Lecture 4 PDF

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Lecture 4...

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Sales management and marketing channels Channel analysis: outsource or integrate? - Vertical Integration

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Today's lecture: Outsourcing Vertical Integration Costs and Benefits of Make-or-Buy Channels Payment Options for Buying Market Channels Make-or-Buy Channel Options Vertical Integration Vertical integration: An organization does all the work (production, sales, inventory, credit). Can take two forms:  Forward or downstream – manufacturer takes up the functions that you’d expect from the intermediaries (distribution, selling etc.)  Backward or upstream – downstream channel member implements channel functions that would be expected from a higher channel member (e.g. retailer produces its own label goods) Outsourcing: An organization (manufacturer) buys the services from a third party – gives them the responsibility to organise some of the channel functions e.g. buys the services of a retailer to sell the product to the consumers. Degrees of vertical integration

Continuum of vertical integration 

“Buy” is endpoint of the continuum  Every function is outsourced. Manufacturer-distributor arrangements involve no sharing (risk, expertise, image), distinction or community.

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Relational governance or “quasi-vertical” integration  The channels have some properties of both owned (make) and independent (buy) channels.  Arises in several ways, e.g. building and maintaining committed relationships perhaps through selective distribution or franchising.  When argument for integration is strong but not 100% convincing, relational governance offers some vertical integration benefit attainment without its costs. E.g. information sharing in relational partnerships nearly always benefits performance, especially in volatile markets. Institutions performing channel functions

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Costs and benefits of vertical integration Costs (Disadvantages)  Manufacturer assumes all distribution costs – if the manufacturer opens its own physical store and distributes the product or if they dodelivery for online sales this means they must invest in the resources they need (e.g. buy trucks, buy logistics systems) to implement these channel functions.  Often the costs and risks are underestimated – substantial costs get underestimated by a manufacturer before it takes them on, as does the risk of the distribution operation and the responsibility for all actions in the channel. Delivery of the product may appear straightforward to the manager but when they come to perform the delivery they find its very expensive or complicated (e.g. if a small winery in Italy wants to sell its wines online to the UK, they may think they can do the delivery when bringing the wines themselves however delivery to the UK may be extremely complicated and expensive) Benefits  Control on different channel functions is beneficial if the firm’s managers exploit it to improve their economic profits.  Creates new opportunities e.g. customer needs – if we have our own stores and interact directly with end users we may get additional info on what

consumers want and this can inform our research and development operations to customise what we offer to the customers or to develop new products that can satisfy customer needs in a better way.

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Manufacturers moving to downstream operations IBM and General Electric – manufacturers of electronic goods, can gain additional profit by offering maintenance service/customer support service, they invested and implemented other channel functions which improved the customer experience of the company and gained the company more profit. If a company sees a decline in sales they can invest in other channel functions in order to minimising risk if something were to go wrong with one of the channel functions they are heavily invested in  Diminishing appeal of manufacturing as a business opportunity  Earn profits not through sales but in maintenance By integrating downstream, they tap into a steady stream of maintenance contracts for the products they manufacture. Examples of vertical integration  Allianz, a German insurance company acquired Dresdner, a prominent investment bank to start selling the finance element of different services -Allianz had no knowledge investment banking - Investment banking fundamentally does not fit with insurance

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Payment options for buying market channels Manufacturers focusing solely on production must obtain distribution services in the marketplace. In contracting with a third party, it assigns certain channel functions to this outside organisation, in return for an economic consideration e.g. price. Three most common – (there isn’t a general rule on how third parties will get paid, everything depends on the agreement between the two parties)  Margin – retailers will get profit margins, e.g. if John Lewis sells apple laptops they’ll take 5% of sales  Commission – fraction of the resale price e.g. business to business sales involving third parties to do negotiation and sales to organisations, e.g. Dell may employ third party sales agents to sell computers to Newcastle University, in this case an additional form of payment may be a commission  Royalty – percentage of the resellers business e.g. copyrights, third party may receive a flat fee for the sales of a product Other variations  Lump sum or flat fee  Functional discount - reimbursed for expenses  Future consideration - e.g. rights to future business or percentage of manufacturer equity Make-or-buy channel options: The buying perspective A manufacturer will decide whether to invest in vertical integration or to outsource the channel function based on the expected efficiency within the process. The manufacturer will consider the profits the process will make, the costs associated with the process and they will decide whether this investment will result in efficiency.

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The buying perspective  Return on Investment is the primary criterion - the organisations goal is long run maximisation of firms overall return on investment  Revenues – Direct Costs = Net Effectiveness = Efficiency Overhead Overhead

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Situations which might bar vertical integration  Firm lacks and can’t obtain the resources - Even if the manufacturer decides it would be better to invest their own resources developing their own operations to implement their own channel functions, such as distribution and logistics for instance, in many cases although they may realise they cannot obtain the resources e.g. cannot find retailers to stock the product. In this case it makes sense to outsource the channel functions. 

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Firm has other priorities which contribute more to ROI – in many cases investing in other channel functions may not be a priority for a company because investing in something else may produce a better return on investment, e.g. a company may consider investing money in creating their own logistics network or open their own stores however their priority’s lie in product development so they decide to invest in this instead of channel functions. The decision about vertical integration will be based on efficiency, profits, revenues, benefits, costs and this makes the process efficient. However, at the same time company’s need to consider whether they have access to the resources to develop their own operations and invest in vertical integration and whether doing this is a priority and will produce optimum return on investment

Six reasons to outsource distribution Motivation – External parties have powerful incentives to do their jobs well, because they are independent companies that accept risk in return for the prospect of rewards. Both positive (profit) and negative (fear of loss) motivation spur third parties to perform. The motivation rationale also depends on the recognition that outside parties are replaceable and thus subject to market discipline. e.g. in the case of a sales agent selling the company’s product to another organisation and the company agrees on a commission based payment this sales agent may have a very high motivation to carry out as many sales as possible because the more they sell the more money they will receive in return, compared to the company having their own sales force which is on a basic channel without any benefits e.g. may have a sales rep who has a specific salary regardless of the number of sales. Specialization – usually when third parties are involved in a marketing channel they are very good at what they are required to do e.g. a retailer knows how to sell products, a logistics company knows how to distribute products, they have the knowledge that is required to implement specific channel functions, not only this but usually these third parties have manners to create a good name in the market in relation to what they’re doing so they have proven they

are the best to implement a specific channel function, they have survived the competition with their competitor. Specialisation and the proven ability of third parties can be another reason for a specific organisation to outsource a specific channel function. 

Survival of the economic fittest - if specialists fail to perform their functions better than their competitors, they do not survive. Distribution in most sectors enjoys low mobility barriers (business is easy to enter and exit). Therefore this function attracts may entrants, and lesser performers get readily eliminated.

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Economies of scale – By pooling demands from multiple manufacturers to provide marketing channel functions, the specialized third-party providers achieve economies of scale (They do a set of distribution functions for multiple parties and thereby earn volume discounts). The economies of scale also enable outsiders to perform functions that would otherwise be uneconomical. By offering a broad range of brands in a product category, the distributor can amortize its fixed costs for distribution facilities/logistics software etc. E.g. an Italian winery to export their wines to the UK they will collaborate with a wholesaler because it will be cheaper for them to export their wines to the UK because the wholesaler is likely to also bring wine from other winery’s in the UK so the cost to move one unit of wine to the UK will be cheaper for the winery than transporting their own wine to the UK

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Heavier market coverage – An external third party can acquire many, smaller customers more frequently because it offers greater assortment to end-users. Distributors can also draw customers to their locations, websites or catalogues all of which offer substantial cover of the market. Ultimately, a third parties ability to amortize the cost of a sale allows it to cover a market more thoroughly. Specific market categories e.g. FMCG’s (for example Buxton Water) require faster distribution. A product like Buxton Water requires to be present everywhere e.g. every supermarket, every corner shop, to maximise product sales of the product as these products do not specifically have high consumer loyalty, there is no opportunity for Buxton to open their own stores in UK cities as they will not maximise sales of their products. A manufacturer that requires heavy distribution will give the retailers responsibility of the sales of the product.

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Independence from any single manufacturer – Diversified outside providers of channel functions can serve as impartial sources of advice. Many outside specialists are local, stable, entities, whose personnel serve the same customers yearly, thus gaining opportunities to learn about their customers and forge strong customer loyalty. e.g. backwards vertical integration e.g. a retailer invests on wholesale operations or manufacturing their own label product a downstream channel member may avoid doing this to not depend on a single manufacturer. Exclusive collaborations is a form of semi-vertical integration e.g. John Lewis agrees with Apple to sell only Apple laptops in the store, in this case of semi-backwards vertical integration the retailer will depend on Apple so if something goes wrong with the product the retailer will be exposed as they

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will lose a big market sale, or will depend on the manufacturers terms and conditions in terms of what profits they can make. The main reason for downstream channel members to collaborate with more manufacturers is to avoid this dependence from a single manufacturer. Reasons for vertical integration

6 main identifiable factors grouped into two categories (tangible and intangible)

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Intangible capabilities Idiosyncratic knowledge – a company may decide to invest in vertical integration because the producer of product/service they deliver requires specific knowledge in terms of how to be handled during distribution; how it should be sold, how we can educate the consumers to use the product etc. Downstream channel members make investments to acquire this knowledge, which becomes a general-purpose asset. A company may think it’s better to interact directly with the end user, or the product may have to be transported or distributed in a particular way and so they take responsivity of the sales themselves.

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Relationships – Connections between distributor personnel and the manufacturer personnel or the manufacturer's customers imply an ability to perform quickly, correctly and with effective communication. E.g. a company that mainly targets business users may have established relationships with the potential customers they want to target so may decide to vertically integrate instead of outsource

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Brand equity – in the case of retailer e.g. John Lewis, Tesco, have strong brands and consumer custom they may invest on manufacturing and create their own private labels, a retailer may invest on backwards vertical integration because of brand equity as consumers will trust and use the products they produce. The latest strategy encourages retailers to use their vast product category knowledge to design new products, then work with manufacturers to determine how to make it.

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Tangible capabilities Customized physical facilities – manufacturer may have a good logistics system and can distribute the product themselves  An important transaction-specific asset can be the actual physical facilities.  Ex. Amazon has outsourced warehousing and shipping functions for years, whereas most book wholesalers send many books at a time to easy-to-find locations (bookstore) because sending a single, appropriate book to individual sites would be costly.

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Dedicated capacity: when distribution capability (e.g., warehousing, transportation, selling, billing) serves a particular channel member, this represents overcapacity. If the manufacturer terminates the business, the downstream channel member suffers excess capacity, which it cannot redeploy without sacrificing productive value (loses). Unlike customised physical facilities, dedicated distribution capacity cannot be put to use to serve another manufacturer. Forward-looking channel members hesitate these charges and refuse to add such capacity. Thus, its worthwhile in ROI terms for the manufacturer to integrate forward

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Site specificity – describes the case where a company may want to enter a particular market that no-one else has an interest in. A manufacturer may need its marketing channel functions performed in a specific location that does not suit other manufacturers needs. A channel member that creates a warehouse facility near the manufacturer for example owns a general-purpose asset if the manufacturer is near other manufacturers but an idiosyncratic asset if the manufacturer appears in a remote location. The value of this site is thus specific to the manufacturer E.g. In Maritime shipping, raw materials are often mined in remote parts of the world, and then shipped from one relatively obscure port to another. Cargo carriers may refuse to offer services on such routes, because few other customers need to ship in either direction. Thus manufacturers may be obliged to integrate forward into shipping. Environmental uncertainty affects vertical integration

In the presence of significant specificity, uncertainty favours vertical integration forward. If there are substantial company-specific capabilities involved in distribution, the firm cannot easily change or find new third parties. The firm will get locked into a channel and small-numbers bargaining in an environment that requires constant adaptation will result in endless bargaining, high levels of opportunism and high transaction costs.

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Additional reasons for vertical integration To reduce performance ambiguity - Performance ambiguity occurs when appropriate measures of performance are unknown, as in the case of discontinuous innovation. To deal with this ambiguity, the principal may seek to increase its long-term ROI by vertically integrating forward to gain both information and an ability to direct behaviour. To learn from customers - E.G. Optical glasses manufacturer purchased web of exclusive wholesalers that serve opticians. Thus gains market knowledge on popular frames and upcoming trends, relying on both intermediate and extreme levels of vertical integration to gain information about end-user demand for eyeglasses. Summary Creating a relationship is a way to compromise between making and buying Integrating forward or backward is difficult and key questions need to be answered Outsourcing is the right point to benefit from the six fundamental advantages of an outside specialist If conditions exist that prevent the firm from benefiting from these six advantages, vertical integration (or a close relationship) is called for...