Many people go into business thinking that if you can eliminate the middleman, you can make a lot more money. As a result, when the Internet came into common use, many in the middle were eliminated. For example, when's the last time you went to a travel agent to book your travel? Of course, the travel agents that understood, and were able to communicate, their "added value" are still in business. A great many that could not are gone. To help avoid having your business or job eliminated, it is important to gain a better understanding of distribution.
When you get to the heart of it, distribution is about the convenience of getting products from the manufacturer to the user. Customers buy products from places that are convenient - usually near where they work, live, or visit. Companies and people that understand this know that if you can make your products more conveniently available, you will sell more.
Economics of distribution
To make money, most manufacturers need to sell their products in sizable quantities. Most customers need just one or a few. Therefore, an opportunity for middle people, or re-sellers, is created. Distributors, or wholesalers, are willing to buy products in quantity, and put them in a warehouse to eventually transport and sell them to many dealers, or retailers. Dealers, in turn, have stores and websites from which they are willing to sell one or a few to lots of buyers. Therefore, a typical distribution system looks like a pyramid with each manufacturer selling their products through a number of distributors, who turn around and sell these products to many dealers, who sell them to a larger number of end buyers. While marketers take full account of these economics and scale issues, we are more focused on the customers - thinking about distribution as a way to provide them with "convenient" places to buy the products they need. Each company that operates at a certain level (or provides a certain function) makes it convenient for the level below (their direct customers) to buy their products. In order to provide convenience to their customers, marketers employ a variety of distribution strategies.
Levels and players
There are three classical distribution levels that provide needed functions - (1) Manufacturer; (2) Distributor, or Wholesaler; and (3) Dealer, or Retailer.
- Manufacturers. They are willing to make the product so their customers don't have to make their own. The idea is that end buyers (these can be consumers, businesses, or governments) can save considerable time and money by buying products made by others and investing the time and money savings in whatever they choose. Manufacturers are willing to do this because they can earn profits to improve the lives of their owners, executives, customers, and employees. To earn the money they need to pay their costs and expenses and earn a reasonable profit, manufacturers typically sell their products for twice their costs, or a gross profit margin of 50%. While gross profit margins can vary from this typical number, there have to be additional factors to justify a different Gross Profit Margin targets. I explained this in my previous post on pricing strategies. To be efficient and keep their prices at "affordable" levels, most manufacturers need to make products in sizeable quantities. There are manufacturers that do custom or small quantity work, but they have to charge custom prices to survive and thrive.
- Distributors. Since only the largest dealers and end buyers can buy products in the quantities manufacturers need to profitably sell them, an opportunity is created for distributors. Distributors typically acquire inexpensive warehouse space in industrial areas that are near transportation centers so they can easily receive goods from manufacturers and ship them to dealers. They also like to sell items in quantity, but exist to sell smaller quantities to lots of dealers that either cannot afford, or do not have the space for, the large quantities retailers would have to buy directly from manufacturers. Therefore, distributors perform a "warehousing" function where they become the warehouses for manufacturers and for their dealer customers. That is their reason for existing. To do this work, they typically need Gross Profit Margins (GPM) of 10 to 15%. The price they need to charge dealers to earn a 15% GPM is 1.18 times the price they pay for products from the manufacturer (1.18C-C)/1.18C = 0.15.
- Dealers. Unless they are very big retail chains that can afford to have their own warehouses and distribution systems, dealers tend to buy smaller quantities of product than manufacturers need to profitably sell, but larger quantities than end buyers want to buy. They add value by locating their stores or offices near where end buyers live, work, and travel. Convenience is their overwhelming added value function. For example, if prospective buyers want to buy a washer or dryer, they can go to a local store that may have some models to show them, but that store typically does not have the space to carry all the inventory of products they sell. They can get these on short notice from distributor warehouses. Depending on the after-sale support they have to provide their customers, dealers typically need 30 to 50% Gross Profit Margins. A very typical dealer GPM is 33%. To realize that margin, Dealers sell products for 1.5 times the price they pay the Distributor.
Big Dealers or "Big Box" stores
A combination of distributor and dealer has evolved over time. It is often called a big box store, or a big dealer. It usually occupies very large space to perform the distribution (warehousing) function and has cash registers and locations to provide the dealer (convenience) function. It is not quite as convenient as a local store (unless one happens to be located near where you live or work). Examples include Target, Walmart, Costco, and Home Depot. Buyers are willing to sacrifice some convenience (by traveling longer distances) to save money since most of the big box stores sell products at lower prices than local stores.
While there are many channels through which products can be conveniently sold, four basic channels dominate the flow of products from manufacturer to end buyer.
- Direct Marketing direct channel. Manufacturers can sell direct to end buyers using direct marketing methods such as Direct mail, Telemarketing, Direct Response Advertising, and Web sites. Direct marketing involves no in-person, face-to-face interaction between buyer and seller.
- Manufacturer's Sales Force direct channel. It is quite costly to sell products direct to end buyers using a sales force. The latest data from McGraw Hill, pegs the cost of making an industrial sales call at $137.02. Since it takes 5 calls, on average, to close a sale (it's actually 4.3, but it is not possible to make a fraction of a call), the cost to close an industrial sales call is between$589.18 and $685.10. Therefore, unless you are selling Boeing 787 aircraft and communications satellites or truckloads of Hostess Twinkies, this channel is quite expensive and cries for a good return on investment for justification. Since manufacturers typically need a price of twice their costs to make money, the end buyer price through both direct channels is typically 2 times their cost of sales, with variations for mitigating factors.
- Two middle people indirect channel - Distributor and Dealer. To support a distributor and dealer selling products, this channel typically requires an end buyer list price of 4 or 5 times the manufacturer's cost of sales.
- One middle person indirect channel - Big Box Store, Value-Added Dealer, or Franchisee. To support one middle person reselling a manufacturer's product, the price required is typically 3 times the manufacturer's cost of sales. Franchise operations, or any operations that have one middle person, follow this model.
Even though the above levels and channels seem to apply to bricks and mortar locations, they also work with online equivalents. If the manufacturer is selling directly to end buyers, the first direct channel above includes online distribution. What's more, distributors and dealers can (and do) sell both online and off. With the advent of the Internet, distribution systems have grown a bit more complex, and in many cases, more convenient for those too busy, lazy, or traffic-stressed to travel to stores and offices.
Since time immemorial, companies and end buyers alike have been looking to cut out the re-sellers, or middle people, to save money and sell more. This is to be expected, and many middle people that have not succeeded in proving their added value to end buyers have gone out of business (as already discussed above). What too many forget, however, is that if you cut out the middle people, you still have to provide their function. That is a fundamental rule of distribution. Unless you are selling digital products that can be distributed over the Internet, if you bypass the middle people, you have to acquire (or pay someone else for) warehouses and you have to provide the convenience to the end buyer.
You also lose the marketing performed by middle people
There is another important issue that is often forgotten when companies consider eliminating middle people. When you bypass them, you also eliminate the benefits of their locations, marketing, and sales efforts. That is, distributors and dealers have their own locations and sales people, and they spend money on marketing. If you cut them, you also lose their locations, sales people, and marketing efforts. You cut convenience for yourself and the end buyers.
How you can successfully employ distribution strategies
If you focus on the convenience as well as the economic aspects of distribution, you will likely to be ahead of your competitors. And if your business is in the middle of the flow of goods from manufacturer to end buyer, you are likely to always be successful if you understand the concept of added value. That is, if you can provide a measure of convenience, or add something else, that your manufacturer suppliers and competitors don't, you can sustain your success. Travel agents went out of business when the Internet made it more convenient for end buyers to book their own travel online. Those that changed their business models to provide better services than their customers could receive from the Internet, survived and thrived. That is what we all have to do. Technology can eliminate many of our jobs if we do not understand how to provide more convenient, added value to our customers, bosses, and constituents than alternatives can. If you don't know this already, hopefully you will learn how to do it. Best of luck.