Distribution channels typically account for 15 to 40 percent of the retail price of goods and services in an industry (Exhibit 1) and there is every reason to expect that they could represent a commensurate opportunity for boosting profits and competitiveness. Indeed, the potential payoff from thoughtful and innovative management of channels could be even greater, given that many organizations have already lavished attention on the reengineering of internal operations, while channel issues tend to suffer from neglect.

The challenges and opportunities presented by channel management are likely to multiply over the next few years as technological developments accelerate channel evolution. Data networks are already enabling end users to bypass traditional channels and deal directly with manufacturers and service providers. The use of online capabilities instead of travel agents in booking airline reservations is one example of this disintermediation. In addition, logistics innovations such as reliable overnight delivery services or information systems that track the inventories of all the dealers in a market are beginning to make local inventories of products or parts obsolete, paving the way for the restructuring of distributor networks.

At the same time, new channels are continuing to emerge in industry after industry, opening up opportunities for companies to cut costs or improve their effectiveness in reaching specific market segments. Mail order, warehouse clubs, and online ordering are all becoming increasingly important to consumer goods manufacturers. In electronics and telecommunications, value-added resellers (VARs) are capturing a rising share of surplus. Direct response marketers and discount operators are becoming formidable players in personal financial services.

Despite the scale and importance of these opportunities, few companies manage to take full advantage of them. For every successful channel innovator, there are a dozen companies that either fail to recognize an opportunity in time or make a botched attempt to improve channel performance. Why does an area of such strategic and tactical significance have such a poor management track record? Two factors stand out: first, channel opportunities are extremely difficult to identify; second, channel decisions tend to be governed not by reason, but by emotion.

Opportunities hard to spot

There are several reasons why detecting channel opportunities is so difficult. For one, consumer buying habits do not change overnight; they shift glacially over time. Consumers in most countries were slow to accept ATMs in banking, for instance, and the move to paying bills by phone or PC still looks uncertain.

Warehouse clubs now represent over $25 billion of US spending on groceries and packaged goods, but it has taken them nearly two decades to reach this level. The few manufacturers that spotted their potential early were able to capture tens of millions of dollars of incremental revenue without cannibalizing more profitable business from traditional channels. Industrial consumers change their habits equally slowly. Buying groups are evolving only gradually among hospitals, for example, despite the enormous pressures on healthcare costs.

Other factors compound the intrinsic difficulty of recognizing market shifts. Since companies that use external channels lack contact with end users, they often have to rely on these channels to feed them information about the market. This makes them dependent on their intermediaries’ sensitivity to emerging consumer trends. A conflict of interests may arise, with channels understandably reluctant to share information about market developments that do not favor them.

For companies seeking a comprehensive, detailed, and up-to-date understanding of market developments, there is no substitute for direct consumer contact. Even when executives are customers for their own company’s products and services, their experiences seldom resemble those of ordinary consumers. Take automotive executives: since they enjoy the privilege of special purchasing programs and never have to negotiate with car dealers, they have little experience of what buying a car is like for most people.

Emotional bias

Decisions about channel opportunities tend to be low on facts and high on emotion. One telephone company defended its use of an expensive direct salesforce by asserting, "We need to control the entire sales process." Few would dispute the importance of maintaining some degree of consumer contact, but this all-or-nothing attitude inhibited early and deep penetration of the emerging cellular market and caused the unnecessary loss of market share and profitability.

Winning companies understand the restrictions and know how to implement changes ...

Entrenched relationships often make businesses reluctant to exit unprofitable channels or drop underperforming intermediaries. Admittedly, there are legal constraints on abrupt changes in channel relationships, but winning companies understand these restrictions well enough to know where the boundaries lie. They know how to implement changes legally (usually possible when there are performance problems) and find ways to augment or replace low-performing elements. Losing companies, on the other hand, tend to throw up their hands and complain that it is impossible to change channels.

... Losing companies tend to throw up their hands and complain that it is impossible to change channels

Signs of latent opportunity

There are six tell-tale symptoms that point to a developing channel opportunity:

1. Unhappy end users

Unhappy consumers are difficult to detect, especially when an entire industry is performing badly. But industries that universally under-serve consumers present the biggest opportunities.

Computer lore has it that Michael Dell started Dell Computer after trying to buy equipment from dealers who knew less about computers than he did. His frustration prompted him to create a direct channel that allowed consumers to obtain product information over the phone from a knowledgeable company employee instead of a store clerk. Dell provided high-performance customized computers, direct technical support, and other value-added services to a small segment of sophisticated PC users. After replicating its US direct marketing strategy overseas, it saw international sales grow from $40 million in 1989 to over $1 billion in 1995.

The auto industry has long suffered from unhappy customers; indeed, many rate a dental appointment as more enjoyable than a visit to a car dealer. A survey conducted by J.D. Power found that 68 percent of consumers hated negotiating prices with dealers, and over one-third of recent buyers felt they had been cheated. General Motors’ Saturn division set out to exploit this dissatisfaction with traditional channels. Its dealerships focused on providing a purchasing experience like that associated with luxury cars. Saturn also introduced a "one price, no haggling" sales method. In 1992, it received the third highest customer satisfaction rating after Lexus and Infiniti. Unit sales approached 300,000 in 1994, up fourfold on 1991.

2. Unexplored new channels

Emerging channels or capabilities invite fresh consumer expectations and can redefine cost or service standards

Emerging channels or capabilities invite fresh consumer expectations and can redefine cost or service standards.

Take direct insurers, which established new standards both in cost and in the precise targeting of consumer needs. GEICO uses television, radio, and mail to market its property and casualty insurance directly to consumers. It avoids the expense of a salesforce or agency and leverages its low cost position to pass on savings of 10 to 15 percent. The United Kingdom’s Direct Line is one of the world’s most profitable auto insurers, with the best retention rate and expense ratio in the industry. It uses information technology to provide a rapid service at a price competitors cannot match.

In consumer goods, warehouse clubs redefined size and price/value relationships, and enjoyed substantial cost advantages not available to traditional retailers. But they also demanded a fresh approach from their suppliers. The packaged goods companies that have been most successful in this channel have created unique SKUs for clubs instead of bundling together multiple retail packs, adapted their shipping processes to reduce clubs’ handling costs, and devised specially tailored pricing and promotion programs.

3. Gaps in market coverage

Companies are often surprised that their customers prefer to buy from a channel which they have overlooked or dismissed

Channels tend to serve distinct market segments, which means that a company that does not participate in a channel misses the segment it serves. This hardly matters if the segment is of no interest, but inattentive companies are often surprised to discover that their target customers prefer to buy from a channel which they have overlooked or dismissed. One computer equipment company lost its biggest potential market segment by neglecting system integrators. A more astute rival stepped in and developed special programs for them.

Similarly, its refusal to pay commissions excluded a large health maintenance organization from the broker market. Yet 30 to 50 percent of all health plan sales to employers were made through brokers—a huge missed opportunity for the HMO.

In the 1980s, Xerox dominated the high-end corporate segments of the copier market. The Japanese, meanwhile, targeted low-end segments and achieved deep penetration by using "Mom and Pop" dealers. Xerox lacked the local relationships it needed to serve small and home offices, so it hired independent sales agents to target the personal copier segment. As a result, its market share in this segment rose from nothing in 1987 to 27 percent in 1994.

4. Deteriorating total system economics

Competitive cost analysis and benchmarking are common enough, but they usually stop at the company. Disregarding the cost implications of the channel means they fail to capture the competitiveness of the whole system. Yet the greatest leverage often lies in the channel, and improvements there may far outweigh a business’s internal cost reductions or operating gains.

One oil company realized in the early 1980s that the net cost per gallon of gasoline sold depended on the throughput per site and the contribution from ancillary businesses such as convenience stores. This insight prompted it to restructure its entire retailing network. It introduced new ancillary businesses, revised dealer contracts so as to capture a greater share of the surplus, bought out dealers in the best sites and took over their operations, and replaced underperforming dealers. Thanks to this total system perspective, the revamped network enjoys the highest volume and lowest cost in its market.

5. Complacent intermediaries

Fat, happy distributors who are unwilling to adapt to new market conditions plague many companies in mature industries

Fat, happy distributors who are unwilling to adapt to new market conditions plague many companies in mature industries as they struggle for growth or confront changing competitive challenges. Some auto makers have found it hard to raise channel performance when many of their dealers have settled into comfortable lives and see no need to improve consumer service or expand sales. This is one case where satisfaction is not necessarily a good thing; your intermediaries’ contentment may be coming at your expense or to the detriment of end users.

At one time, healthcare insurers in the United States merely paid the doctor’s bills. With the advent of managed care, however, they have become increasingly active in utilization review and other activities to measure physician performance. And, in building up networks of physicians associated with their insurance products, the leading companies have made patient satisfaction a key criterion in determining both physician compensation and membership in the network. Payors that focus more on physician satisfaction than on patient satisfaction are likely to lose out as the market becomes more competitive.

6. Dated systems at interfaces

Business reengineering has been fashionable for some time, but it has usually been carried out inside an organization’s boundaries. With giant strides toward improved efficiency and effectiveness behind them, some companies are discovering promising new opportunities at the interfaces with channels and end users. The same kind of potential previously unlocked by adopting crossfunctional approaches and breaking down internal silos is now being released through the redesign of these interfaces. Since manufacturers’ channel relationships tend to be information-intensive and to grow more complex over time, they are often ripe for these broader change efforts.

Many packaged goods manufacturers are taking a bite out of excess inventories and unnecessary paperwork by installing EDI (electronic data interchange) and ECR (efficient consumer response) programs that help retailers manage inventories and cut total costs. Jeans maker VF Corp., for example, uses a new artificial intelligence system to create model assortments of its wares for individual stores.

Capturing the opportunities

What distinguishes the companies that succeed in tapping channel potential is the degree of rigor and objectivity they bring to the task. Many others have failed because they took a narrow and superficial look at channel performance and never probed alternatives objectively. The winners refuse to accept conventional wisdom or act on unsubstantiated biases, investing their time and energy in evaluating options thoroughly.

What you can do to capture channel opportunities depends on the symptom that betrays latent potential (Exhibit 2):

1. Clarify and emphasize key drivers of consumer satisfaction

Companies make assumptions instead of researching consumer preferences to find the few things that truly make users happy

Too many companies make assumptions about service and performance requirements, instead of researching consumer preferences to understand the few things that truly make users happy. They end up with a long list of performance standards that may or may not include the things consumers value, and that buries genuine priorities under trivia. What they should do is invest in the things that are low in cost but have real consumer benefits, and avoid or reduce heavy expenditure on features that are not highly valued by target customers.

One fast-food franchiser used extensive market research to streamline its quality checklist. It learned that its customers cared most about getting their food hot and fast. When it came to cleanliness, all that consumers wanted was a sanitary facility, not necessarily a sparkling one. So franchisees shifted some of their efforts from polishing counters to delivering food. Revenues and consumer perceptions soared.

2. Thoroughly evaluate current and alternative channels

Channels should be judged both by their ability to meet consumer needs and by their underlying economics. Look at how effectively and efficiently a channel performs all the separate roles it plays—sales, distribution, service, and so on—and assess its performance from the viewpoint of each important end user segment.

Many customers will accept a lower level of service for a cheaper price, through a discount outlet or over the telephone

Many consumer industries, for instance, have customers who will accept a lower level of service in exchange for a cheaper price when buying through a discount outlet or over the telephone. Such a segment can only be served by adding this type of channel. For example, almost all of the competitors that once scoffed at Dell’s direct marketing approach in personal computers now offer catalogues and telesales. Channel economics will often dictate which channel should be used to serve low-volume or low-margin consumers profitably. The more complex needs and higher profitability of large customers often justify a direct salesforce while smaller customers are more economically served by a multiproduct broker or agent. Healthcare and telecommunications are just two examples of industries that use this rather common practice.

3. Manage transitions carefully

Channel conflict is a thorny problem that often deters companies from changing channel strategies

As you add new channels or restructure existing ones to fill gaps in market coverage, clearly define and communicate the role of each channel participant in terms of the segments it serves, the products it offers, and the functions it performs. Channel conflict is a thorny problem that often deters companies from changing channel strategies. It can be avoided if you make sure intermediaries are not competing for the same consumers in the same circumstances. Eliminating overlaps will be easier if you have distinct value propositions for well-defined consumer segments.

This way, adding new channels will expand demand, rather than cannibalizing old channels. Addressing different segments with different channels is most effective when the rest of the marketing mix (pricing, packaging, and so on) is aligned with the segment strategy.

Levi Strauss is one company that markets successfully through multiple channels by targeting different segments with different brands. Dockers Authentic and Silver Tab are sold by department stores and specialty outlets, Dockers and 501s by middle-market retailers, and Britannia by discount chains. Packard Bell has managed conflict by differentiating its personal computers and tailoring products and margins to individual retail channels. It currently offers five different PC models, each configured to support the requirements of a specific channel. Such a strategy allows retailers to remain competitive across channels, and provides incentives to stock the product in the form of increased profits.

4. Restructure channel networks to improve economics

Deteriorating system economics are unlikely to get better on their own. Successful channel managers actively maintain the competitiveness of the entire system, not just the internal elements. Since channel costs are frequently sensitive to economies of scale, companies in mature industries may be able to strengthen their networks by encouraging consolidation and rationalizing to make survivors more viable.

Philip Morris facilitated mergers among its distributors in the 1980s to create intermediaries that could survive in a shrinking cigarette market. Volvo recently announced a program to consolidate its US network and make dealerships more efficient. As well as improving intermediaries’ cost structures, proactive rationalization upgrades the whole channel network by favoring successful participants.

5. Realign incentives with objectives

To change the behavior of complacent intermediaries, companies may have to rethink their incentives. Those designed to support performance objectives—such as sales volume growth or improvements in consumer satisfaction ratings—are the most direct and easy to administer. In the early 1980s, one automotive company discovered that consumer complaints about service were partly attributable to the fact that dealers made very little margin on repairs, particularly on warranty repairs. When it restructured reimbursements to support warranty service and introduced intensive consumer satisfaction measurement programs, service performance and consumer satisfaction improved dramatically.

Companies often overlook the hidden incentives they create that can lead to counterproductive behavior

Designing incentives is usually straightforward once you know what you would like your channels to do. But companies often overlook the hidden incentives they create that can lead to counterproductive behavior.

One lubricant manufacturer allowed its distributors to sell products in two ways: inventory sales, which attracted a gross margin, and sales on behalf of the company, which earned a fixed fee for services rendered. Its intention was to give distributors pricing flexibility so that they could sell to big end users that demanded large discounts. But the distributors eventually began to use services-rendered sales as a way to offer heavy discounts, thus guaranteeing themselves a fixed spread. The results were predictable: services-rendered sales grew and the manufacturer’s margins fell.

6. Redesign systems at interfaces

Reshaping the company-channel interface to reduce total costs—for example, by introducing automatic inventory replenishment systems—has paid off in many industries. To help its dealers remain competitive, General Electric’s appliance division developed extensive support programs, including a computerized inventory system to accelerate inventory turns and reduce carrying costs. Caterpillar’s computerized dealer network is able to locate and deliver parts within 48 hours worldwide.

Redesign usually has the added benefits of making a company a preferred supplier and raising switching costs for the channel. Building systems that constantly measure performance by product for each outlet enables companies to spot trends early and work productively with intermediaries.

Companies have many ways of unlocking profits in their channels of distribution. Some are familiar; others have recently emerged in the wake of IT developments and innovations in management techniques. Many improvements, such as realigning incentives, can be made relatively quickly. Others, such as making the transition to a new channel structure, take longer.

Whatever the strategy, the crucial first step is to recognize that an opportunity exists. This is seldom easy, as witnessed by the host of businesses that keep failing to take advantage of new channel possibilities. To win in channel management, companies must take a rigorous, systematic, and continuously innovative approach to finding and capturing these opportunities.