Making industrial products is a tough way to earn a living. Producers of everything from adhesives and chemicals to metals and specialty paper have had to cope with a decade of disruption in their sales channels whether they dealt with original-equipment manufacturers directly, through distributors, or both. Distributors and end customers have consolidated, undermining long-established sales strategies; large customers have adopted increasingly sophisticated approaches to buying; and new technologies have made the producers' pricing schemes more transparent to all.

Consider the plight of electrical-wire and -cable producers. In search of economies of scale, distributors of these products consolidated during the late 1990s.¹ Utilities—which are the end users of electrical wire and cable—also merged rapidly. Meanwhile, metals and other inputs to wire and cable products began to be sold through on-line marketplaces, which made the producers' cost base transparent. The result was that long-standing customer and supplier relationships were upended and the bigger surviving customers and distributors could extract pricing concessions from producers.

Despite these developments, few industrial-products manufacturers have altered their approach to selling. It is easy to understand why. Making changes to sales structures—for instance, by rapidly augmenting or replacing channel partners—is risky. One electrical-equipment manufacturer that had sold its products through third-party sales representatives tried to jump-start its growth by adding a channel and offered its new distributors products on advantageous terms that were then passed on to customers. Savvy buyers, however, continued to obtain information from the old sales reps (value-added resellers that could solve their problems), though they bought from the new, lower-priced distributors. Sales plummeted because many of the best third-party sales reps, which owned key markets, dropped the company's product line in irritation.

Fortunately, companies can turn the information transparency tables to their own advantage by using the new technologies themselves

Yet doing nothing holds dangers as well. At the very least, manufacturers must review the way they sell their wares, and to whom, if they hope to understand the impact of changing their sales practices. Fortunately, these companies can turn the information transparency tables to their advantage by using the new technologies to assess the performance of their customers, channel partners, and channel practices while learning how to improve their own economics. Armed with such insights, many industrial-products companies can decide whether it would be best to restructure their channels or to manage the existing ones better.

New challenges

Information transparency is the thread connecting the producers' channel challenges. On-line auctions give customers more information than ever about the producers' pricing; rapid data transmission helps purchasing agents do their jobs more effectively; and downstream consolidation makes information move more easily because it moves through fewer companies. The new climate has had its most obvious impact on the prices manufacturers can charge. But it is also testing the channel approaches that many of them have used for decades by influencing which companies they choose as their partners, the way they motivate partners to increase their sales, and the activities the partners undertake.

More sophisticated buyers

E-mail, on-line auctions, standardized desktop tools, electronic document sharing, and even mobile phones have made information flow more readily within buyer organizations, across industries, and even, sometimes inadvertently, across competitors. More information is just the beginning. Equally important is what end customers and distributors have done with it by developing detailed data on their purchases, comparing how and how often they buy goods from competing producers, and extracting concessions from these companies.

A second issue is the rise of electronic marketplaces, which enable purchasers to pit producers against one another in reverse auctions, yielding prices that are highly visible and often lower. Although in some sectors the new sales channels haven't caught on, for many industrial-products companies they have quietly become a part of the normal way of doing business. Companies can respond in a number of ways—from retreating upmarket to specialty channels less touched by on-line auctions to using them as a means of cutting out distri-bution intermediaries and pursuing high-volume strategies.

Downstream consolidation

As if the new tools and capabilities of industrial distributors weren't enough, they have also consolidated rapidly: by some estimates, the top ten now represent 40 percent of US industry revenues.² Buyers too have joined forces, some through megadeals, such as the 1998 DaimlerChrysler merger, others through countless smaller arrangements, such as Delphi's acquisition (from TRW) of Lucas Diesel Systems in 2000 and of Eaton's switch and electronics unit in 2001. Finally, the emergence of large retailers in certain industries has had a significant effect. In the home-construction sector, for instance, the top ten distributors (which include certain retailers, such as The Home Depot) command no less than 70 percent of industry revenues (Exhibit 1), and some regional lumberyards and flooring distributors are disappearing.

Besides weakening the market power of industrial producers, downstream consolidation complicates channels. Markets that were once well covered suddenly become poorly served when distributors merge and shift their product or market focus, manufacturers cut the number of suppliers and distributors they use, or large retailers squeeze out distributors. Continued movement offshore by consolidating manufacturers compounds the problem by forcing them to find new ways of reaching end users as the importance of traditional domestic distributors declines.

Responding with insight

Industrial-products companies understand the winds of change and their consequences, but it hasn't always been obvious how these companies should react. Fortunately for them, the very information transparency that has been so vexing in some respects can now be applied to channel analysis, thereby giving them deeper insights into their customers, distribution economics, and competitors.

When distributors controlled access to end customers, producers had difficulty obtaining the information they needed about demand, pricing, and customer-service requirements. To assess the performance of their distributors, they could do little more than determine how many units they sold through each. All that has changed with the coming of better third-party market research, internal data-capture systems, and analytic and on-line tools. Indeed, many companies face a new challenge: too much data. This problem can be so acute for any producer with large numbers of distributors and end-user customers that in many cases it would do well to appoint a special analytic team to study channel issues. Such a team ought to include people well versed in the contents of company databases as well as generalists with the problem-structuring skills to design well-targeted analyses of issues like the profitability of customers and products across and within channels. (Some queries take days to run, so framing questions carefully is vital.) The right team can provide valuable information about a company's customers, channel economics, and competitors.

Learn more about customers

Advanced electronic-data-interchange (EDI) and other e-enabled systems now give industrial companies unprecedented access to information about their end-user customers. Cheap forms of communication (such as e-mail) help third-party market research and price-tracking firms assemble more information at lower cost than ever before. Using all this data has become cheaper and easier thanks to increased computer processing power, better software, and tools, such as data warehousing, that have made sophisticated market research techniques (conjoint analysis, for example) more readily available.

Producers can not only create a more nuanced understanding of their customers but also tailor their channel approaches in response

This information not only helps producers build a more nuanced understanding of their customers but also tells them how to tailor their channel approaches in response. One US chemical company used such insights to recast its incentives to distributors. It began by dividing the United States into 15 geographic markets. Then it combined third-party market research (on topics such as the size of its markets, the number of end users in them, and the kinds of end-user segments they include) with its own customer and channel databases (which contained information on the market share of distributors and estimates of end-user penetration and relative brand strength by market). The results were illuminating. In some markets, end users were extremely loyal to their distributors; in others, they pitted distributors against one another to get the best price; and in still others, local consultants advised them on what to buy and how much to pay. The chemical company also learned that its distributors played different roles across geographies, sometimes acting as wholesalers, sometimes as retailers, and sometimes in both capacities.

One implication of these findings was that to cover the whole country, the company needed no fewer than ten distributors claiming to have national reach. Another was that its one-size-fits-all compensation structure was poorly aligned with the market conditions experienced by some of its channel partners. Tailoring incentive systems to individual markets gave the company opportunities to increase its share of them without changing its products significantly. Like many channel revolutions, the new strategy looks straightforward in retrospect. But ten years ago, the company would have been hard-pressed to decide how many channel partners to keep, much less which ones and what it should do to design the most effective incentives for each of them.

Reappraise channel economics

Knowing your customers is only part of the picture; a producer contemplating changes to its accustomed channels must also understand both its own economics and those of its distribution alternatives. This knowledge can help companies evaluate the attractiveness of serving customer segments directly (as against using intermediaries) or of working with particular distributors.

Such diagnoses are now possible because, for many transactions, producers can combine real-time price and volume data (provided by EDI systems) with the internal cost data compiled by enterprise-resource-planning (ERP) systems. Useful information of this kind, which has only recently become available to companies in an easily manipulated form, enables them to determine how much profit they make from their individual channel partners and from the end-user customers for the products and services they offer.

The pocket margin waterfall, a tool commonly associated with pricing analysis, has important applications for companies setting their channel strategy. Its use involves subtracting direct product costs and costs incurred specifically to serve an individual account from the price paid by an end customer.³ The cost of serving individual accounts can be borne by either the producer or its distributors.

An analysis generally shows that the largest cost of working through intermediaries is their discount

Producers can learn a good deal by using the pocket margin methodology to compare the cost of sales made through distributors with the cost of direct sales or to compare costs across different channel partners. An analysis of direct sales versus sales through distributors (Exhibit 2) generally shows that the largest cost of working through intermediaries is their discount—the difference between the price paid by the end customer and the list price the distributor would pay the producer in the absence of other rebates. In most industries, the distributor discount is 20 to 30 percent of revenues; however, it sometimes goes above 50 percent and occasionally dips into single digits. If glaring differences in the discounts of different channel partners cannot be explained by variations in performance, that is an important warning sign of uneconomic arrangements.

Another red flag is the surprisingly high cost of smaller-ticket items such as order processing or technical and sales support; distributors can be very cost-effective at certain steps of the chain and inefficient at others, especially when it would be necessary to make investments to become a low-cost provider of services used by only a few customers. In some cases—particularly when distributors have trouble covering all locations requiring product deliveries—such inefficiencies prompt producers to remove a costly step in the process by offering some customers new direct-ship or direct-order services. In other instances, producers avail themselves of the services of new kinds of intermediaries, such as consolidated logistics warehouses or credit- or payment-processing specialists, to serve as support resources for some or all of their channel partners. This approach makes sense when the activity in question must be performed only periodically and there are major economies to be had.

Know your competitors

Electronic marketplaces, which help purchasing agents extract concessions from producers, also help producers learn about their competitors. One equipment manufacturer exploited this information transparency by analyzing a series of bids it had lost to a competitor. By comparing detailed bid prices with the catalog prices posted on the competitor's Internet sales site, the manufacturer reconstructed the competitor's sales and discounting strategy for each main customer segment. With that information, the manufacturer could teach its distributors how to estimate the likely prices and terms of future transactions and to develop sales strategies in response. The channel partners were thankful for the support of the manufacturer and quietly helped it gain share and boost margins.

From insight to action

We have found that a radical shift from one channel approach to another (say, from distribution to direct sales) rarely makes sense

Rarely would an industrial-products company finish reevaluating its channels without finding ways to improve them. Action generally takes any of three forms: restructuring the channel, selecting new partners, or improving the management of existing partners. In our experience, concentrating on one form at a time helps companies avoid precipitate actions they might later regret. We have also found that a radical shift from one channel approach to another (say, from distribution to direct sales) rarely makes sense.

Instead, the changes should be subtle, as Okonite, a producer of electrical wire and cable, showed when it developed a new channel strategy. The company responded to consolidation among its distributors by circumventing the traditional two-step ones and deepening its relations with selected utilities; in particular, it supplied municipal utilities with engineering resources to help them plan new projects. These customers came to view the company as their trusted partner rather than just another producer, and this helped it make some valuable discoveries: they needed more flexible and easier-to-install cable, for instance, as well as a more streamlined, service-oriented buying process. No producer was providing these benefits, so when the company did, it flourished even as many competitors foundered on the rocks of commoditization.

The restructuring option

Restructuring channels means changing the kinds of channel partners a company uses; for example, it might augment or replace its traditional distributors with value-added resellers, brokers, mass retailers, or on-line channels. If distributors provide inadequate market coverage or if resource constraints make it impossible to expand the existing channel configuration, restructuring could be the answer. In other cases, the impetus to restructure comes from fundamental changes in the nature of end-user demand (such as a desire for solutions) that a company's current channel partners are unlikely to satisfy even if retrained. (An important economic indicator would be evidence that profits were migrating to channel partners or end users.) Finally, competitive research might reveal that other players were adopting new, more successful channel models that called for a response.

One electrical-equipment and -machinery company restructured its channel upon finding that its sales force wasn't active in several attractive regions and that its sales of equipment for systems upgrades lagged behind those of competitors. Rather than expand the sales force, the company developed new channel partnerships—one to create an on-line system for handling all estimates, proposals, and service agreements and another for monitoring customer life cycles and recommending upgrades. Freed of these burdensome tasks, the sales force could expand the company's revenues in new geographies. Meanwhile, equipment-upgrade sales more than doubled thanks to the new channel partnership.

Despite such success stories, it is risky to redesign channels, because doing so requires companies to entrust some or all of their revenues to new partners that lack established relationships with end customers. Testing out new arrangements before implementing wholesale changes can mitigate the risk but never eliminates it.

Selecting new partners

Sometimes a company needs better rather than new kinds of channel partners. If customer analysis reveals that end users value skills and services the current partners can't provide, or if the cost structures of some partners are less favorable than those of their peers in the distribution network, it could be time to choose new ones.

Before doing so, however, companies ought to consider investing in their channel partners' skills. Manufacturers should weigh two key questions—how much will the training cost and how likely is it to succeed?—against the risks of cutting loose long-standing distribution partners. In many industries, intermediaries have served a customer base for generations; they know the locations of all prospects in a territory and can predict which of them will and won't buy. In industries ranging from hydraulics to electrical products to heating oil, we have found that when a manufacturer drops a distributor that then picks up another line, 20 to 50 percent of the volume the manufacturer used to enjoy in that territory stays with the distributor.

In short, swapping one channel partner for another, like restructuring a channel, is risky. Field research can help—particularly interviews with customers of the distributor in question, for it is vital to know why they buy and how privileged these relationships are. Armed with this information, industrial companies are in a better position to decide which distributors to jettison.

Better channel management

Even when analysis shows that a manufacturer doesn't have to restructure its channel or switch partners, it is bound to have opportunities to improve channel management. Doing so is particularly relevant when competitive analysis indicates that other companies are getting better results with similar sets of distributors.

Incentives, for instance, are a vital component of channel management. When one chemical company assessed its rebate program, it found that its salespeople were applying rebates haphazardly, often offering them to weak distributors in hopes of gaining incremental sales in competitive markets or to distributors regarded as loyal (though analysis suggested they weren't). Not surprisingly, these rebates were costly and ineffective. The company's solution was to strengthen the program by standardizing it, which helped the sales reps focus on selling products rather than administering rebates. In other cases, tailored incentives are the key, though channel strategists, not individual salespeople, should do the tailoring.

Again, training is important. When economic analysis reveals that certain customers are putting pricing pressure on distributors, for instance, a manufacturer should arm them with better information: a shortlist of customers whose approach to purchasing appears to be sophisticated, an analysis of those customers' alternatives, and training and materials to communicate the distinctiveness of the manufacturer's offerings.

The risks inherent in channel management differ from those in designing channels and choosing partners. Channel-management initiatives don't introduce new intermediaries to deal with customers, so mistakes are less likely to cause massive shifts in market share. Nonetheless, effective implementation can be tricky and calls for tight monitoring and fine-tuning. To evaluate initiatives, an industrial company can rely on the same tools it uses to identify them.

Channel change is scary. But with the right insights about customers, competitive conditions, and economics, manufacturers can successfully redirect their channel strategies and improve their performance.