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Changing Channel Distribution Models in the Internet Age

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While the recent meltdown of the dot-com sector has raised concerns about Internet business models in general, there is little doubt that "channel power" - the use of electronic distribution channels - will continue to have a significant impact on the e-commerce business landscape.

The adoption of channel power has meant a seismic shift in the relationships between consumers, retailers, distributors, manufacturers and service providers. It presents many companies with the option of reducing or eliminating the role of intermediaries and lets those providers transact directly with their customers.

But some observers are questioning whether it makes sense for all companies to take advantage of the new possibilities.

Eric K. Clemons, Wharton professor of operations and information management, says that in examining the transformations that have occurred in two industries - securities trading and travel - he has found many individual companies wondering if their market share and profitability will increase or decrease as a result of consumer adoption of direct distribution.

Direct distribution offers a company significant opportunities, but it also can present "numerous strategic uncertainties," Clemons says. He suggests that before launching an e-commerce effort and bypassing its traditional distribution channels, a business should analyze which products are appropriate for electronic distribution, which consumer activities will be supported by which channel participants, and which segments or groups of consumers are likely to adopt electronic distribution.

While the answers will depend to some extent on the specific industry, Clemons also offers three questions companies should ask to determine if the relevant market is newly vulnerable to attack:

  • Easy to enter: How easy will it be to enter the channel and attack existing businesses?
  • Attractive to attack: Is the market attractive to attack, with the prospect of initial profitability?
  • Difficult to defend: Can the existing players defend themselves, and do the new entrant' s current distributors and other channel partners have the ability to punish the entrant for launching an electronic attack?

Clemons notes that a channel can become vulnerable if it is easy to enter as a result of a new regulatory change (such as the establishment of the European Common Market, which increased the vulnerability of financial institutions that were previously protected by national borders); technological change (cellular telephony, for example, increased the pressure on Bell operating companies by offering alternatives to their local, land-line-based service); or even consumer preferences (as consumers become more net-savvy, online shopping may threaten established mall operators and the owners of large physical stores).

Don' t overlook "the importance of the key word ' newly' in the phrase ' a market that is newly easy to enter,' " says Clemons. "A market whose entry barriers have not recently changed can be assumed to be more or less in competitive equilibrium, but when entry barriers suddenly drop we can expect rapid and massive changes in corporate populations."

Once a market is identified as being easily entered, other vulnerabilities should be assessed. Clemons points to two conditions that indicate susceptibility to penetration.

"The first condition is the presence of a strong customer profitability gradient - extreme differences in profitability between the best and the worst customers in a market," he says. "This is most frequently due to uniform or simplistic pricing despite great differences in the cost to serve the customer base."

Using an example from an industry outside eCommerce and direct distribution to make his point, Clemons cites the British credit card industry, noting that British banks long engaged in a simplistic, "one size fits all" approach to their credit cardholders, where the best and worst customers were charged similar fees and interest-rates.

This resulted in extreme differences in profitability due to a cross subsidy: customers who carried balances forward and paid finance charges were effectively subsidizing customers who paid off their balances in full during the grace period and thus were receiving interest free loans rather than providing the bank with a profitable revenue stream from finance charges.

"A second cross-subsidy existed because the banks were overcharging all credit card customers to subsidize the expense of providing free checking to virtually all individuals," says Clemons. "The combination of simplistic pricing and cross-subsidies created incentives for Capital One and other US-based monoline credit card issuers (issuers that do not participate in any other kind of financial or banking activity) to attack with use-sensitive fees and interest-rate-based forms of pricing."

In e-commerce applications, as well as in traditional ones, situations like this make it easier for a new entrant to operate, utilizing a strategy of "opportunistic pickoff," where the new competitor does not need to subsidize bad accounts and does not need to subsidize additional lines of business. "Consequently a new entrant is ideally positioned to make better offers to the customers it does want to attract, in the product markets it does want to enter," says Clemons.

But simply having the ability to enter a market through direct distribution - even one that is attractive to attack because it offers a strong customer profitability gradient - doesn' t always mean it' s in the best interest of a business to do so. Two major considerations are the speed with which customers can reasonably be expected to accept the new distribution channel (generally, quick acceptance will indicate profitability while slow acceptance can point to unacceptably high start-up costs that lead to failure), and whether established companies in the industry or other players may punish the new entrant. Punishment, too, is strongly related to the speed of consumer adoption.

For example, asks Clemons, will consumer packaged goods manufacturers initiate direct distribution of their products to consumers, bypassing traditional channels like grocery stores?

Initially, it would appear that consumers would flock to the new model, embracing the opportunity to shop from the comfort of their living room. Further, direct delivery from manufacturers would cut out "middlemen" costs, letting manufacturers offer competitive pricing to consumers. Think about what the Internet did to travel agents - online search engines that can instantly locate available flights and the lowest fares were linked to e-commerce-enabled websites that can book flights and generate tickets or electronic ticket surrogates (e-tickets). As airlines increasingly deal directly with passengers, agency commissions have been slashed from an initial level of 10% to the smaller of 10% or a cap of $50, then to 8% or $50, and then to 8% or $35.

But bypassing a distribution channel isn' t always so simple, says Clemons.

"Unlike a category like e-ticketing for air travel, physical products like groceries must actually be delivered, generally at a time and place convenient for the consumer, and often quite rapidly and with careful control of temperature and other conditions during shipment," he notes. "Thus, for packaged goods, there will be a real and significant fixed cost per delivery. Without a sufficient number of products to offer economies of scope, distribution costs will be extraordinarily high and will reduce or eliminate consumer adoption of this new channel unless the channel operator is willing to sustain large losses by subsidizing logistics."

During this period, traditional retailers will undoubtedly retain both considerable market share and the ability to punish the first manufacturer in any category that attempts to implement a bypass strategy. This punishment on the part of retailers could include such actions as withholding product promotions, reducing shelf space, and increasing store-level margins (ultimately charging consumers a higher price) on brands from manufacturers that they consider to be hostile to their own best interests as retailers.

Similar analysis probably explains what actually occurred when the first online brokers began operations, says Clemons.

"The first Internet-based traders were discount brokers like Charles Schwab and online entrants like E-Trade," says Clemons. "This was no coincidence. Full service houses like Merrill Lynch and Salomon Smith Barney hesitated for fear of alienating their account executives and financial consultants, who might have left the firm, taking clients with them. But when Schwab, E-Trade and other online brokers made inroads, the major ones had to develop their own online systems and could more easily justify this development to their personnel."

As with online trading, it appears inevitable that alternative electronic distribution will gain ground in a variety of categories. Some, like air travel and e-ticketing, already have seen significant impact from electronic bypass; others, like grocery retailing, will take much, much longer. While Clemons' initial studies were drawn from contrasting air travel with grocery distribution, "the principles apply equally well to insurance agencies considering a move to alternative electronic distribution, or to the manufacturers of consumer durables like digital cameras that are considering direct distribution via the Internet," he says. His group' s most recent studies have examined the electronic distribution of purely digital goods, such as music and news stories, and considered the change in strength of top recording artists (considerable gains) and top reporters (far more limited).

One thing is certain. An enterprise that does not take the time to consider its vulnerabilities and opportunities in the e-commerce arena stands a good chance of being surpassed by ones that do, either because it missed opportunities it should have seized, or, perhaps more likely, because it attempted to seize opportunities that did not yet exist.

All materials copyright © 2001 of the Wharton School of the University of Pennsylvania.

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