Description
The report covers topics like distribution channel design,cost-based approach.
Distribution Channel Design
Vertical Integration v/s Intermediation
At the fundamental level of decision making in distribution management is the question as to whether the organization should engage a channel partner or carry out distribution on its own. The make or buy decision is crucial at different levels, when the organization has to decide on which functions to be delegated to the channel partners and which ones to be carried out by itself. Decision regarding “doing” and “outsourcing” has been a topic of interest to economists as well as management scholars for a long time. While an obvious explanation is “costs and benefits”, managers need to look beyond the simplistic cost?based understanding of such choice. Evidently, these other factors will include the customers’ needs as well as the organisation’s needs. In this note, an attempt is made to comprehend the factors influencing such choice in terms of (a) costs, (b) customers’ needs, (c) company’s needs and (d) synthesis of the two needs.
Costbased Approach
According Transaction Costs Economics, vertical organisation structure (owned or administered) arises when market mechanism fails. Markets and firms are alternative instruments for completing related set of transactions and whether a set of transactions ought to be executed across markets or within a firm depends on the relative efficiency of each mode.1 This is particularly relevant in the field of distribution management, where a company has to decide whether to carry out a set of activities through its own branches or outsource it to an agent or distributors, as the case may be. Every organization has to surrender some resources to
© 2006, Prof. R. C. Natarajan, TAPMI, Manipal. This note was prepared as an aid to students of MBA in understanding concepts of distribution channel choice. Oliver E. Williamson (1975), Markets and Hierarchies: Analysis and Antitrust Implications, The Free Press, NY, p.8.
1
1
gain something else.2 The costs that are incurred by an organization in choosing an option are termed as opportunity costs. Whenever an organization has to make a choice, it incurs an opportunity cost. The organization wants to avoid or minimize these costs. Thus, every transaction, which symbolizes a decision, has a set of opportunity costs associated with it, in addition to the actual costs incurred. Thus, all the expenses resulting from negotiating, monitoring and enforcing activities that are necessary for a firm to accomplish its distribution tasks through exchange are called transaction costs.3 The decision taken by an organization to make or buy distribution functions binds in at least in the medium term. Decision to carry out the functions itself compels the organization to invest in infrastructure and manpower whereas decision to engage an agent to perform the function creates a contract and, perhaps, such conditions that cannot be readily shifted back to direct channel quickly. Thus, either decision commits the organization to it for a period and may be expensive to withdraw from it in favour of the other decision. Such expenses may involve investing on inventory, equipments, manpower, buildings etc. in case of a decision in favour of direct channel, or what is also called vertical marketing integration. In the case of engaging a channel partner, the cost may involve the time of waiting before the contract can be terminated and/or the severance pay, if any, stipulated in the contract, in addition to the potential damages the channel partner may cause on leaving in terms of poor service to customers, damage to inventory etc. Therefore, any decision in this regard has to be taken keeping in mind this commitment for a reasonable period. In the section (a), the paper examines in a simple mathematical approach the choice between make and buy and the implications on the pay?back volume or simply the break?even volumes under different conditions.
(a) Demonstration of CostBased Approach
We shall now see how the firm can decide whether to make or buy distribution functions based on costs. To start with, we proceed on certain simplified premises as follows: Let f1 be the fixed cost under the direct channel.
2
Pelton, Lou E., David Strutton & James R. Lumpkin (2002), Marketing Channels: A Relationship Management Approach, McGraw-Hill, p. 359.
3
ibid, p. 359
2
Let f2 be the fixed cost under agency?based distribution. Evidently,4 f1>f2. Let v be the variable cost per unit of goods sold Let c be the agency?commission per unit of sales Let p be the price per unit Let Q be the quantity of sales We are interested in knowing under what conditions agency?system of distribution will be cheaper than the direct channel. First, let us consider total cost under the direct channel (TCD). Total Cost = Fixed Cost + (Variable Cost x Quantity of Sales) i.e TCD = f1+vQ (1)
Next, let us consider the total cost under the Agency system (TCA) TCA = f2+(c+v)Q (2)
Now, if the organization were to be indifferent between the two choices of distribution, then
TCD = TCA
That is, f1+ v Q = f2+(c+v)Q
Simplifying this equality, we get f1 ? f2= c Q
4
This is because under Direct Channel, the organization has to arrange for its own troop of salesmen, storage facilities etc., which add to fixed costs.
3
i.e.
c=
f1 ? f 2 Q
(3)
The equation (3) implies that at that level of Q where the gain in the fixed cost per unit is the same as the per unit agency?commission, the organization is indifferent between the two choices. The value of Q that satisfies this condition is found by rewriting (3) as follows:
Q =
f1 ? f 2 c
(3.a)
That is the number units is obtained by the ratio between gain in fixed cost due to shifting over to agency and the per?unit rate of agency?commission. This gives rise to further understanding as follows: (a) When c <
f1 ? f 2 , the agency system will be more profitable, since the per?unit Q
incremental cost due to agency?commission is less than the per unit gain in the fixed cost due to the shift. (b) When c >
channel is more profitable, since the per?unit incremental cost due to agency?commission is more than the per?unit gain in fixed cost due to the shift. To understand at which level of Q these two situations occur, we need to use graphic analysis. Now, refer to Chart 1.5 At Q*, the
5
Rupees
f1 ? f 2 , direct Q
f1 ? f 2 Q
Chart 1
Agency is more profitable
Direct channel is more profitable
f1 ? f 2 >c Q
f1 ? f 2 =c Q
c
f1 ? f 2 <c Q
Q*
Quantity
The shape of the curve is shown as a rectangular hyperbola. If we denote the variable on the y-axis as r, and the variable on the x-axis as Q, then the curve stands for rQ = f1 ? f 2 , which is of the form xy=k, the equation for a rectangular parabola. Please note that f1 and f2 are not variables in this context.
4
organization is indifferent between the two options. To the left of Q*, the organization finds it more profitable to engage intermediaries. To the right of Q*, the organization finds it more profitable to use its own integrated channel. The usefulness of this concept lies in the understanding that in a start?up market, fixing of commissions for the channel are dependent upon the difference in expected fixed costs per unit of sales from the two methods of distribution. This is an important aspect in distribution, especially when one has no idea what commission to fix for a channel function. It may be tempting to raise the question, ís it not important to consider revenue as well instead of merely the costs? As is known, revenue function is simply a product of the price and the quantity of sales. If we see the algebraic explanation in the previous pages, the decision is completely independent of the revenues. This is because, where Q* occurs is independent of the revenue function. This is explained in next chart. In Chart 2, Q* appears at far right on the x?axis, implying that at very high levels of sales, it will be economically more profitable for the organization to vertically integrate. There is a curious aspect in this diagram, where we find that QA appears to the left of QD. This means that the breakeven volume for an organization is smaller when it chooses agency channel than when it chooses direct channel. Is it a general truth? Alternatively, are there situations when both can be the same or the positions can be reversed? To examine this, we use a little algebra again. To do this, we proceed on the reverse logic to seek what happens if the inequality is true or what are the conditions if the inequality is true. We start with the assumption, QD > QA
f1 p ?v
>
f2 p ?c ?v
(4)
where, p stands for the price per unit
By cross?multiplying, we get f1(p?c?v) > f2(p?v) positive] 5
[since (p?c?v) and (p?v) are expected to be
Chart 2
Cost / Revenue
on cti n fu Q =p :R
Breakeven volume Under direct channel
Re
nu ve
e
= TC A
v)Q (c+ f 2+
Breakeven volume Under Agency channel
v)Q (c+
vQ
T vQ =f 1+ CD
f1 f2
c= tan ?
?
QA
(p?v) (f1?f2) > c f1
QD
Q*
Quantity
f1 ? f 2 c > f1 p ?v
(5)
What inequality (5) suggests is that as long as the proportionate gain in fixed cost by shifting from direct channel to agency channel is greater than the proportion of contribution that goes
QA = f2 f1 and QD = ( p ? c ? v) ( p ? v) From Chart - 2, QD > Q A . Hence,
( p ? c ? v) f 2 f1 f2 > ? > ( p ? v) ( p ? c ? v) ( p ? v) f1 c f f c ? 1? > 2 ?1- 2 > ( p ? v) f1 f1 ( p ? v) f ? f2 c Q.E.D ? 1 > ( p ? v) f1
6
out as agency commission, the breakeven volume under agency will be smaller than under direct channel. This can be proved from the Chart?2 too, as follows:6 To cite an example, let us say the fixed cost under direct channel is Rs.5 lacs and under Agency channel Rs.4 lacs. The proportion of gain in fixed cost by moving from direct to agency channel is 20%. Suppose the commission per unit is Rs.1.20, price per unit is Rs.20 and variable cost per unit is Rs.12. Then the contribution is (Rs.20?Rs.12 =) Rs.8. The ratio of commission to contribution is 15%, which is less than 20% shown above. Therefore, in this case, the breakeven volume under agency will be lower than the breakeven volume under direct channel. On the contrary, if the agency commission is Rs.2.40 per unit, the ratio becomes 30%, higher than the 20% shown above. Then, the breakeven volume under direct channel will be lower than that under agency channel.
Chart 3
Cost / Revenue
Breakeven volume Under Agency channel Breakeven volume Under direct channel
= TC A v c+ +( f2 )Q
u en ev R
Q =p :R ion t nc fu e
v (c+
)Q
vQ
vQ =f 1+ TC D
f1 f2
?
c= tan ?
Q*
6
QD
QA
Quantity
This simple proof was demonstrated by Mr. Satvik, G.V., student of PGP 2005-07, TAPMI, Manipal.
7
This is shown in Chart 3, without involving any numbers, but only modifying the magnitude of the commission, denoted by tan?. Now, we know the following: 0? f2 ? f1 and 0? c ? (p?v). So, it is easy to perceive the following: As f 2?0,
f1 ? f 2 ? 1 and f1
Chart 4 1
c p ?v
QD=QA QD>QA QD<QA
f1 ? f 2 f1
0 0
8
Value of f2
f1
Value of c (p-v)
As f 2 ? f 1,
f1 ? f 2 ? 0 f1
Similarly,
As c ? 0,
c ? 0 and p ?v
c ? 1 p ?v
As c ?(p?v)
This is captured in the Chart?4, which is based on two x?axes and one y?axis. What does this develop into conceptually? For a start?up operation, it is important for an organization to consider the breakeven volume of operations while choosing between direct and agency mode. Thus, this analysis throws light on the fact that the choice between the modes of distribution is purely dependent upon the costs of operations. It does not follow in simplistic sense that higher commissions warrant a direct channel or higher fixed costs warrant agency channel. In the first part of this section, we saw that the choice was based purely on fixed costs and commission while variable costs and price played no role in it. However, in the later analysis, we see that price and variable costs play an important role, when the company’s ability to accept a long payback period is limited. That is, when break?even quantity becomes an important issue, all the four issues become important in decision?making.
(b) CustomerNeeds Approach
In this section, we shall look at customers’ value needs—which lead to the functions to be performed by the channel—and how it impacts the make or buy decision of the organisation. For this purpose, we shall keep the company’s cost?factors out of our discussion. Customers’ value?expectations from the channel and their product?market factors are as follows:7 1. Product information: This is more closely related to direct channel.
7
Adapted from V. Kasturi Rangan, Melvyn A.J. Menezes & E.P. Maier (1992).
9
a. Searching time—if the customer is unwilling to spend time to search, it will call for greater reach b. Technical complexity 8; this may require training of the customer, which will entail greater involvement of the company’s direct salesforce and/or increase the cost of training the customer through a detailed manual and perhaps, even after sales training on installation c. Rate of technological change—a product whose technological change is rapid will result in customers’ seeking greater technical information and assurance for upgradation to thwart technological obsolescence. 2. Product customisation: This is more closely related to direct channel a. Adjustment—making specific technical features available to the customer given the customer’s specific characteristics. 3. Product quality assurance: This is more closely related to direct channel. a. Criticality of the product to the customer—this will have an influence on the effort the customer puts in the purchase of the product 4. Lot size: This is more closely related to indirect channel, by and large a. Smaller lot size go directly into customer’s consumption whereas larger lot size require customer to hold inventory b. Order size—customers will prefer greater availability when their order size is smaller, due to the same reason as in (4.a) above In addition, the consumers’ other needs are: i. Availability of varieties in one?stop shop ii. Frequent purchase
8
Notwithstanding the article cited in footnote 6 relates to industrial product, these aspects are relevant to consumer products as well, if we think of electronic consumer goods, computers and accessories.
10
iii. Waiting time iv. Consumption at the most convenient time These convert into the channel function of availability and inventory carrying. These two factors are more closely related to indirect channel. Similarly, there are other needs such as i. Lack of knowledge of installation ii. Need to safely carry the product to the place of usage iii. Training to use the product iv. Post?purchase assistance in terms of clarifications, trouble?shooting etc. These convert into the channel functions of post?sale service and logistics. Post?sale service is more closely related to indirect channel whereas logistics is can be served by a hybrid channel. In organisations, the factors mentioned above can take any combination, and depending upon that combination, the channel choice will be made among direct, indirect or hybrid channel.
Chart-5
Customer's Requirement of Channel Functions 1. Product Information 2. Product Customisation 3. Product Quality Assurance 4. Lot Size 5. Assortment 6. Availability 7. After-sales Service 8. Logistics Channel Choice Implication
Source: Kasturi Rangan V. et al (1992), p. 74
High High Important Large Non-Essential Not Critical Not Critical Complex Direct Hybrid Indirect
Low Low Unimportant Small Essential Critical Critical Simple
11
Direct channel refers to the company’s salesforce handling the entire distribution activities— which is the “make” decision. Indirect channel refers to engaging distributors and/or dealers to deliver value to the consumers, with the company’s salesforce having minimal contact with the final consumers. Hybrid channel is a combination of distributors and company salesforce sharing the functions largely. The Chart?5 shows the kind of choice that each of the factors entail. This diagram summarises that factors 1, 2 and 3 are closer related to direct channel, items 4, 5, 6 and 7 are closer related to indirect channel and factor 8 falls between the two extremes implying a combination of both types of channels to co?exist. In the context of consumer goods, channel design is highly influenced by customer’s value? needs. For example, when the customer’s usage of a product is in small units, irregular and infrequent, then the channel has to perform inventory?holding in smaller lots. And, if the customer’s involvement in purchasing process is low, the organisation has no option but to ensure that (a) the product in small pack?size is available closest to homes and (b) the product is available throughout the year. Such a functional requirement makes it necessary that the organisation goes in for intensive distribution strategy that may follow the structure of organisation?stockist?distributor?wholesaler?retailer.
(c) Companyneeds Approach
The third approach of distribution channel choice is based on the needs of the organisation. The aspect of organisational design has been covered in Transaction Cost Economics (TCE) in great length, and the system of governance has been the focus of Agency Theory (AT). Transaction Cost Economics TCE deals with the choice between the two extremes of vertical integration and dealing through market mechanism. By default, in line with the tradition of neo?classical economics on which TCE is based, an organisation should deal through market mechanism. However, when certain conditions prevail market mechanism fails. These conditions are (a) high degree of environmental uncertainty, (b) transaction?specific assets of high value and (c) frequent transactions between the two parties. Environmental uncertainty makes it difficult to assess transaction cost accurately and, if at all possible, it is made extremely expensive. Transaction? specific assets make it too risky for the organisation to leave the activities to the exchange partner who may—and, in the absence of effective monitoring mechanism, will—act 12
opportunistically,9 warranting greater amount of monitoring. Finally, high frequency of transactions makes it necessary to engage in high amount of monitoring. The conditions outlined in the previous paragraph indicate clearly that TCE considers information at the core of the choice between make and buy. The principal who wishes to engage an agent to carry out activities on his behalf is characterised, as all humans are, by bounded rationality. His access to information and the ability to assimilate them is limited. This is one of the reasons why opportunism is costly to prevent through monitoring mechanism. Under these conditions, the organisation will be better off integrating vertically forward. In essence, vertical integration arises when market?mechanism fails.
Agency Theory
Agency theory deals with the choice of governance mechanisms under conditions outlined by TCE. It recommends principal’s incentivising information?sharing by the agent. It considers two problems—known as agency problems—namely, (a) adverse selection due to misrepresentation by the agent about his competencies and calibre and (b) moral hazard which is the agent’s tendency not to carry out the activities as promised to the principal under conditions of the principal’s bounded rationality. Under such possibilities, agency theory recommends behaviour?
Average Cost
based incentives—instead of outcome?based—so as to make the agent act in the interest of the principal. Unlike TCE, agency theory does not deal with the choice of distribution channel structure. Instead, it deals with the method of control under conditions of principal’s bounded
Chart-6.a
D A
C B
I
E
Source: Bucklin, Louis P. (1966), p. 22
Delivery Time
9
Opportunism is defined by Oliver Williamson as “self-seeking with guile”. Thus, it does not regard prudent business actions by the exchange partner as opportunistic.
13
Average Cost
rationality and the agent’s proclivity to act opportunistically.
Chart-6.b
CC
(d) CustomerNeeds & Organisation Needs: Synthesis
It is easy to comprehend that an organisation cannot look at only one aspect of its requirements for making a major decision such as channel?design. Louis Bucklin in 1960s formulated a pure economic model of channel structure (Bucklin, 1966). According to Bucklin, a combinations of factors—consumer’s needs as well as organisation’s needs—such as lot size, delivery time and market decentralisation influence channel structure. Lot size, as explained in the preceding sections, enables consumer to hold least inventory and thus passes the inventory?holding function to the channel. Delivery time, according to Bucklin, is the waiting time the consumer has to spend after placing the order before s/he gets the stock. Understandably, if the consumer prefers lower waiting time, intensive distribution is warranted. Market decentralisation denotes the degree of dispersion of the delivery points as well as
Average Cost
Source: Bucklin, Louis P. (1966), p. 23
Delivery Time
the number of delivery points. When market decentralisation is high, the consumer needs to spend less energy in reaching the nearest delivery point.
Chart-6.c
D
T CC
M
B
To fulfil the needs of the consumers in terms of their preferred lot size, delivery time and market decentralisation, the channel has to perform certain functions and when these functions are specialised, more number of tiers 14
N
Source: Bucklin, Louis P. (1966), p. 25
I
E Delivery Time
start emerging in a channel structure. However, each type of channel—direct or indirect—can perform the functions with various degrees of cost?effectiveness. This is shown in Chart?6.a here. The chart, per sé, shows the relationship between the average cost per unit for the organisation under different delivery time. Understandably, the more the waiting time, the organisation needs to hold fewer units in inventory and hence the cost per unit is low. The curve ACI denotes the average cost per unit under different delivery time when direct channel is used. However, at very high delivery time, the organisation may still have to incur certain costs and hence the curve decreases at decreasing rate. The curve DCB denotes the average costs at different delivery time when indirect channel is used. The curve starts at a slightly higher level of delivery time since at very low delivery time, direct channel’s average cost is infinitely high. However, when the delivery time is very high, it falls below that of indirect channel, since it can postpone production and thus inventory?holding costs and warehousing costs. The level of E is the delivery time at which the organisation is indifferent between the two types of channel. Below E, indirect channel is preferable and above E direct channel is preferable for the organisation. The Chart 6.b shows the cost to the customer. The curve CC is the cost to the consumer due to varying levels of delivery time. At low very levels of delivery time, the consumer does not incur any cost since s/he does not have to expend much time or energy or cost for getting her requirements. However, her cost per unit increases with the increase in delivery time, since longer delivery time increases her requirement to hold additional inventory in buffer. When we conbine charts 6.a and 6.b, we get a synthesis of the requirements of the
Average Cost
organisation and the consumers to arrive at an optimal choice of channel structure. This is shown in Chart 6.c. Here, the curve T represents the total cost due to delivery time; it is a sum of the cost to the organisation and the cost to the consumer. In this case, the least cost delivery is possible through
Chart-6.d
D T CC
M1
B
I
E
Source: Suitably developed from Bucklin, Louis P. (1966), p. 25
N1 Delivery Time
15
indircect channel (cost=M) warranting the consumer to wait only for a short time (time=N). This is facilitade by the fact that the consumer’s waiting?cost curve CC is rather steep. However, if consumer does not mind waiting longer, it is possible to comprehend a situation where s/he can be better reached through a direct delivery system. This is shown in Chart 6.d. In this diagram, when the consumer’s cost of waiting is reasonably flatter across different levels, the organisation is better off servicing her through direct delivery mechanism. The total cost is minimum to the right of E. This is because, the cost?to?consumer curve CC in this chart, when compared to that in Chart 6.b., is flatter. This implies that the consumer is willing to wait longer by, perhaps, holding extra inventory as buffer.
Reference
Bucklin, Louis P. (1966), A Theory of Distribution Channel Structure, IBER Special Publications, Univ. of California, Berkeley Eisenhardt, Kathleen M. (1988), “Agency? and Institutional?Theory Explanations: The Case of Retail Sales Compensation,” Academy of Management Journal, Vol. 31, No. 3, 488?511 Ghoshal, Sumantra and Peter Moran (1996), “Bad for Practice: A Critique of the Transaction Cost Theory,” Academy of Management Review, Vol.21, No.1, 13?47 Pelton, Lou E., David Strutton & James R. Lumpkinl (2002), Marketing Channels: A Relationship Approach, McGraw?Hill, p. 356?382. Rangan, V. Kasturi, Melvyn A.J. Menezes & E.P. Maier (1992), “Channel Selection for New Industrial Products: A Framework, Method and Application,” Journal of Marketing, Vol. 56 (July), 69?82. Williamson, Oliver E. (1971), “The Vertical Integration of Production: Market Failure Considerations,” American Economic Review, Vol. 61(2), pp. 112?123 Williamson, Oliver E. (1996), “Economics and Organization: A Primer,” California Management Review, Vol. 38 (2), pp. 131?146
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doc_411154013.pdf
The report covers topics like distribution channel design,cost-based approach.
Distribution Channel Design
Vertical Integration v/s Intermediation
At the fundamental level of decision making in distribution management is the question as to whether the organization should engage a channel partner or carry out distribution on its own. The make or buy decision is crucial at different levels, when the organization has to decide on which functions to be delegated to the channel partners and which ones to be carried out by itself. Decision regarding “doing” and “outsourcing” has been a topic of interest to economists as well as management scholars for a long time. While an obvious explanation is “costs and benefits”, managers need to look beyond the simplistic cost?based understanding of such choice. Evidently, these other factors will include the customers’ needs as well as the organisation’s needs. In this note, an attempt is made to comprehend the factors influencing such choice in terms of (a) costs, (b) customers’ needs, (c) company’s needs and (d) synthesis of the two needs.
Costbased Approach
According Transaction Costs Economics, vertical organisation structure (owned or administered) arises when market mechanism fails. Markets and firms are alternative instruments for completing related set of transactions and whether a set of transactions ought to be executed across markets or within a firm depends on the relative efficiency of each mode.1 This is particularly relevant in the field of distribution management, where a company has to decide whether to carry out a set of activities through its own branches or outsource it to an agent or distributors, as the case may be. Every organization has to surrender some resources to
© 2006, Prof. R. C. Natarajan, TAPMI, Manipal. This note was prepared as an aid to students of MBA in understanding concepts of distribution channel choice. Oliver E. Williamson (1975), Markets and Hierarchies: Analysis and Antitrust Implications, The Free Press, NY, p.8.
1
1
gain something else.2 The costs that are incurred by an organization in choosing an option are termed as opportunity costs. Whenever an organization has to make a choice, it incurs an opportunity cost. The organization wants to avoid or minimize these costs. Thus, every transaction, which symbolizes a decision, has a set of opportunity costs associated with it, in addition to the actual costs incurred. Thus, all the expenses resulting from negotiating, monitoring and enforcing activities that are necessary for a firm to accomplish its distribution tasks through exchange are called transaction costs.3 The decision taken by an organization to make or buy distribution functions binds in at least in the medium term. Decision to carry out the functions itself compels the organization to invest in infrastructure and manpower whereas decision to engage an agent to perform the function creates a contract and, perhaps, such conditions that cannot be readily shifted back to direct channel quickly. Thus, either decision commits the organization to it for a period and may be expensive to withdraw from it in favour of the other decision. Such expenses may involve investing on inventory, equipments, manpower, buildings etc. in case of a decision in favour of direct channel, or what is also called vertical marketing integration. In the case of engaging a channel partner, the cost may involve the time of waiting before the contract can be terminated and/or the severance pay, if any, stipulated in the contract, in addition to the potential damages the channel partner may cause on leaving in terms of poor service to customers, damage to inventory etc. Therefore, any decision in this regard has to be taken keeping in mind this commitment for a reasonable period. In the section (a), the paper examines in a simple mathematical approach the choice between make and buy and the implications on the pay?back volume or simply the break?even volumes under different conditions.
(a) Demonstration of CostBased Approach
We shall now see how the firm can decide whether to make or buy distribution functions based on costs. To start with, we proceed on certain simplified premises as follows: Let f1 be the fixed cost under the direct channel.
2
Pelton, Lou E., David Strutton & James R. Lumpkin (2002), Marketing Channels: A Relationship Management Approach, McGraw-Hill, p. 359.
3
ibid, p. 359
2
Let f2 be the fixed cost under agency?based distribution. Evidently,4 f1>f2. Let v be the variable cost per unit of goods sold Let c be the agency?commission per unit of sales Let p be the price per unit Let Q be the quantity of sales We are interested in knowing under what conditions agency?system of distribution will be cheaper than the direct channel. First, let us consider total cost under the direct channel (TCD). Total Cost = Fixed Cost + (Variable Cost x Quantity of Sales) i.e TCD = f1+vQ (1)
Next, let us consider the total cost under the Agency system (TCA) TCA = f2+(c+v)Q (2)
Now, if the organization were to be indifferent between the two choices of distribution, then
TCD = TCA
That is, f1+ v Q = f2+(c+v)Q
Simplifying this equality, we get f1 ? f2= c Q
4
This is because under Direct Channel, the organization has to arrange for its own troop of salesmen, storage facilities etc., which add to fixed costs.
3
i.e.
c=
f1 ? f 2 Q
(3)
The equation (3) implies that at that level of Q where the gain in the fixed cost per unit is the same as the per unit agency?commission, the organization is indifferent between the two choices. The value of Q that satisfies this condition is found by rewriting (3) as follows:
Q =
f1 ? f 2 c
(3.a)
That is the number units is obtained by the ratio between gain in fixed cost due to shifting over to agency and the per?unit rate of agency?commission. This gives rise to further understanding as follows: (a) When c <
f1 ? f 2 , the agency system will be more profitable, since the per?unit Q
incremental cost due to agency?commission is less than the per unit gain in the fixed cost due to the shift. (b) When c >
channel is more profitable, since the per?unit incremental cost due to agency?commission is more than the per?unit gain in fixed cost due to the shift. To understand at which level of Q these two situations occur, we need to use graphic analysis. Now, refer to Chart 1.5 At Q*, the
5
Rupees
f1 ? f 2 , direct Q
f1 ? f 2 Q
Chart 1
Agency is more profitable
Direct channel is more profitable
f1 ? f 2 >c Q
f1 ? f 2 =c Q
c
f1 ? f 2 <c Q
Q*
Quantity
The shape of the curve is shown as a rectangular hyperbola. If we denote the variable on the y-axis as r, and the variable on the x-axis as Q, then the curve stands for rQ = f1 ? f 2 , which is of the form xy=k, the equation for a rectangular parabola. Please note that f1 and f2 are not variables in this context.
4
organization is indifferent between the two options. To the left of Q*, the organization finds it more profitable to engage intermediaries. To the right of Q*, the organization finds it more profitable to use its own integrated channel. The usefulness of this concept lies in the understanding that in a start?up market, fixing of commissions for the channel are dependent upon the difference in expected fixed costs per unit of sales from the two methods of distribution. This is an important aspect in distribution, especially when one has no idea what commission to fix for a channel function. It may be tempting to raise the question, ís it not important to consider revenue as well instead of merely the costs? As is known, revenue function is simply a product of the price and the quantity of sales. If we see the algebraic explanation in the previous pages, the decision is completely independent of the revenues. This is because, where Q* occurs is independent of the revenue function. This is explained in next chart. In Chart 2, Q* appears at far right on the x?axis, implying that at very high levels of sales, it will be economically more profitable for the organization to vertically integrate. There is a curious aspect in this diagram, where we find that QA appears to the left of QD. This means that the breakeven volume for an organization is smaller when it chooses agency channel than when it chooses direct channel. Is it a general truth? Alternatively, are there situations when both can be the same or the positions can be reversed? To examine this, we use a little algebra again. To do this, we proceed on the reverse logic to seek what happens if the inequality is true or what are the conditions if the inequality is true. We start with the assumption, QD > QA
f1 p ?v
>
f2 p ?c ?v
(4)
where, p stands for the price per unit
By cross?multiplying, we get f1(p?c?v) > f2(p?v) positive] 5
[since (p?c?v) and (p?v) are expected to be
Chart 2
Cost / Revenue
on cti n fu Q =p :R
Breakeven volume Under direct channel
Re
nu ve
e
= TC A
v)Q (c+ f 2+
Breakeven volume Under Agency channel
v)Q (c+
vQ
T vQ =f 1+ CD
f1 f2
c= tan ?
?
QA
(p?v) (f1?f2) > c f1
QD
Q*
Quantity
f1 ? f 2 c > f1 p ?v
(5)
What inequality (5) suggests is that as long as the proportionate gain in fixed cost by shifting from direct channel to agency channel is greater than the proportion of contribution that goes
QA = f2 f1 and QD = ( p ? c ? v) ( p ? v) From Chart - 2, QD > Q A . Hence,
( p ? c ? v) f 2 f1 f2 > ? > ( p ? v) ( p ? c ? v) ( p ? v) f1 c f f c ? 1? > 2 ?1- 2 > ( p ? v) f1 f1 ( p ? v) f ? f2 c Q.E.D ? 1 > ( p ? v) f1
6
out as agency commission, the breakeven volume under agency will be smaller than under direct channel. This can be proved from the Chart?2 too, as follows:6 To cite an example, let us say the fixed cost under direct channel is Rs.5 lacs and under Agency channel Rs.4 lacs. The proportion of gain in fixed cost by moving from direct to agency channel is 20%. Suppose the commission per unit is Rs.1.20, price per unit is Rs.20 and variable cost per unit is Rs.12. Then the contribution is (Rs.20?Rs.12 =) Rs.8. The ratio of commission to contribution is 15%, which is less than 20% shown above. Therefore, in this case, the breakeven volume under agency will be lower than the breakeven volume under direct channel. On the contrary, if the agency commission is Rs.2.40 per unit, the ratio becomes 30%, higher than the 20% shown above. Then, the breakeven volume under direct channel will be lower than that under agency channel.
Chart 3
Cost / Revenue
Breakeven volume Under Agency channel Breakeven volume Under direct channel
= TC A v c+ +( f2 )Q
u en ev R
Q =p :R ion t nc fu e
v (c+
)Q
vQ
vQ =f 1+ TC D
f1 f2
?
c= tan ?
Q*
6
QD
QA
Quantity
This simple proof was demonstrated by Mr. Satvik, G.V., student of PGP 2005-07, TAPMI, Manipal.
7
This is shown in Chart 3, without involving any numbers, but only modifying the magnitude of the commission, denoted by tan?. Now, we know the following: 0? f2 ? f1 and 0? c ? (p?v). So, it is easy to perceive the following: As f 2?0,
f1 ? f 2 ? 1 and f1
Chart 4 1
c p ?v
QD=QA QD>QA QD<QA
f1 ? f 2 f1
0 0
8
Value of f2
f1
Value of c (p-v)
As f 2 ? f 1,
f1 ? f 2 ? 0 f1
Similarly,
As c ? 0,
c ? 0 and p ?v
c ? 1 p ?v
As c ?(p?v)
This is captured in the Chart?4, which is based on two x?axes and one y?axis. What does this develop into conceptually? For a start?up operation, it is important for an organization to consider the breakeven volume of operations while choosing between direct and agency mode. Thus, this analysis throws light on the fact that the choice between the modes of distribution is purely dependent upon the costs of operations. It does not follow in simplistic sense that higher commissions warrant a direct channel or higher fixed costs warrant agency channel. In the first part of this section, we saw that the choice was based purely on fixed costs and commission while variable costs and price played no role in it. However, in the later analysis, we see that price and variable costs play an important role, when the company’s ability to accept a long payback period is limited. That is, when break?even quantity becomes an important issue, all the four issues become important in decision?making.
(b) CustomerNeeds Approach
In this section, we shall look at customers’ value needs—which lead to the functions to be performed by the channel—and how it impacts the make or buy decision of the organisation. For this purpose, we shall keep the company’s cost?factors out of our discussion. Customers’ value?expectations from the channel and their product?market factors are as follows:7 1. Product information: This is more closely related to direct channel.
7
Adapted from V. Kasturi Rangan, Melvyn A.J. Menezes & E.P. Maier (1992).
9
a. Searching time—if the customer is unwilling to spend time to search, it will call for greater reach b. Technical complexity 8; this may require training of the customer, which will entail greater involvement of the company’s direct salesforce and/or increase the cost of training the customer through a detailed manual and perhaps, even after sales training on installation c. Rate of technological change—a product whose technological change is rapid will result in customers’ seeking greater technical information and assurance for upgradation to thwart technological obsolescence. 2. Product customisation: This is more closely related to direct channel a. Adjustment—making specific technical features available to the customer given the customer’s specific characteristics. 3. Product quality assurance: This is more closely related to direct channel. a. Criticality of the product to the customer—this will have an influence on the effort the customer puts in the purchase of the product 4. Lot size: This is more closely related to indirect channel, by and large a. Smaller lot size go directly into customer’s consumption whereas larger lot size require customer to hold inventory b. Order size—customers will prefer greater availability when their order size is smaller, due to the same reason as in (4.a) above In addition, the consumers’ other needs are: i. Availability of varieties in one?stop shop ii. Frequent purchase
8
Notwithstanding the article cited in footnote 6 relates to industrial product, these aspects are relevant to consumer products as well, if we think of electronic consumer goods, computers and accessories.
10
iii. Waiting time iv. Consumption at the most convenient time These convert into the channel function of availability and inventory carrying. These two factors are more closely related to indirect channel. Similarly, there are other needs such as i. Lack of knowledge of installation ii. Need to safely carry the product to the place of usage iii. Training to use the product iv. Post?purchase assistance in terms of clarifications, trouble?shooting etc. These convert into the channel functions of post?sale service and logistics. Post?sale service is more closely related to indirect channel whereas logistics is can be served by a hybrid channel. In organisations, the factors mentioned above can take any combination, and depending upon that combination, the channel choice will be made among direct, indirect or hybrid channel.
Chart-5
Customer's Requirement of Channel Functions 1. Product Information 2. Product Customisation 3. Product Quality Assurance 4. Lot Size 5. Assortment 6. Availability 7. After-sales Service 8. Logistics Channel Choice Implication
Source: Kasturi Rangan V. et al (1992), p. 74
High High Important Large Non-Essential Not Critical Not Critical Complex Direct Hybrid Indirect
Low Low Unimportant Small Essential Critical Critical Simple
11
Direct channel refers to the company’s salesforce handling the entire distribution activities— which is the “make” decision. Indirect channel refers to engaging distributors and/or dealers to deliver value to the consumers, with the company’s salesforce having minimal contact with the final consumers. Hybrid channel is a combination of distributors and company salesforce sharing the functions largely. The Chart?5 shows the kind of choice that each of the factors entail. This diagram summarises that factors 1, 2 and 3 are closer related to direct channel, items 4, 5, 6 and 7 are closer related to indirect channel and factor 8 falls between the two extremes implying a combination of both types of channels to co?exist. In the context of consumer goods, channel design is highly influenced by customer’s value? needs. For example, when the customer’s usage of a product is in small units, irregular and infrequent, then the channel has to perform inventory?holding in smaller lots. And, if the customer’s involvement in purchasing process is low, the organisation has no option but to ensure that (a) the product in small pack?size is available closest to homes and (b) the product is available throughout the year. Such a functional requirement makes it necessary that the organisation goes in for intensive distribution strategy that may follow the structure of organisation?stockist?distributor?wholesaler?retailer.
(c) Companyneeds Approach
The third approach of distribution channel choice is based on the needs of the organisation. The aspect of organisational design has been covered in Transaction Cost Economics (TCE) in great length, and the system of governance has been the focus of Agency Theory (AT). Transaction Cost Economics TCE deals with the choice between the two extremes of vertical integration and dealing through market mechanism. By default, in line with the tradition of neo?classical economics on which TCE is based, an organisation should deal through market mechanism. However, when certain conditions prevail market mechanism fails. These conditions are (a) high degree of environmental uncertainty, (b) transaction?specific assets of high value and (c) frequent transactions between the two parties. Environmental uncertainty makes it difficult to assess transaction cost accurately and, if at all possible, it is made extremely expensive. Transaction? specific assets make it too risky for the organisation to leave the activities to the exchange partner who may—and, in the absence of effective monitoring mechanism, will—act 12
opportunistically,9 warranting greater amount of monitoring. Finally, high frequency of transactions makes it necessary to engage in high amount of monitoring. The conditions outlined in the previous paragraph indicate clearly that TCE considers information at the core of the choice between make and buy. The principal who wishes to engage an agent to carry out activities on his behalf is characterised, as all humans are, by bounded rationality. His access to information and the ability to assimilate them is limited. This is one of the reasons why opportunism is costly to prevent through monitoring mechanism. Under these conditions, the organisation will be better off integrating vertically forward. In essence, vertical integration arises when market?mechanism fails.
Agency Theory
Agency theory deals with the choice of governance mechanisms under conditions outlined by TCE. It recommends principal’s incentivising information?sharing by the agent. It considers two problems—known as agency problems—namely, (a) adverse selection due to misrepresentation by the agent about his competencies and calibre and (b) moral hazard which is the agent’s tendency not to carry out the activities as promised to the principal under conditions of the principal’s bounded rationality. Under such possibilities, agency theory recommends behaviour?
Average Cost
based incentives—instead of outcome?based—so as to make the agent act in the interest of the principal. Unlike TCE, agency theory does not deal with the choice of distribution channel structure. Instead, it deals with the method of control under conditions of principal’s bounded
Chart-6.a
D A
C B
I
E
Source: Bucklin, Louis P. (1966), p. 22
Delivery Time
9
Opportunism is defined by Oliver Williamson as “self-seeking with guile”. Thus, it does not regard prudent business actions by the exchange partner as opportunistic.
13
Average Cost
rationality and the agent’s proclivity to act opportunistically.
Chart-6.b
CC
(d) CustomerNeeds & Organisation Needs: Synthesis
It is easy to comprehend that an organisation cannot look at only one aspect of its requirements for making a major decision such as channel?design. Louis Bucklin in 1960s formulated a pure economic model of channel structure (Bucklin, 1966). According to Bucklin, a combinations of factors—consumer’s needs as well as organisation’s needs—such as lot size, delivery time and market decentralisation influence channel structure. Lot size, as explained in the preceding sections, enables consumer to hold least inventory and thus passes the inventory?holding function to the channel. Delivery time, according to Bucklin, is the waiting time the consumer has to spend after placing the order before s/he gets the stock. Understandably, if the consumer prefers lower waiting time, intensive distribution is warranted. Market decentralisation denotes the degree of dispersion of the delivery points as well as
Average Cost
Source: Bucklin, Louis P. (1966), p. 23
Delivery Time
the number of delivery points. When market decentralisation is high, the consumer needs to spend less energy in reaching the nearest delivery point.
Chart-6.c
D
T CC
M
B
To fulfil the needs of the consumers in terms of their preferred lot size, delivery time and market decentralisation, the channel has to perform certain functions and when these functions are specialised, more number of tiers 14
N
Source: Bucklin, Louis P. (1966), p. 25
I
E Delivery Time
start emerging in a channel structure. However, each type of channel—direct or indirect—can perform the functions with various degrees of cost?effectiveness. This is shown in Chart?6.a here. The chart, per sé, shows the relationship between the average cost per unit for the organisation under different delivery time. Understandably, the more the waiting time, the organisation needs to hold fewer units in inventory and hence the cost per unit is low. The curve ACI denotes the average cost per unit under different delivery time when direct channel is used. However, at very high delivery time, the organisation may still have to incur certain costs and hence the curve decreases at decreasing rate. The curve DCB denotes the average costs at different delivery time when indirect channel is used. The curve starts at a slightly higher level of delivery time since at very low delivery time, direct channel’s average cost is infinitely high. However, when the delivery time is very high, it falls below that of indirect channel, since it can postpone production and thus inventory?holding costs and warehousing costs. The level of E is the delivery time at which the organisation is indifferent between the two types of channel. Below E, indirect channel is preferable and above E direct channel is preferable for the organisation. The Chart 6.b shows the cost to the customer. The curve CC is the cost to the consumer due to varying levels of delivery time. At low very levels of delivery time, the consumer does not incur any cost since s/he does not have to expend much time or energy or cost for getting her requirements. However, her cost per unit increases with the increase in delivery time, since longer delivery time increases her requirement to hold additional inventory in buffer. When we conbine charts 6.a and 6.b, we get a synthesis of the requirements of the
Average Cost
organisation and the consumers to arrive at an optimal choice of channel structure. This is shown in Chart 6.c. Here, the curve T represents the total cost due to delivery time; it is a sum of the cost to the organisation and the cost to the consumer. In this case, the least cost delivery is possible through
Chart-6.d
D T CC
M1
B
I
E
Source: Suitably developed from Bucklin, Louis P. (1966), p. 25
N1 Delivery Time
15
indircect channel (cost=M) warranting the consumer to wait only for a short time (time=N). This is facilitade by the fact that the consumer’s waiting?cost curve CC is rather steep. However, if consumer does not mind waiting longer, it is possible to comprehend a situation where s/he can be better reached through a direct delivery system. This is shown in Chart 6.d. In this diagram, when the consumer’s cost of waiting is reasonably flatter across different levels, the organisation is better off servicing her through direct delivery mechanism. The total cost is minimum to the right of E. This is because, the cost?to?consumer curve CC in this chart, when compared to that in Chart 6.b., is flatter. This implies that the consumer is willing to wait longer by, perhaps, holding extra inventory as buffer.
Reference
Bucklin, Louis P. (1966), A Theory of Distribution Channel Structure, IBER Special Publications, Univ. of California, Berkeley Eisenhardt, Kathleen M. (1988), “Agency? and Institutional?Theory Explanations: The Case of Retail Sales Compensation,” Academy of Management Journal, Vol. 31, No. 3, 488?511 Ghoshal, Sumantra and Peter Moran (1996), “Bad for Practice: A Critique of the Transaction Cost Theory,” Academy of Management Review, Vol.21, No.1, 13?47 Pelton, Lou E., David Strutton & James R. Lumpkinl (2002), Marketing Channels: A Relationship Approach, McGraw?Hill, p. 356?382. Rangan, V. Kasturi, Melvyn A.J. Menezes & E.P. Maier (1992), “Channel Selection for New Industrial Products: A Framework, Method and Application,” Journal of Marketing, Vol. 56 (July), 69?82. Williamson, Oliver E. (1971), “The Vertical Integration of Production: Market Failure Considerations,” American Economic Review, Vol. 61(2), pp. 112?123 Williamson, Oliver E. (1996), “Economics and Organization: A Primer,” California Management Review, Vol. 38 (2), pp. 131?146
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