Lead or Follow: Channel Pricing Strategies
For Today's Economy
Introduction
Channel pricing is one of the least understood
and most complex aspects of a supplier’s go-to-market
strategy. To develop an effective strategy, suppliers
must establish discount levels for various customer
segments and multiple channels serving each segment.
In addition, e-commerce and evolving logistics capabilities
are changing the roles that partners perform and,
therefore, the compensation that they should earn.
Channel power, conflict, and competition further
complicate the development of effective strategies.
To be economically rational, a strategy must consider
go-to-market costs. Suppliers, however, have different
costs to serve each channel and partner. Furthermore,
distributors, retailers, and other channels have
unique cost structures and value propositions of
their own.
Given this complexity, it is no wonder that many
suppliers simply copy their competitors’ programs
or remain paralyzed by indecision. With no underlying
rationale, suppliers drive down their own and their
competitors’ profitability by offering deeper
discounts, rebates, and allowances. At best, many
suppliers resort to a rash of special deals that
are costly to manage and represent no overall strategy.
Progressive suppliers understand channel pricing.
They take a leadership position to protect their
own profits and profits throughout their industry.
A leadership position can lower operating costs,
improve customer satisfaction, and accelerate growth.
Suppliers without a well considered strategy subject
themselves to continued margin erosion and the dissipation
of their value to the channel and to the customer.
Channel pricing is fundamentally different than
traditional pricing. Traditional pricing sets the
value of a product or service to customers in a
competitive market. While value pricing is important,
it is not sufficient. The value of a product or
service depends on the customer’s entire experience
including the interaction that the customer experiences
with the distribution channel. If the supplier
does not get its channel pricing right, it will
never fully realize the value of its offering.
Channel pricing establishes the amount of compensation
that independent distribution partners earn on the
sale of products or services. It pays for the activities
that third parties perform on the supplier’s
behalf. It establishes whether distributors, retailers,
resellers, or other channels will focus on a supplier’s
brand or, conversely, seek alternatives. It drives
the channel’s behavior to take costs out of
the supply chain or invest in activities that generate
demand. Most manufacturers think of channel pricing
as little more than volume discounts or growth incentives.
While these programs may play a role, in today’s
complex environment, suppliers must utilize
channel pricing to pay for functions performed,
motivate behavior, manage conflict, and take costs
out of the supply chain.
Factors Driving Suppliers to Rethink Their
Channel Pricing Strategies
More than ever, markets are experiencing profound
change. Is e-commerce the Second Coming of the industrial
revolution? Maybe yes, maybe no. One thing that
we can count on is a continued evolution of the
relationships between suppliers and their downstream
partners. Suppliers must change the way they pay
their partners as these relationships evolve.
Advances in E-Commerce and Logistics
Systems
Just as the end of the Cold War kicked off a new
era of globalization, revolutionizing relationships
between the East and the West, e-commerce is revolutionizing
the business world and will surely revolutionize
relationships between suppliers and distributors.
How will these relationships change? There are
many ways. One possibility is that suppliers will
sell direct to customers over the Web. This is tempting
because they get closer to the customer and do not
have to pay large discounts to the channel. Many
suppliers will not adopt this strategy, because
by cutting the channel out of the supply chain,
they will lose volume.
Other suppliers will develop e-commerce offerings
that include their partners. For example, they will
take orders from end users over the Web and dole
those orders out to channel partners to fulfill.
This approach creates a new role for traditional
partners. In a variation, partners influence customers
to buy directly from the supplier’s Web site.
This approach creates an agency relationship between
the supplier and the partner.
Some manufacturers will change their downstream
supply chain. Historically, distributors held inventory
in each local market. Today, UPS and other third-party
logistics providers deliver next-day ground virtually
anywhere in the United States from a handful of
locations. This new capability changes the need
for distributors to stock at the local level. These
dynamics enable a manufacturer to outsource logistics
to the most efficient partner—not necessarily
the traditional distributor. Manufacturers that
move in this direction must alter their channel
pricing structure so that they do not compensate
distributors who no longer perform the logistics
function.
Regardless of the approach that each supplier selects
in today’s economy, the common denominator
is that relationships with downstream channel partners
will change. As these relationships evolve, suppliers
must change their channel pricing structures to
reflect the functions that channels perform.
Channel Consolidation and Globalization
Distribution channels are consolidating to take
advantage of economies of scale and to leverage
volume purchasing power. This consolidation enables
them to extract ever-increasing concessions from
their suppliers. Suppliers that are not armed with
an understanding of channel economics place themselves
at a disadvantage in these relationships. Channel
pricing programs, including discounts, rebates,
commissions, allowances, and special deals, are
very costly. Examples that illustrate these costs
include:
Channel pricing incentives do not have to be paid
in large percentages to motivate behavior.
Of course, the amount of the incentive depends upon
the volume that the percentage applies to. A 1%
incentive represents far more for a partner that
purchases $100,000,000 annually versus one that
buys $10,000 per year. In either case, however,
it is useful to remember that a typical distributor
or retailer generates 2% to 3% net profit before
tax. A 1% incentive, if it went to the channel partner’s
bottom line, could increase net profit by 50%.
Channel Pricing Structures for the 21st
Century
In channel pricing, the old status quo just does
not work any more. Suppliers that are locked into
historical volume-based structures simply do not
have the flexibility to respond to the dynamics
of the today’s economy. They lack the flexibility
to pay new or existing channel partners for the
functions that they perform and not for the functions
that they do not perform. They allow channel conflict
to erode their market position and fail to capitalize
on opportunities to motivate channel performance.
This chapter focuses on five channel pricing strategies—functional
discounts, activity-based pricing, results-based
programs, multi-price strategies, and resale price
setting. Each has a unique purpose and should be
employed to achieve specific objectives. While they
are distinct approaches, they are not mutually exclusive.
Some suppliers require different pricing strategies
for each market segment or even multiple strategies
for certain channels. While these strategies add
complexity, suppliers that do not invest in highly
developed programs will let inefficiencies, ineffectiveness,
and conflict erode their profits and market share.
While we use terminology such as discounts and
incentives, the actual payment mechanisms utilized
within channel pricing strategies can take many
forms. Channel pricing can take the form of discounts,
rebates, commissions, net pricing, or non-traditional
mechanisms such as value exchanges, fees, services,
or goods.
Functional Discounts
Functional discounts are emerging as an important
option for virtually all suppliers. Historically,
distributors, retailers, or other channel partners
would perform a fairly consistent “bundle”
of functions. The traditional distributor purchased
inventory, sold it, supported it, and managed credit
with the supplier and the customer. In the past,
distributors performed
all of these functions reasonably well. Today,
however, new entities in the supply chain perform
subsets of these functions far more efficiently
than traditional distributors. In many cases, a
third-party logistics provider can manage inventory,
a rep can provide sales support, a call center
can provide technical support, and a credit agency
can hold receivables at substantially lower costs
than traditional distributors.
When suppliers unbundle functions to utilize the
most efficient service providers, they must also
unbundle the compensation that they offer to their
channel partners. They must only pay channel partners
for the functions that they perform.
Under a functional discount structure, the supplier
breaks its traditional discount into discrete functional
components. For example, a manufacturer that formerly
offered a 50% discount could offer a base discount
of 25% and additional discounts of 10% for logistics,
5% for presale support, 5% for postsale support,
and 5% for credit and transaction processing.
While many distributors will continue to earn the
full 50%, those that only perform a subset of the
functions will earn reduced compensation. This type
of structure gives the supplier the flexibility
to hire a third party to perform any or all of the
functions.
Functional discounts can alleviate destructive
channel conflict. If customers utilize the sales
or support services of a high-support channel but
then purchase from a low-cost channel, the customer
takes a “free ride” on the high-support
channel. A functional discount levels the playing
field by limiting the ability of the low-cost channel
to undercut the price. Suppliers considering this
approach must determine whether their products require
high support. If they do not, there is no reason
to protect the high-cost channel.
Activity-Based Pricing
Activity-based pricing is similar to functional
discounting except it focuses on motivation rather
than compensation. Activity-based pricing assumes
that a channel partner is performing a set of functions
such as logistics, order processing, sales, or service.
Within the context of these functions, however,
channels can perform more or less effectively.
Prompt payment discounts are a classic example
of suppliers using channel pricing to motivate behavior.
With a prompt payment discount, the supplier’s
goal is to reduce its financing costs. Providing
an incentive quickens payment and lowers costs.
It is a win-win situation for the supplier and the
channel partner.
Progressive suppliers are moving beyond prompt
payment discounts and are using channel pricing
to motivate a wide array of value-added activities.
These activities generally fall into two categories—activities
that generate demand and those that reduce a supplier’s
retained costs. In consumer markets, for example,
suppliers use promotional allowances to motivate
retailers to generate demand through advertising,
display, and promotion. In business-to-business
markets, suppliers pay to motivate specification
work, lead follow-up, promotional frequency, and
technical support. From a cost savings standpoint,
suppliers use order quantity, EDI, prompt payment,
and other cost-to-serve incentives to motivate channels
to lower the supplier’s sales, order processing,
logistics, credit, and other costs.
Results-Based Programs
When designing programs to motivate channel behavior,
suppliers must determine whether to pay for activities
or results. Results-based programs provide rewards
to channels that grow, hit volume, market share,
loyalty, or other targets. Results-based programs
are attractive because they align with a supplier’s
objectives. For example, if a supplier is charged
with achieving 15% growth, it seems logical to pass
that incentive on to the channel and pay more to
those partners that attain those results.
There are important factors to consider before
passing results-based incentives on to channel partners.
A key consideration is the impact that the program
will have on overall channel compensation. A results-based
program can unwittingly result in lower margins
for distributors who then stop supporting the product
line. Results-based programs, if not structured
properly, can increase destructive channel conflict,
penalize a supplier’s best partners, and reduce
supply chain efficiency.
Multi-Price Strategies
Suppliers utilize multi-price strategies to manage
channel conflict. A multi-price strategy enables
a supplier to sell to one partner at multiple prices
under different circumstances. Two common approaches
are target rebates and registration programs.
Under a target rebate system, a supplier sells
to a partner at a relatively high price. This price
enables the partner to mark up and earn an adequate
return when selling to high-support customers. To
some customers, the partner sells below cost. The
supplier rebates the partner back to the selling
price. In addition, the supplier pays a commission
for the functions that the partner performs. This
structure eliminates the partner’s ability
to buy at a low price and undercut other partners
selling into higher-priced segments. This approach
is prevalent in healthcare, graphics arts, and certain
industrial markets.
A registration program protects channels that invest
in demand generating activities over a long sales
cycle. A partner that specifies a manufacturer’s
brand for a large job would earn a larger commission
on that job than partners that were not involved
in the up-front selling. Without this type of program,
channel partners would not invest in selling activities
because they know that they would be undercut on
price when it comes time to bid the job. This approach
is common in high tech markets.
Resale Price Setting
In an approach that is gaining popularity, suppliers
are dictating minimum resale prices to their channel
partners. This tactic eliminates destructive channel
pricing conflict. Under this approach, a high-support
channel does not have to worry about being undercut
by a low-cost reseller. Most manufacturers assume
that this runs afoul of trade laws. It does not
if the manufacturer carefully administers the program
through a unilateral pricing policy.
Minimum resale pricing is useful for high-share,
premium brand suppliers that require high support
from their distribution channels. Companies that
are utilizing minimum resale pricing policies include
Whirlpool and other high-end appliance manufacturers,
Michelin, Tumi, and Saturn. Suppliers without strong
brand positions should not use this approach, because
customers will simply turn to lower-priced alternative
brands.
Factors to Consider in the Development
of Effective Channel Pricing Structures
Each supplier’s channel pricing structure
must reflect its products, services, customers,
channels, and resources. What works for one supplier
will not necessarily work for another. Some suppliers
may drive business results by utilizing all of the
channel pricing strategies identified above. Others
may require a singular approach. In any event, it
is critical for suppliers to understand the dynamics
behind the market to design a program that delivers
results. The following analyses will better position
the supplier to understand channel dynamics, make
better channel pricing decisions, and develop more
effective solutions.
Objectives and Values
To design effective channel pricing structures,
start with your objectives. The program must reflect
the supplier’s overall sales and marketing
strategy. Is the objective to push new products
or services? reduce transaction costs? manage channel
conflict? Effective design can drive successful
business results in these and other areas. Dysfunctional
channel compensation programs can thwart sales and
marketing efforts or wreak havoc with operations.
Customer Segmentation
Identify the activities and functions required
to satisfy customer needs. Segment customers based
on their buying needs, purchase potential, and price
sensitivity. This step establishes the activities
that the supplier or its channels must perform.
It also establishes whether there are customer segments
that require unique channel pricing models.
Channel Capabilities and Objectives
Profile existing and alternative channels to determine
whether they have the capabilities to satisfy customer
requirements. Consider all channel options including
direct, distributors, e-commerce, logistics, and
other third-party providers. For each channel option,
determine whether functions such as sales, credit,
logistics, technical support, and order processing
can be separated or whether the channel must be
hired to perform a bundle of activities.
Revenue Opportunity
Discounts are based on costs as a percentage of
revenue. Consequently, it is necessary to identify
the supplier’s revenue potential through each
channel option. Start with the price that the end
user pays (street price). This price level sets
the amount of revenue that the supplier could generate
by selling direct.
The supplier’s revenue will depend upon channel
conflict and power. An evaluation of channel conflict
indicates whether partners will abandon the product
line as a result of excessive competition. An evaluation
of channel power considers whether the supplier
will lose sales if it does not sell through the
end users’ preferred channels.
The supplier must evaluate the revenue that its
own and competing offerings provide for the channel.
Suppliers can pay lower discounts if their product
outsells the competition.
Competitor Offerings
Determine the discounts and other forms of compensation
that competitors offer to channel partners. This
is a data point for the discounts that the supplier
may require. If the supplier has channel power,
it will be able to offer lower discounts than competitors.
If the supplier has little or no channel power,
it will have to offer discounts that are equal to
or higher than the competition.
Cost Analyses
Three cost analyses provide important information
for suppliers to develop optimal channel pricing
strategies.
