Description
The report about 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.
Distribution Management Vertical Integration v/s Channel
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 and (c) company’s needs. Cost?based 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 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
© 2005, Prof. R. C. Natarajan, TAPMI, Manipal. This note was prepared as an aid to students of MBA in understanding concepts of distribution channel choice in a simplified situation. Oliver E. Williamson (1975), Markets and Hierarchies: Analysis and Antitrust Implications, The Free Press, NY, p.8.
1
Pelton, Lou E., David Strutton & James R. Lumpkinl (2002), Marketing Channels: A Relationship Approach, McGrw-Hill, p. 359.
2
1
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 favor 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. (a) Demonstration of Cost?Based 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. 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)
3 4
ibid, p. 359
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.
2
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 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 (3.a) c
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. Chart 1
f1 ? f 2 Q
Rupees
(b) When c >
Direct channel is more profitable
Agency is more profitable
f1 ? f 2 >c Q
f1 ? f 2 =c Q
c Q*
f1 ? f 2 , direct Q 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.
f1 ? f 2 <c Q
To understand at which level of Q these two situations occur, we need to use graphic analysis.
Quantity
3
Now, refer to Chart 1.5 At Q*, the 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) (p?v) (f1?f2) > c f1 [since (p?c?v) and (p?v) are expected to be positive]
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.
5
4
f1 ? f 2 c > f1 p ?v (5)
What the inequality (5) suggests is that as long as the proportionate gain in fixed cost by
Chart 2
Cost / Revenue
on cti un ef pQ R= :
Breakeven volume Under direct channel
nu ve Re
= TC A
v)Q (c+ f 2+
Breakeven volume Under Agency channel
)Q c+v (
vQ
Q f +v C D= 1 T
f1 f2
c= tan ?
?
QA
QD
Q*
Quantity
shifting from direct channel to agency channel is greater than the proportion of contribution that goes out as agency commission, the breakeven volume under agency will be smaller than under direct channel. To cite an example, let us say the fixed cost under dire 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
5
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. This is shown in Chart 3, without involving any numbers, but only modifying the magnitude of the commission, denoted by tan?. 6 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 3
Cost / Revenue
Breakeven volume Under Agency channel Breakeven volume Under direct channel
= TC A v (c+ f 2+ )Q
nu ve Re
nc fu e
pQ R= n: tio
v (c+
)Q
vQ
Q f +v C D= 1 T
f1 f2
?
c= tan ?
Q*
QD
QA
Quantity
It is easy to prove that c = tan ?. Just imagine that v = 0; then the (c+v)Q line will have the x-axis as the baseline. Then, rate of commission [c] is the vertical line [opp.side] divided by the adjacent side, which proves that c = tan ?
6
6
As f 2 ? f 1, Similarly, As c ? 0, As c ?(p?v)
f1 ? f 2 ? 0 f1
c ? 0 and p ?v
c ? 1 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 note, we saw that the choice was based purely on fixed costs and
Chart 4 1
c p ?v
QD=QA QD>QA QD<QA
f1 ? f 2 f1
0 0 Value of f2 f1
Value of c (p-v)
7
commission while variable costs and price played no role in it. However, in the current 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.
8
doc_727204808.pdf
The report about 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.
Distribution Management Vertical Integration v/s Channel
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 and (c) company’s needs. Cost?based 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 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
© 2005, Prof. R. C. Natarajan, TAPMI, Manipal. This note was prepared as an aid to students of MBA in understanding concepts of distribution channel choice in a simplified situation. Oliver E. Williamson (1975), Markets and Hierarchies: Analysis and Antitrust Implications, The Free Press, NY, p.8.
1
Pelton, Lou E., David Strutton & James R. Lumpkinl (2002), Marketing Channels: A Relationship Approach, McGrw-Hill, p. 359.
2
1
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 favor 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. (a) Demonstration of Cost?Based 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. 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)
3 4
ibid, p. 359
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.
2
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 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 (3.a) c
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. Chart 1
f1 ? f 2 Q
Rupees
(b) When c >
Direct channel is more profitable
Agency is more profitable
f1 ? f 2 >c Q
f1 ? f 2 =c Q
c Q*
f1 ? f 2 , direct Q 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.
f1 ? f 2 <c Q
To understand at which level of Q these two situations occur, we need to use graphic analysis.
Quantity
3
Now, refer to Chart 1.5 At Q*, the 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) (p?v) (f1?f2) > c f1 [since (p?c?v) and (p?v) are expected to be positive]
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.
5
4
f1 ? f 2 c > f1 p ?v (5)
What the inequality (5) suggests is that as long as the proportionate gain in fixed cost by
Chart 2
Cost / Revenue
on cti un ef pQ R= :
Breakeven volume Under direct channel
nu ve Re
= TC A
v)Q (c+ f 2+
Breakeven volume Under Agency channel
)Q c+v (
vQ
Q f +v C D= 1 T
f1 f2
c= tan ?
?
QA
QD
Q*
Quantity
shifting from direct channel to agency channel is greater than the proportion of contribution that goes out as agency commission, the breakeven volume under agency will be smaller than under direct channel. To cite an example, let us say the fixed cost under dire 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
5
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. This is shown in Chart 3, without involving any numbers, but only modifying the magnitude of the commission, denoted by tan?. 6 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 3
Cost / Revenue
Breakeven volume Under Agency channel Breakeven volume Under direct channel
= TC A v (c+ f 2+ )Q
nu ve Re
nc fu e
pQ R= n: tio
v (c+
)Q
vQ
Q f +v C D= 1 T
f1 f2
?
c= tan ?
Q*
QD
QA
Quantity
It is easy to prove that c = tan ?. Just imagine that v = 0; then the (c+v)Q line will have the x-axis as the baseline. Then, rate of commission [c] is the vertical line [opp.side] divided by the adjacent side, which proves that c = tan ?
6
6
As f 2 ? f 1, Similarly, As c ? 0, As c ?(p?v)
f1 ? f 2 ? 0 f1
c ? 0 and p ?v
c ? 1 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 note, we saw that the choice was based purely on fixed costs and
Chart 4 1
c p ?v
QD=QA QD>QA QD<QA
f1 ? f 2 f1
0 0 Value of f2 f1
Value of c (p-v)
7
commission while variable costs and price played no role in it. However, in the current 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.
8
doc_727204808.pdf