations and even dictate changes in manufacturers' internal operations -- such as demanding that suppliers begin using new merchandise-tracking systems.

The mega-distributors insist that such a shift has been beneficial for the economy as a whole, and customers in particular. For instance, Wal-Mart spokeswoman Linda Blakley says the company's "aim is simple." The retailer is "looking out for the customers' best interests and working hard to save 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 live in a world where prices should be higher and items harder to find."


The Hope: Many companies see deals with mega-retailers as a great way to boost sales and market share.

The Reality: Mega-retailers live by high volume and low prices -- so they use their powerful leverage to demand price cuts and other concessions from their suppliers. Companies end up with thin profit margins, and their innovative products are often treated as little more than commodities.

The Solution: Companies must control their own distribution -- whether that means driving hard bargains with retailers, executing a direct-marketing strategy or even opening their own outlets.Still, for many suppliers, the outcome is not so happy. The saga of toy maker Little Tikes shows what happens when manufacturers give up control over distribution. First, some background. During the 1960s, 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. This created a chain reaction. Smaller stores were forced to lower their prices, too, and thereby endure unacceptable profit margins. The smaller stores then put pressure on wholesalers, who demanded lower prices from the toy makers -- who in turn were forced to lower product quality and make cheaper toys.

Little Tikes founder Thomas G. Murdough Jr. was unhappy with the poorly made toys flooding the market. He believed that he could avoid the deep discounting and low product quality of other manufacturers by keeping tight control over distribution.

When he founded the company in 1970, he developed toys using a technology called rotational molding. Borrowed from methods used to produce large agricultural and chemical containers, the process allowed Mr. Murdough 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 effective relationships with independent distributors. The company did sell through large chains, but instituted a firm pricing plan. Little Tikes offered its retail partners a 3% advertising discount on products -- but they would lose that discount if they sold the products below a minimum advertised price. In addition, Little Tikes only selectively released new, innovative products -- the lifeblood of the company -- to mass retailers.

The combined strategy of cutting-edge innovation and control over sales and distribution was an overwhelming success.

In 1984, Mr. Murdough sold his company to Rubbermaid for $50 million, but stayed on as president. Rubbermaid officials placed pressure on Mr. Murdough to distribute more new Little Tikes products through mass retailers. Frustrated, Mr. Murdough resigned in 1989.

Rubbermaid dropped the selective-distribution and discount policies. Sales temporarily skyrocketed.

But problems were brewing. The perception of exclusivity that had been the brand's hallmark was lost in the jumble of neighboring and inexpensive Chinese toys. While the firm kept innovating, its products no longer seemed special. Ultimately, the Little Tikes name came to be associated with deeply discounted toys sold on the mass market. And retailers, who had been slashing prices on the toys, realized they weren't making any money -- destroying their incentive to carry the products.

The move into megas, coupled with generally slowing demand and higher materials costs, proved disastrous. In 2005, Little Tikes had sales of around $250 million, $20 million less than in 1989. In 2006, Newell Rubbermaid Inc. sold Little Tikes to MGA Entertainment Inc.

Newell Rubbermaid spokesman David Doolittle says, "As markets change, business strategies must evolve, and we managed Little Tikes in line with the shifting dynamics of the toy market." Isaac Larian, chief executive of MGA Entertainment, says, "The Little Tikes brand remains very powerful and positive with consumers. Little Tikes is often rated as the most trusted, durable, safe and fun brand in the market segments in which it competes."

For another stark example of the megas' power, consider the case of car companies and dealerships. Until the 1980s, auto retailing consisted largely of independent dealerships that relied mainly on selling one brand for their livelihood. These dealers, which could not match the economic power of Ford Motor Co., General Motors Corp. or Chrysler Corp., had to follow the dictates of managers in Detroit. The large auto makers had the power to make life very easy or very hard for these distributors.

Then foreign competition -- especially from Japan -- became a major threat to the Big Three car makers. So they took a drastic step to boost flagging sales. Beginning in the late 1970s, manufacturers permitted their dealers to sell other brands if those brands didn't constitute direct competition. For instance, a luxury-car dealer would probably be allowed to sell another manufacturer's economy cars.

In time, this eroded the manufacturers' power over their dealers -- and more and more dealers basically began selling everything. Detroit 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. Not wanting to start over, Detroit chose to stay with the existing dealer network.

The result? Detroit now finds itself dealing with nationwide chains of mega-dealers. For these retailers, the only brand that matters is the one serving 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 "better" Chevrolets, Dodges or Hyundais.

For the mega, it's no problem. Customers will still buy, revenue will continue to come in, and the dealership will continue to grow. But what about Ford? The company has borne the risk of developing new products, dealt with the lawyers and government 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 complex than presented here. The current system evolved, the company says, because of a number of factors -- driven by car companies, dealers and state laws. Moreover, the company notes, dealers who are awarded a Ford, Lincoln or Mercury franchise offer a full line of the brand's merchandise in their showrooms as part of their franchising agreement.

The company also argues that it is being aggressive about delivering "more of the products customers really want, including new cars, crossovers and trucks that feature advancements in safety, quality, environmental innovation and design."

Staying in Control

How do manufacturers avoid the distribution trap? Follow the example of companies such as Harley-Davidson Inc. and Caterpillar Inc., which have recognized the critical importance of controlling what happens to their products throughout the sales and distribution chain. And that means they have used the creative energy of their employees to benefit their own stakeholders, rather than those of the mass marketers.

One way for a growing company to avoid the influence of the megas is through smart acquisitions. Instead of placing products in a big retailer to boost volume, a company could acquire other businesses that have strong ties to independent distributors. That way, even if the company's core business must work with the megas, its other product lines can grow outside their influence.

Still, controlling distribution doesn't necessarily mean avoiding big distributors entirely. If companies must deal with retail giants, they should push for favorable terms -- ideally, working with them as truly equal partners.

Take Nike Inc.'s relationship with the big athletic retailer Foot Locker Inc. The companies are teaming up to launch a network of specialty basketball stores called House of Hoops by Foot Locker, which will sell only Nike products. The move served Nike's larger strategy of targeting core consumer segments.

Finally, controlling distribution may mean selling directly to customers. This can take a number of forms. The most expensive -- and risky -- is setting up proprietary outlets. Nike, for instance, operates a variety of company stores along with House of Hoops.

Of course, most companies won't have the means to create retail stores. Fortunately, the Internet and other technologies have made it simple to sell directly to customers.

Striking a Balance

Consider Step2 Co., a maker of toddler and preschool play products and home-and-garden products that Mr. Murdough founded after leaving Little Tikes. For years, the toy maker has been striking a delicate balance between selling through the megas and selling directly to customers.

The company, owned by private-equity firm Liberty Partners, sells many products through mass retailers, which helps build brand awareness. But Step2 keeps its newest innovations close to the vest. It often offers them exclusively through the company's Web site and independent retailers that support the complete line. Only much later -- after the products' novelty value has worn off -- does Step2 offer them through outside retailers.

For instance, the company launched the LifeStyle Deluxe Kitchen and LifeStyle Grand Walk-In Kitchen play sets as exclusives on the Web. After a year or so, they moved 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 over their products, processes and internal operations.

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