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Introduction to Channels of Distribution

Channel Design Decisions: Selecting the Type of Channel Structure

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Planning your channel of distribution entails making decisions in two areas. First, you must identify the basic type of channel that best fits your firm’s needs. Next, you must select the specific types and numbers of middlemen that are needed to provide adequate market coverage for your product. Lets start by exploring the first issue -- what should be our basic channel structure?

Basic Channel Structures

Based on our discussion so far, you may have the impression that all channels of distribution possess essentially the same basic structure. Specifically, manufacturers or producers sell to wholesalers, who sell to retailers, who sell to consumers. This is far from reality. There are many different types of channel structures that have evolved over time. Like biological organisms, channels of distribution continually change as a result of market, competitive and other environmental pressures. Let's explore some of the more typical channel structures for both consumer and industrial products that link producers with their customers. 

Channels for Consumer Goods

The Direct Channel

Exhibit 1
Channels of Distribution
Consumer Goods

A direct channel of distribution is one in which the producer distributes the product directly to the end-user (Exhibit 1).  Companies, such as Amway and World Book, that use their own sales forces to sell door-to-door or via party plans are employing direct channels. Your local donut shop is employing a direct channel when it makes its product fresh each day for sale directly to consumers. Manufacturers that use telemarketing, catalogs, and magazine or TV ads with 1-800 numbers to take orders and then ships these orders directly to buyers are employing direct channels. Most consumer services also are distributed via this type of channel.  As an example, consider your local pest control service.  The service provider performs the service at your home -- a direct channel.

Some marketers of consumer products prefer direct channels because they can control all aspects of the marketing program and, possibly, better control costs. In contrast, when intermediaries are used, some control is inevitably lost. Direct channels are excellent for products that must be demonstrated, require specialized technical servicing, or very aggressive selling. The direct channel makes it possible for the manufacturer to ensure that critical marketing activities are performed correctly.

Exhibit 2
Land's End Website

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The advent of the internet is making direct channels increasingly feasible for the distribution of many consumer goods. Firms can contact individual customers directly via the world-wide-web, take orders, and ship their products via UPS directly to these customers. Even very small, specialized manufacturers now have this capability. Of course, the drawback here is that products cannot be examined or sampled prior to purchase. Some internet marketers have found ways around this problem. Land’s End, for example, on its web-site, asks customers to provide basic body-type information and then will build a computer ‘model’ that shows customers how selected clothing items may look on someone of their body type (Exhibit 2).  Similarly, Gateway Computers has set-up showrooms in critical markets where customers can examine its computers before placing an order direct with Gateway. Named Gateway Country, these showrooms do not stock computers for resale. Customers can see, touch, test and custom configure a system to meet their needs with the help of highly trained sales representatives. Gateway then builds the system and ships it directly to a customer's home or business. By the end of 1998, there were 147 Gateway Country stores located across the U.S..

The Semi-Direct Channel

An common channel for consumer goods interjects a retailer between the producer and consumer. This channel is illustrated by channels in which CompUSA and Wal-Mart exist. Large retailers, such as these, prefer to buy direct from manufacturers in order to reduce costs, obtain custom-made merchandise, and receive other benefits available only from the manufacturer. Wal-Mart, in particular, because of its size and buying power, has its own distribution centers at key locations around the country. These centers allow Wal-Mart to perform most of its own wholesaling and physical distribution functions, making it possible, and quite cost-effective, to ‘eliminate the middleman.’

Exhibit 3
Sears Home Central

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Some services also employ this channel structure. For example, home maintenance contractors may be hired through Sears Home Central (Exhibit 3). Sears, via its authorized contractors, provides a "house-full" of services, including home improvements, cooling and heating systems, and product installation.

Manufacturer-Wholesaler-Retailer-Consumer Channel

Exhibit 4
M&M Network

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The most commonly employed and traditional channel for consumer goods is the manufacturer - wholesaler - retailer - consumer channel. Because most consumer goods are so widely used, it is virtually impossible for producers of these products to directly reach each retailer that sells to its consumer base. Moreover, the majority of retail stores are still small, independent operations. Envision how difficult it would be for Mars, Inc. to distribute its candy products (such as M&Ms in Exhibit 4) directly to all the small convenience stores, local grocery stores, and vending operations.

Most local restaurants employ this traditional channel structure. These retailers purchase products from food service distributors (wholesaling operations) that serve their local areas. Ben E. Keith, for example, delivers food products and alcoholic beverages (mainly beers) to restaurants in Texas and adjoining states.

Agents in Consumer Channels

In some consumer goods channels, particularly those for convenience goods, manufacturers may employ agents to make sales to wholesalers or retailers. Agents generally work on a commission basis, usually acting as an independent sales force for the producers they represent. A familiar type of agent is the real estate broker that you may hire to help you sell your house. Other types of agents commonly used by manufacturers are manufacturers’ representatives and selling agents. Both work on a commission basis and perform some or all of the manufacturer’s marketing tasks. Agents can provide valuable expertise for manufacturers that do not have the desire or know-how to market their own products, or just need to supplement their own sales staff.

The role of the agent is illustrated by the manufacturers’ rep that works for the small manufacturer of gift products . These manufacturers generally are small operations that cannot afford to hire their own sales personnel. The rep works on a commission basis, handling the manufacturer’s gifts and, possibly, other complementary gift lines produced by other manufacturers. The rep makes sales calls on retail gift shops in a particular geographic region. Any orders that are obtained are sent to the manufacturer who fills the order and has it shipped directly to the retailer. The rep, in this case, does not maintain any inventory, nor does it physically handle the product.

Channels for Industrial Goods

Channels of distribution for organizational products are similar to those for consumer products.

The Direct Channel

Exhibit 5
Channels of Distribution
Industrial Goods

The direct channel is far more important for marketing organizational goods than for consumer goods. Industrial installations and major items of equipment often must be produced to specifications, require custom installation, and user training. These products usually require extensive liaison between the manufacturer’s sales staff and the customer’s buying center. A direct channel provides the control necessary to ensure that the buyer’s needs are correctly addressed.

Manufacturer -- Wholesaler -- Business User

Exhibit 6
Zimmerer Kubota

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Some industrial products require the services of wholesaling middlemen. Kubota, a producer of construction and farm equipment, markets its products through a series of distributors (often called jobbers), such as Zimmerer Kubota and Equipment (Exhibit 6).  To ensure its products are properly sold and serviced, Kubota provides extensive training and support to its distributors.

Exhibit 7
Allied Signal's CPG

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In some cases, more than one level of wholesaling middleman may be required. For example, Allied Signal’s Consumer Products Group (CPG) manufactures and markets branded automotive products directly to the after-market consumer, as well as to automotive equipment manufacturers and installers (Exhibit 7). Multiple levels of wholesalers are required to ensure that its products are available to automotive repair shops around the world.  CPG is a world leader in manufacturing branded oil/air filters, spark plugs and other car care products. CPG is comprised of four major business units: FRAM, Autolite, Prestone and Holts. Autolite is one of North America’s largest producers of spark plugs. FRAM has been a leader in automotive filters for more than 60 years. It supplies FRAM oil, fuel, air hydraulic and transmission filters for a variety of applications in gasoline- and diesel-powered vehicles. 

Agents in Organizational Channels

Agents are commonly employed by small manufacturers of organizational products to act as their ‘sales forces.’ Usually, these manufactures produce a single line of products that require a high degree of sales expertise. Moreover, the resources of these manufacturers are quite limited. Agents provide the level of expertise required to properly represent the manufacturer’s products and generally are paid on a commission basis. This latter point makes the agent particularly attractive to the small manufacturer because commissions are variable costs on their income statements.

Dual Distribution

Exhibit 8
Dual Distribution
Pepsi's Alternative Channels

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Many products are distributed via multiple, often competing, channels to reach the same target markets. This practice is called ‘dual distribution’ and is becoming increasingly common. For example, Pepsi employs multiple channels for its soft-drinks (see Exhibit 8). The concentrate (syrup) is produced in two plants that is then distributed to both company-owned and franchised bottling and distribution plants. These plants, in turn, distribute Pepsi products to the consumer via retail stores, food service retailers (restaurants), and vending operations.  

Dual distribution often results because many large retailers want to buy directly from manufacturers.  As a result, many producers are dropping their traditional wholesalers when selling to large retailer such as Wal-Mart, but are still using these wholesalers to serve smaller retailers that, in many cases, compete with Wal-Mart for the same customers.

Vertical Marketing Systems

The preponderance of channel structures discussed to this point reflect traditional channel arrangements in which each level in a given channel operates under independent ownership.  In other words, the producers, wholesaling middlemen, and retailers in the channel are separate business entities. Each possesses its own goals, objectives, and priorities that can lead to conflict within the channel. As a result, each of these independent channel members tends to make decisions in its own best interests. The interests of other channel members and the concerns about the overall efficiency of the channel become secondary.

Exhibit 9
Vertical Marketing 
Systems

Vertical marketing systems (VMSs) have evolved over time in some industries to minimize such ‘channel conflict’ and improve channel efficiency. Vertical marketing systems, as the name implies, are systems of vertically integrated channel members that are organized  to induce cooperation and control into the channel in any of three ways (Exhibit 9):

1. By the common ownership of multiple levels of the channel by a single firm. Such arrangements are called corporate vertical marketing systems.

2. By creating contractual arrangements between channel members that specify exactly how the channel should function. Various types of cooperatives and franchise operations fall into this category. These VMS’s are referred to as contractual vertical marketing systems.

3. By virtue of the sheer ‘power’ that one member of the channel may have over other channel members to influence the decisions of those members. Channels of this nature are called administered vertical marketing systems.

Corporate Vertical Marketing Systems

In corporate vertical marketing systems, a single channel member owns other levels of the channel. For example, Sherwin-Williams, a producer of high quality paints has forward integrated into the operation of its own retail paint stores. Similarly, Sears has backward integrated over time into manufacturing.  Additional examples of corporate vertical marketing systems are provided by Goodyear and Liz Claiborne. Goodyear, of course, produces automotive tires and also operates automotive service centers that sell these tires. Liz Claiborne, a producer of cosmetics and designer clothing, now operates a series of retail stores, primarily located in outlet malls.

Corporate VMS’s provide their owners with the highest possible degree of control over how the channel operates. All marketing decisions that affect product quality, image, and customer satisfaction are centrally controlled.

Administered Vertical Marketing Systems

In an administered VMS, one member of the channel is in a position of leadership and, as a result, can substantially influence the decisions of other channel members. Generally, this ‘channel captain’ is substantially larger than other firms in the channel. In the past, channel captains typically have been large manufacturers.  For example, General Electric and Procter & Gamble, as very large manufacturers of popular consumer products, are very powerful members of the channels they serve. Their sheer size and the tremendous demand for their products allow these companies to dictate how their products are handled by most middlemen.

Today, channel captains are not limited to manufacturers. Large retailers and wholesalers also can be channel captains. As a case in point, Wal-Mart, because of its tremendous size and purchasing power, is a channel captain in many of the channels for products sold through its stores. Wal-Mart can dictate terms to many of its suppliers. Failure to comply with Wal-Mart's demands may mean the difference between profitability and bankruptcy!

Contractual Vertical Marketing Systems

In contractual vertical marketing systems channel functions are coordinated and controlled by legal contracts between channel members.  There are three basic types of contractual VMS: (1) Voluntary Chains; (2) Retailer Cooperatives; and, (3) Franchises.  

Wholesaler Sponsored Voluntary Chain

The voluntary chain is a contractual arrangement between a large wholesaler and a series of smaller, independent retailers. In this arrangement, retailers agree by contract to buy from only one wholesaler who, in turn, agrees to provide each retailer with all its products and required services.  Voluntary chains are common in the grocery and hardware industries. In the hardware industry, a well-known voluntary chains is Sentry Hardware (a Fleming-sponsored voluntary chain).

Examples of voluntary chains in the grocery industry are Fleming Foods and Supervalue. Fleming Foods sponsors the Independent Grocer’s Alliance (IGA). The company is the second-largest wholesale food distributor in the US (behind Supervalue). Fleming supplies branded and private-label grocery and nonfood merchandise to more than 3,000 supermarkets. In addition to sponsoring IGA, Fleming serves independent retailers and sponsors other voluntary chains of independents under the names Food 4 Less and Piggly Wiggly. Fleming also operates about 280 company-owned stores in regional chains such as Baker's, Rainbow Foods, SuperSaver, and Sentry. Fleming has five private labels (BestYet, IGA, Marquee, Piggly Wiggly, and Rainbow).

By agreeing to operate under the guidance of Fleming Foods, IGA retail grocers achieve the buying power that allows them to compete on a cost and price basis with supermarkets operated by large corporate chains. Moreover, Fleming provides retailers with an impressive array of management services. In my opinion, it is the ability to tap into these services that allows IGA members to effectively compete! These services include (among others):

Site selection
Store design and layout
Professional product and market research
Financing
Training
Management & merchandising assistance
Cooperative promotion programs
Computer hardware and software for retail applications
Legal services

The nation's largest wholesaler of groceries, SUPERVALU (www.supervalue.com) supplies about 4,800 grocery stores nationwide with brand-name and private-label merchandise. The company is a major retailer as well, with nearly 350 company-owned stores, including superstores under the Cub Foods, Shop 'n Save, and Bigg's names; Save-A-Lot limited assortment stores; and Scott's Foods, Laneco, and Hornbachers supermarkets. The company is expanding its presence in the Mid-Atlantic region with its purchase of Richfood, a major food distributor that owns nearly 95 supermarkets.

Retailer Cooperative

Retailer cooperatives are a second form of contractual VMS. While the voluntary chain is organized by a wholesaler, the retailer coop is set-up by retailers. However, the basic functions and advantages of both forms of contractual VMS are fundamentally the same.

Retailer coops are very common in both the hardware and grocery industries. In retail hardware, this form of VMS still accounts for a significant proportion of total industry sales -- about 35%. True Value Hardware and Ace Hardware are representative examples of retailer-owned hardware cooperatives.

Associated Wholesale Grocers, Wakefern, Associated Foods Stores, and Certified Grocers probably are the best examples of retailer coops in the grocery industry. According to Hoovers, Associated Wholesale Grocers (AWG), is the nation's second-largest retailer-owned cooperative (Wakefern is the largest). AWG is jointly owned by over 350 retailers. There are roughly 850 supermarkets operating under the AWG banner in 10 Midwestern and Southern states. Members each own an equal amount of stock, with end-of-the-year profits passed on in the form of dividends based on how much merchandise they bought from the cooperative. Like Fleming Foods and IGA, AWG supplies food and nonfood merchandise, including private-label products. It also provides services ranging from market research and store merchandising to loan programs and real estate lease assistance. The cooperative also franchises several formats for stores of various sizes.

Started by seven men who each invested $1,000, Wakefern Food has grown into the largest supermarket cooperative and wholesaler in the US. The coop is owned by about 40 independent grocers who operate about 190 ShopRite supermarkets in Connecticut, Delaware, New Jersey (where it is a dominant chain), New York, and Pennsylvania. About half of ShopRite stores offer pharmacies. In addition to name-brand and private-label products, Wakefern supports its members with advertising, merchandising, insurance, and other services. Although the holdings of members range in size from one store to 32 (Big V Supermarkets), each member holds an equal voting share.

Certified Grocers of California (http://www.certifiedgrocers.com) distributes food and general merchandise to about 2,750 independent grocers in Arizona, California, Hawaii, Mexico, and the South Pacific. The food wholesaler and cooperative supplies dry groceries, frozen and prepared foods, meats, and deli items, as well as its own bakery and dairy goods. In addition to name-brand items, its offerings include private labels Springfield, Gingham, Golden Creme, La Corona, and Special Value. The co-op also supplies member support services, including store remodeling, financing, and insurance. Certified serves about 680 retailers, many of whom own shares in the company.

Associated Food Stores is a regional cooperative wholesaler owned by the more than 600 independent supermarkets and convenience stores it serves. Member stores are sprinkled throughout Arizona, Colorado, Idaho, Montana, Nevada, and Oregon, but the majority of stores are located in Utah. Associated Food Stores also sells to nonmembers. Member services include development assistance for new stores or for improvements to existing stores. Associated Food Stores owns about 25% of Western Family, a grocery wholesalers' partnership that produces Western Family private-label merchandise. The co-op was formed in 1940.

Franchises

Franchises involve contractual agreements between a parent company (franchiser) and independent business operators (franchisees). In the contract, the franchiser grants the franchisee the right to operate under its trademark. The franchiser typically provides a wide range of management services to its members. The franchisee, in return, pays royalties or fees to the franchiser. Franchise systems continue to grow in importance in our economy. Today, franchises generate over $800 billion in sales annually, accounting for over 1/3 of all retail sales.  There are two basic types of franchise operating formats: (1) product franchises; and, (2) business format franchises.  

Product Franchises

Product franchises are prevalent in the automobile, soft-drink, and petroleum industries. Ford, GM, Chrysler, Honda, and others authorize their dealers (franchisees) to sell their cars and provide them with a variety of supporting services ranging from sales and automotive servicing training to promotional support programs. Soft-Drink manufacturers, such as Pepsi, franchise wholesalers to both bottle and distribute Pepsi products. Similarly, EXXON, Chevron, and Texaco franchise the sales of their products through retail gasoline stations.

Business Format Franchises

Exhibit 10
Some Common 
Franchises

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Business format franchises (Exhibit 10) are the most common form of franchise operation. Indeed, this is the type of franchise you and I normally envision when the term franchise is mentioned. Included in this category are virtually all of the fast food, consumer services, hotel / motel, and retail store franchises that dominate most local economies. Virtually every community has a McDonald’s, KFC, Wendy’s, Midas Muffler, La Quinta Motel, H&R Block, Subway, and/or a 7-11. With this form of franchise, the franchisee is purchasing a method of operation -- a way to do business. The franchisee is buying a package that has been well-tested and proven to work! If the franchisee runs the business as intended by the franchiser, he or she is virtually guaranteed to succeed!

The Advantages of Franchising

Franchising has distinct advantages over operating as an independent business. The biggest advantage to the franchisee is the tremendous reduction in risk associated with running one's own business due to the proven format of the franchise operation. The franchisee is provided with management assistance, training, and a wide range of support tools. Equally as important are the scale economies in purchasing and promotion provided by the franchiser. The franchiser has the overall size and, therefore, buying power to allow each franchisee to compete on a cost and price basis with larger corporate chains. In addition, by pooling the resources of a number of franchisees, the franchiser can run very sophisticated promotions that include advertising and sales promotions that individual franchisees could not afford on their own.

Franchisers also benefit from the relationship. Because the franchisee must contribute the capital to establish the franchise, the franchiser needs less capital for expansion, and can expand more rapidly. The risk of doing business is essentially shared with the franchisees.

Not all franchises are equally profitable. Unfortunately, some franchises are so poorly organized and managed that they essentially amount to scams. Moreover, some are much more expensive to establish than others. For example, a typical Subway can be set-up for around $100,000. In contrast, the cost of setting up a McDonalds or KFC franchise will easily exceed $1,000,000.

Exhibit 11
Shared Promotion Costs 
in the Franchise

A significant advantage to franchising is the ability to share promotional costs. Each franchisee typically contributes a small percentage of its profits to a common promotional pool. These funds are employed to create promotional programs that benefit all franchisees operating in a given geographic area. For example, McDonald’s requires each franchisee to contribute 4% of gross sales annually to the corporate advertising and promotion budget.  The Minit-Lube newspaper ad in Exhibit 11 is typical of the joint promotions sponsored by many franchises. Note that the Minit-Lube locations in the Dallas area are clearly highlighted on the left side of the ad.

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Page last modified: April 02, 2001