Strategic Channel Design

Erin Anderson • George S. Day • V. Kasturi Rangan

When choosing distribution channels^

companies need to rely on design

principles that are aligned with their

overall competitive strategy and

performance objectives.

Accelerating technological change, heightenedmarketplace demands, more aggressive globalcompetition, and shifts in the workforce and

population demographics are affecting distributionchannels, forcing companies to reconsider fundamen-tal assumptions about how they reach their markets.The magnitude of change demands a strategic per-spective that views channel decisions as choices from acontinually changing array of alternatives for achievingmarket coverage and competitive advantage — subject,of course, to the constraints of cost, investment, andflexibility. Tactical responses, based on maintainingpower balances, managing conflicts, and minimizingtransaction costs to pursue greater efficiency, will notsuffice.

Changes in distribution channels come slowly, part-ly because the inherent complexity of the many linksthat connect value-adding functions in a channel ob-scures the need for change. Distribution channels arealso dauntingly rigid and stable because of powerful,persistent inertia. Faint-hearted managers, unwilling todisrupt existing channels and incur predictable short-run costs for less certain gains from a new configura-tion or approach, may become discoursed, resultingin a growing mismatch between the firm's overall strat-egy and its means of distribution. Our main premise isthat the pressures for change are overcoming the inertiain distribution channels. Customary and comfortableincremental approaches cannot cope.

Frequently, a firms distribution method is an ap-

pendage to its strategy — the result of opportunistic,reactive, one-by-one decisions accumulated over timeand frozen by perceived barriers. Instead, the firm'soverall strategic direction must guide changes in chan-nels. Therefore, we propose a process for incorporatinga strategic perspective into decisions on the future con-figuration of channel functions, control of the func-tions, and resource commitments. This process requiresfirms to assess their current channels, identify alterna-tives based on creative combinations of value-addingchannel fiinctions, and evaluate the alternatives withina broad context that highlights potential competitiveadvantages.

First, we oudine some forces for change in distribu-tion channels. Next, we examine the implications ofthese changes for channels, including changing com-mitments, vertical compression, horizontal diversity,and the need to re-examine channel alliances. We alsosuggest how to design channels strategically.

Forces for Change

In the face of inertia, tradition, entrenched industrypractice, and a lack of alternatives, most firms stayedwith their established channels and seldom changedthe way they exercised control.' Three forces are nowchanging the customary rules of channel management:(1) proliferation of customers' needs, (2) shifts in thebalance of channel power, and (3) changing strategicpriorities. Channels have become dynamic webs, com-prising many direct and indirect ways to reach andserve customers.^

Proliferation of Customers' NeedsWhen markets are simple and stable, the appropriate

Erin Anderson is professor of marketing, INSEAD. George S, Day is the

Geoffrey T. Boisi Professor of Marketing, Wharton School, University of

Pennsylvania. V. Kasturi Rangan is the Eliot I Snider and Family

Professor of Business Administration, Harvard Business School

SLOAN MANAGEMENT REVIEW/SUMMER 1997 ANDERSON ET AL. 59

channel configuration is usually evident. Firms willdistribute directly when they want to closely controlselling, serving, and pricing or have only a few readilyidentifiable customers. When the market requires avariety of related goods in small quantities, companiesprefer to use intermediaries because of their widecoverage (due to economies of scope and scale), expe-rience, and specialized distribution in their industries.Theoretically, the higher the required investments inspecialized assets for servicing the end customer, themore appropriate are direct channels.' However, theseguidelines for channel configurations are obscuredwhen markets are fragmented into segments so diversethat many products are mass customized."* Three factorscontribute to mass customization and, hence, marketfragmentation:

Expanding capabilities for addressability and variety.Firms have greater ability to address individually eachcustomer or small subsegment of their market with acombination of database technology' and flexible man-ufecturing.' Now firms can engage in a direct dialoguewith their customers and appreciate the diversity oftheir needs.

Channel diversity. Increasingly, firms are shiftingfrom centralized batch production to localized, one-at-a-time production. Meanwhile, distributors, notjust manufacturers, are exploiting the generic capabil-ities for addressability and variety to automate manyfunctions, such as order receipt, shipping, inventorymanagement, and stock replenishment, so they canrespond to orders more rapidly and cheaply and cus-tomize products.' The net result is continuing turmoiland channel diversity.'

Customer expectations. Customers have become ac-customed to the benefits of customized products andgreater services, ready availability through their pre-ferred channel, and rapid order flilfillment.' Thus ctis-tomers increasingly demand improved performancethat is based on what they now know is possible.

In short, the new ability to address customers insmall groups encourages channel diversity. Address-ability and diversity together raise customer expecta-tions. And these expectations put further strain ondistribution channels.

Shifts in the Balance of Channel PowerFew businesses that reach their markets indirectly are

exempt from intermediaries' seemingly inexorablegains in power and control. In retailing, this is evidentin the growth of high-volume chain retailers (for ex-ample. Toys 'R' Us now controls 25 percent of the toymarket in the United States), the consolidation amongretailers that reduces the number of direct competitors,and the emergence of buying groups that permit smallstores (notably in hardware) to improve their buyingpower. There have been comparable gains by largemultilocation distribution firms at the expense of small,local distributors.'"

The increased concentration of channel structures hasadverse effects on suppliers' profitability. All the ele-ments underlying buyers' power in the Porter indtistry-forces model — enhanced bargaining power, moreknowledgeable buyers, and credible threats of back-ward integration — favor the intermediaries or endbuyers."

Enhanced bargaining power. When there are a fewcustomers making large-volume purchases, the suppli-ers' ability to withstand pressures for discounts, priceconcessions, and costly services erodes quickly. Thepressures mount when the retailers or distributors feceslim profit margins relative to the suppliers. For exam-ple, in the United States, grocery retailers with marginsof 1 to 2 percent are turning to manufacturers thathave margins of 10 to 15 percent to bargain for someof that value. They not only have become more effec-tive but also are designing their own merchandisingprograms and demanding supplier participation to un-derwrite these programs. They have also demandedthat suppliers cater to the differences in their storesand in customer profiles.

The net result of power shifts is not always evident.'Although many observers believe that manufacturershave lost ground to suppliers, analysis reveals that bothmanufacturers and retailers have lost power to theconsumer.

More knowledgeable buyers. A major determinant ofmarketing power has always been the agents' level ofknowledge." Big resellers enhance their relative powerby increasing their knowledge of: (1) their suppliers'costs — because they may be negotiating to buy pri-vate-label products from these same suppliers, (2) theirown operations — by taking advantage of transactionprocessing systems that can capture and interpret salesdata about each item and merge it with cost informa-

60 ANDERSON ET AL. SLOAN MANAGEMENT REVIEW/SUMMER 1997

tion, and (3) their customers' needs. For example,Merck purchased its pharmaceutical distributor,Medco Containment Services, Inc. In addition towider product distribution, Merck managementgained detailed information from Medco's databases,which link pharmacies, patients, physicians, third-party payers, and managed care organizations, that canguide research and help market new products."*

Credible threats of backward integration. Buyers andchannel intermediaries can fluther enhance their power

ncreasingly, companies arehanding off noncritical activities

or functions so they canconcentrate on enhancing their

competitive position.

by threatening to take over some of their suppliers' ac-tivities or displacing them with their own products.The supplier knows the profit consequences of reducedcapacity utilization and overhead coverage. Chain retail-ers' growth of private-label sales has forced the branded-goods makers to cut their prices, eliminate slow-mov-ing brands altogether, and sharply rationalize theirproduct lines." Meanwhile, the increase in chain dis-tributors' scale and scope permits them to take overmore of their suppliers' activities, thereby strengthen-ing their relationship with the end customer and creat-ing a disadvantage for the supplier.

Changing Strategic PrioritiesIncreasingly, companies are handing off noncriticalactivities or functions so they can concentrate on en-hancing their competitive position. In rationalizingorganizational and channel structures, firms are guid-ed by:1. An emphasis on understanding and responding tocustomers' real requirements in order to deliver supe-rior value. When activities do not relate to these out-comes, a firm sees them as superfluous.2. A willingness to cross artificial boundaries withinthe organization and challenge how all activities andprocesses that comprise value-adding processes, such

as order fulfillment, are linked.""' Can individual activi-ties be combined, eliminated, done in parallel, or re-ordered? Applying the same logic to distributionmeans that a firm must make rationalization decisionsat the individual channel function level — not at thehigher level of the channel institution.'^3. An effort to perform activities where they make themost sense. Any activity that is not pivotal to the strat-egy can be performed better by another organization."

Along with rationalizing their activities, firms are ex-ploring new relationships and alliances with customers,suppliers, and intermediaries. The resulting networksor value-adding partnerships are like confederations ofspecialists. They are flexible, specialized, and empha-size interfirm relationships, with a pooling of comple-mentary skills and resources to achieve shared goals."

The resulting openness to partnering is producingnew channel collaborations for the sharing of activitiessuch as order fulfillment, inventory management, dis-tribution, purchasing, and post-sales service. " The newlinkages require relationship management skills andcareful negotiations. Both participants must realizedurable mutual benefits in financial terms (through in-creased revenues or lower costs) or hard-to-quantifybenefits due to risk sharing or the pooling of expertiseand market knowledge. Such mutual benefits are in-creasingly feasible because of advances in informationtechnology that have sharply reduced the costs of co-ordinating and administering transactions betweenpartners.

Implications for Channels

We can interpret the three forces for change — in-creasing customer needs, shifts in the balance of power,and changing strategic priorities — more fundamen-tally from the vantage points of recent developments ineconomic and organizational theory. Most distributionchannels are subject to a combination of shifring pat-terns of commitment, vertical compression, horizontaldiversity, and functional decomposition.

Shifting Patterns of CommitmentFewer firms are committed to retaining their verticallyintegrated distribution systems. Instead, many firmshave dismanded or downsized their corporate distri-bution arms and outsourced the functions to third

SLOAN MANAGEMENT REVIEW/SUMMER 1997 ANDERSON ET AL. 61

parties. But, rather than shifting to conventionalarms-length transactions with traditional distributionintermediaries (e.g. full-line, Rill-function distributors),many firms are experimenting with new arrangements.

Some arrangements make relationships so close thata customer cannot see the seam between producer anddistributor. Because these arrangements involve sub-stantial, durable, and irreversible investments on bothsides, they resemble strategic alliances.'' At the sametime, other suppliers have numerous third-party ar-rangements, thereby diversifying their channels tomatch the diverse needs in their markets. ^ The resultis a complex collection of potentially overlapping out-lets, with the potential for channel rivalry and conflict.

Greater turbulence and the attendant uncertaintyerodes the inertial forces that hold firms to their estab-lished channel systems. Webster notes that the dramat-ic downsizing and personnel turnover that began inthe 1980s accelerates internal change, simply becausethe defenders of the status quo no longer hold theirold positions.^' When ties among key personnel break,organizational arrangements may change because newdecision makers have different opinions that are not"clouded by the continuity of experience."

Vertical Compression iIn traditional vertical channels, firms transferred re- ;sponsibility from one layer to the next, like passing thebaton in a relay race. Thus a manufacturer sends a ;truckload shipment to a wholesaler, which then breaksit up and sells to a dealer, which, in turn, stocks theproduct and persuades the customer to buy (see Figure1, option 1). If the product needs after-sales service, thecustomer takes it back to the dealer, which maintains jand repairs the product in the field. Even though theproduct may pass through several layers in the distribu- ition system, the customer relies solely on the dealer forthe fidfiUment of all channel functions, such as infor- 'mation, inventory, and repair. "* Others in the verticalsystem have a support role. In this case, the wholesalerprovides a wide assortment of products for the dealersselection, but customers fiilfill all their needs (assort-ment, lot sizes, information, and repair) through thedealer alone. Manufacturers can gain access to cus-tomers through alternate channel systems as well —directly or through representatives or one-step inter-mediaries such as distributors (options 2 and 3 in Fig-

Figure 1 Traditional Channel Options

Manufacturer

0Wholesaler

Dealer

@Own Salesforce or Reps Distributor

Customer

ure 1). But no matter the system used, the customerfulfills its channel function requirements mainly fromone source.

A small customer that buys through the dealerchannel might prefer to get technical information di-recdy from the manufacturer, but, because of the smalllot size of its purchases, it would have to get productinformation as part of the local dealers distributionsupport. The manufacturer would find it too costlyto contact and provide this information directly, andthe customer would find it costlier still to awaitproduct shipment from the factory. Even though thecustomer is not fully served by the manufacturerwith regard to "information," overall, it is still betterto get it from the dealer than not at all. (Of course,the dealer can also provide other relevant informa-tion about alternative products.)

Now, innovative IT, direct marketing, database mar-keting, and variations allow some manufacturers tocontact far-flung, small customers for only a fraction ofthe cost of a direct sales call. Computer-aided quick-shipment systems enable transporters to schedule anddispatch less-than-truckload orders with about thesame speed and efficiency as Rill loads. The small cus-tomer, therefore, may not suffer any inconvenience orproduct unavailability. Flexible mantifacturing systemsallow suppliers to produce small lots at only a marginal-ly higher cost than scale-efficient large orders.

The roles of the intermediary, the distributor, andthe dealer are all evolving. New forms of direct chan-nels are emerging, and indirect channels are gettingshorter with fewer intermediary layers. The role ofthe distributor as buffer between the manufacturerand the retail dealer is threatened in many markets.

62 ANDERSON ET AL. SLOAN MANAGEMENT REVIEW/SUMMER 1997

As channels compress, the role of the master dis-tributor or the wholesaler is most at risk (see Figure2). With quick-shipment distribution logistics, retail-ers no longer lose time in ordering directly from thesupplier. And, with the amount of information avail-able to the supplier, tracking and responding to retail-level orders is vastly more manageable. IT and quick-shipment logistics have greatly diminished the needfor dual inventories in the pipeline. In an intenselycompetitive environment, the extra margin saved atthe master-distributor level can become a price advan-tage at the customer level — or can fund efforts to dif-ferentiate the retailer's offering." For example, withmore than 300 stores selling about 40,000 SKUs(stock-keeping units), W W Grainger has forced a re-orientation in the electrical goods industry. Both theseller and the dealer see the master distributor as un-wanted fat in the system. Home Depot in the con-struction industry and Terminix and Orkin in thepest-control industry are flirther examples.

Ironically, in many industries, mantifacturers with-out the inventory-carrying capacity, the geographicreach, or the capability to fiilfill small orders set upmaster distributors as the essential conduit to retail dis-tribution. But retail dealers have become larger andmore sophisticated in handling both suppliers and cus-tomers. For small retail dealers, which still need extrasupport in product assortment or credit, master dis-tributors may be the only alternative. But only thosethat proactively use advances in information and logis-tics technology to their advantage and combine themwith excellent servicing of small orders will survive.

Those suppliers that have successfiolly tised a master-distributor channel in the past will find it hard to by-pass this level. Master distributors perform inventoryand credit functions and own the relationships withdealer accounts. Newer, more nimble competitors,however, may choose the cost-efFicient alternative ofeliminating the master distributor. Of course, the mas-ter distributor may make it difficult for an entrant togain coverage, but if the entrant succeeds, the supplierwith the master-distributor channel will lose revenue,share, and profits. Then the pressure to change will betremendous. However, the long-established suppliershave entrenched relationships with the master distribu-tors, and these channel partners will be willing to slicetheir margins or increase their channel efforts.

Figure 2 The Role of the Master Distributor

Supplier

Retail Distributor(e.g., Grainger,Home Depot)

Master Distributor

"""'"1"""-Dealer

Electrical ContractorDo-it-Yourself

Customers

Horizontal DiversityAll channels drift out of alignment with supplier andcustomer needs over time, eventually leading to con-flict, reevaluation, and change. Now these changesare occurring so swifdy that there is no time to deter-mine whether an initial channel design is effective.Eisenhardt and Zbaracki refer to such an environ-ment as "high velocity." *

How should a company manage in a high-velocityenvironment? New research in strategic decision mak-ing indicates that the traditional exhaustive and inclu-sive planning model doesn't work. Instead, moreeffective firms sacrifice thorough planning for experi-mental action by generating large numbers of optionsbut not thoroughly analyzing most of them. An ef-fective firm launches many small experiments or trials,carefiilly analyzes only a few options, and reacts quick-ly to feedback from the experiments. There is no timefor exhatistive forecasting and analysis, and it is diffi-cult to pin down means-ends relationships and fore-cast outcomes. Hence, organizations place many small"bets" and then enlarge those that seem to be mostfavorable. In distribution, this means experimentingwith many different ways of reaching the market(e.g., direct mail, telemarketing, and more traditionalresellers), often simultaneously.

Placing many small bets may seem indecisive andirrational, but it is now seen as the first step in arational strategy of holding options.^'' A strategicoption is a company's small investment in an opera-tion that creates the right but not the obligation totake flirther action. Options theorists argue that many

SLOAN MANAGEMENT REVIEW/SUMMER 1997 ANDERSON ET AL. 63

seemingly small or half-hearted organizational com-mitments will actually amount to a lot if the commit-ment keeps a company in the game or is a learningexperience. Because options buy time and knowl-edge, they are probes; although they may be costly,they prevent more expensive mistakes and indicatewhere to commit resources more heavily

When is it worthwhile to purchase options? Theo-rists argue that options are best suited for highly uncer-tain environments, where investors have difficulty de-termining an assets worth. Therefore, options becomethe best way to estimate the worth of a later, larger in-vestment. Options are valuable in high-growth indus-tries, in particular, because uncertainty su^ests oppor-tunity, which suggests making investments — butinitial investment decisions are difficult to make ratio-nally. Options are even more valuable when they cantbe imitated quickly or easily and provide lead timeover competitors.

Turbulent environments make it difficult to pre-dict what type of channel is appropriate. As productseventually assume accepted configurations, as seg-ments emerge, and as buyer behavior becomes pre-dictable, a firm that invested in the wrong channelconfiguration will discover that it has miscalculated.Hence, while firms may find themselves trapped inan inappropriate delivery system, the best they cando is to alter their channel systems incrementally toalign them with customer expectations.

Contrast this with the supplier who seeks channeldiversity by generating many options and thoroughlyevaluating a few. That is, the Firm does businessthrough many different distribution entities in manydifferent ways, thereby creating many openings andgleaning varied information. As the market clarifies,the manufacturer can judiciously sell some options(e.g., sell out a distribution joint venture or liquidatean equity position in a distributor), fail to exercisesome options (cease distributing through the channelentity), and call some options (invest in them moreheavily by purchasing equity, injecting resources, orcultivating commitment). Because channel relation-ships are very diffictilt for competitors to duplicate ormatch, these options have substantial value.• Multiple Channels. Multiple channels reflect therange of channel options available to buyers and sup-pliers. A buyer of personal computers, for example.

could buy the same model from a direct-mail cata-logue, a computer superstore, or a specialty store, eachfor a different price and service. Ideally, these differentservice levels refiect the needs of different buyers. Aconsumer who is price sensitive but very knowledge-able about product features and specifications wouldorder from a direct-mail catalogue. But the customerwho seeks a great deal of product information and ed-ucation might prefer a computer specialty store. Addi-

A environments stabilize,distribution arrangements

should become fewer,more substantial, and more stable,and reflect a coherent, articulated

channel strategy.

tionally, this customer would need the reassurance,hand-holding, and local service of the specialty store.

Unfortunately, consumers do not come neady seg-mented into such airtight compartments. There isconsiderable movement between segments and acrosspurchases. Moreover, with accelerating product life

: cycles, proliferation of products, and fragmentationof customer segments, multiple channel approaches

' are often the only way to provide market coverage.Different customers with different buying behaviorswill seek channels that best serve their needs.

But options are not a perfect solution. Customerscan infiltrate from the adjoining segments by patron-

i izing both the flill-service channel and the low-pricechannel (see Figure 3). As long as higher price fairlyrefiects higher service, customers will be loyal to a

' particular channel, but if the service is unnecessary or1 can be obtained at a lower cost, customers will cross

to the low-price channel. In some businesses, presalesservice is a public good that customers can avail them-selves of without making a purchase. For example, acustomer can get a full-flinction demonstration at acomputer specialty store and then buy the productfrom a low-cost mail-order retailer. The customer getsa free ride on the full-service channel.

In managing multiple channels, companies demar-

64 ANDERSON ET AL. SLOAN MANAGEMENT REVIEW/SUMMER 1997

cate products and models by channels, thus min-imizing direct comparison. The demarcations, ofcourse, work only when there are meaningflil dif-ferences among products. Sometimes, despiteproduct differences, competing channels canoffer similar problem-solving capabilities bypatching or bundling products appropriately, forexample, personal computers for workstations. Insuch cases, a company can render the patched so-lution uncompetitive in price. Other coordina-tion mechanisms, such as joint incentives or cus-tomer partitioning, work only when one channelmember is supplier-owned (e.g., has its ownsalesforce or captive distribution). The supplier-owned part of the channel can absorb the negative con-sequences of the mechanisms, if the systemwide restiltsare worth the cost. But such mechanisms rarely workwhen all the multiple members are independent.

Multiple channels are most prevalent in fast-changing market environments. When the product-market matures slowly, the channel has time to adaptto changes in customer-buying patterns. Even ifmultiple channels are necessary to refiect market plu-rality, each channel is clearly specialized to serve a spe-cific buying pattern. Crossovers are less common. Dis-count stores in the late 1970s and early 1980s wereclearly targeted to the value-conscious shopper, andthe service-conscious shopper continued to patronizethe specialty stores. The two channels ofi:en stocked,displayed, and sold different brands and attracted avery different clientele. This does not occur in themore dynamic industries. Computer models that startout in specialty stores end up with the catalog retailersin less than six months. Early buyers may not facechannel dissonance, but late-comers always do. Whilelater buyers may seek the service of a specialty outlet,the price of a discount outlet is too tempting to passup. Moreover, in dynamic environments, customers'shopping and buying behaviors, buying criteria, andsegments change frequendy.

In coping with turbulence, channel diversity pays,but only if the arrangements are treated as options.Further, they must decide what to do with options asthe market stabilizes. Bowman and Hurry point outthat a bundle of options allows a firm to perseverethrough hard times; their small investments can becarried while they serve their place-holding and learn-

Figure 3 Multiple Channels

Supplier

No-Frills/Low-Cost Channel Full-Service/Full-Cost Channel

Price-Sensitive

Customers

"• Customers Who Wear' Different Hats for Different

Purchase Occasions

• Service-• Sensitive• Customers

ing function until the market improves.'" A bundle ofoptions also allows a firm to move faster, as it recog-nizes and seizes opportunities. Failing to realize op-tion values means a firm is merely exploring; it doesnot develop ideas, realize opportunities, or develop adistinctive competence.-'Thus manufacturers shouldnot seek multiple coverage indefinitely. As environ-ments stabilize, distribution arrangements should be-come fewer, more substantial, and more stable, andrefiect a coherent, articulated channel strategy.

Functional Decomposition =Do high-velocity environments favor channel special-ists at the expense of generalists? Specialists have fewroutines and narrow operations; generalists do moreand cover more domains. For example, a value-addedreseller of computer systems that focuses on architec-tural firms is a specialist. A computer chain selling awide range of computer hardware and softM are forbusiness and personal use is a generalist because it re-sells many products to wholesale and retail buyers.

In a high-velocity environment, it is unclear whatto sell, how, and to whom. Specialists are probes ofpieces of the environment; promising pieces warrantholding a specialist option. Yet, in many ways, thegeneralist appears well suited to a high-velocity envi-ronment. Because it does some of everything, it canhedge. In the language of organizational ecology, ageneralist has slack or capacity that is not fully used,which can be redeployed.'" Hence, in this type ofenvironment, it is useful to have distribution optionswith both specialists and generalists.

What happens if and when the environment stabi-

SLOAN MANAGEMILNT RKVIEW/SUMMKR 1997 ANDERSON iiTAL. 65

lizes? Poptilation ecology theorists argue that the gener-alist, being a jack of many trades, becomes a master ofnone. Surrounded by swarms of varied specialists (acritical assumption), the generalist watches its marketbreak into pieces, many of which gravitate to a suitablespecialist. Many specialists, as well as the generalists, willprove unsuitable (Are architects an appropriate seg-ment? Is value-added reselling an appropriate func-tion?) and will exit. Population ecology does not predictwhich specialists wiU survive — only that the survivorstend to be specialists. When markets stabilize, most ofthose options with generalists and many of those withspecialists will be less appropriate in the newly stableenvironment. A firm with a portfolio of options will beable to focus on the most suitable channels.

A firm does better in uncertain environments bydealing through many specialists because specialiststend to be focused and, hence, more nimble than themanufacturer. Further, the specialists have valuablelocal knowledge about small market niches. Bucklinsuggests that when consumer demand is varied andcomplex, distribution channels will be varied as well."The manufacturer cannot acquire as much marketknowledge as many local entities can collectively. Itwill be overwhelmed by the task of integrating the in-formation and making a decision. Hence, it will bebetter to deal through many entities and let the mar-ket sort out which are appropriate.• Composite Channels. Organizational ecology theo-ry explains both greater diversity and the increase incomposite channels in which both the supplier and itschannel partners divide up the execution of the chan-nel functions. The supplier performs some fiinctionssuch as sales negotiation and order generation, whileits channel partners deliver physical distribution andorder fulfillment. Other channel members might spe-cialize in functions such as after-sales service. Themembers work together with certain members special-izing in certain functions (see Figure 4). The differ-ence between composite and conventional channels isthe horizontal task allocation. A team of channel part-ners (including the supplier), each specializing in a fewtasks, satisfies the customer's total needs. In the con-ventional channel, the hand-offs are vertical; eachmember performs the fiill channel fiinctions that itsimmediate customers require.

As we suggested earlier, the trend toward functional

Figure 4 Composite Channels

Supplier

DemandGeneration

PhysicalDistribution

After-SalesService

OwnSalesforce

OutsideDistributor

Inside or OutsideService Specialists

Customer

specialization (and therefore horizontal channels) isdriven by customers' desires to receive products andservices in the most cost- and time-efficient manner.If channel functions have to be unbundled andsourced separately, customers, especially large ones,will be willing to do so.

In the health care industry, there are many suchcomposites. For example, Becton-Dickinson's Vacu-tainer Systems division negotiates directly with alllarge hospital buying groups for its blood-collectionneedles, syringes, and accessories.' When the deal isfinalized, Becton-Dickinson signs a contract with thegroup and provides a list of authorized distributors.Becton-Dickinson's distributors effect the physical dis-tribution — ordering, storing, and supplying prod-ucts to the appropriate hospital at the desired time inrequired lots. It can do this cost efficiendy, given theplethora of other products it already supplies the hos-pitals, so order entry and fulfillment costs are incre-mental. At the same time, the cost containment in thehealth care industry makes it attractive for buyers tonegotiate directly on high-volume/high-value orders.The competitive environment gives suppliers bettercontrol on sales, profits, and market shares as well.

The computer industry also has a rich variety ofcomposite channels. Value-added resellers (VARs) areable to tailor solutions for customers in niche markets(banking, retailing, CAD-CAM, etc.) While VARsprovide the specific knowledge on the software, theywork closely with computer vendors for hardwareequipment and system configuration. Ctistomers needthe hardware and sofiware to be integrated in order to

66 ANDERSON ET AL. SLOAN MANAGEMENT REVIEW/SUMMER 1997

address their problems, but the channel expertise issuch that it takes two members to find a perfect so-lution.

With new channel forms come new managementchallenges; the biggest is channel compensation.Because the channel member dealing with the cus-tomer no longer performs all channel functions, itcannot expect to receive a traditional margin or com-mission. Ideally, channel members under the newsystem are compensated only for the functions theyperform. But herein lies a catch. All members in thehybrid system must adequately perform their fiinc-tional responsibilities for the final sale to occur. If onemember fails, the whole team suffers, unless anotherteam member fills in. Free riders can abuse their posi-tion by cutting corners in their responsibilities, andthe most valuable player ofben has to bear the cost. Inthe traditional vertical system, poor performance cor-

Because the channel memberdealing with the customer nolonger performs all channel

functions, it cannot expect to receivea traditional margin or commission.

related direcdy with lower sales and therefore lowermargins.

Composite channels are costly to monitor and ad-minister and seem to work only in environmentsthat can afford high channel margins. In low-marginindustries, composite channels seem to work onlyfor market leaders. Such suppliers usually use theirmarket clout to infiuence their hybrid channel part-ners. Free-riding, for instance, is punishable by lossof orders. A leading industrial supply company, forexample, calls on many of its accounts directly butroutes all orders through its distribution network —a classic composite system. It will not choose a free-riding distributor, however. The company has multi-ple distributors in the same market area. Those notplaying by the rules are not mentioned warmlyby the salesforce when the order is written. The-oretically, the ctistomer cotild still buy from the free-

rider but will rarely do so because of the infiuence ofthe direct sales channel.

Unfortunately, for weaker suppliers, the coordina-tion costs of the composite channel often exceed thebenefits of its functional effectiveness. Such firmsthen trade off effectiveness for the simplicity andfunctional aggregation of the vertical arrangement.They may have to rely on full-function distributorsto compete with the specialized composite channelsof the market leaders.

Designing the Channel Strategy

The channel design process is similar to the steps fol-lowed in developing a competitive strategy.'' The dif-ference is that the channel supports the overall strategy:its prime requirement is to enhance effective deliveryof the customer value proposition. In this stipportrole, the channel must meet the requirements of:1. Effectiveness — How closely does the channel de-sign address customers' stated and tinstated require-

ments:2. Coverage — Can the customer find and appreciatethe value in a firm's offering?3. Cost-efficiency — Can the company justify a trade-off in cost-efficiency to gain greater strategic effective-ness and coverage because of the mtiltiplier effect thatdistribution has on increasing the impact of the othermarketing variables?4. Long-run adaptability — Can the channel designhandle possible new products and services and incor-porate emergent channel forms?

Assessing the Company^s SituationThe first step in channel design is to identify the threats,opportunities, strengths, and weaknesses that will in-fluence channel performance and viability. A companyshotild analyze competitor's shares of existing channels,the relative profitability of each channel, coverage ofthe market served, and the cost of each channel fiinc-tion. A company must consider likely changes in buy-ing patterns, potential competitive entrants, long-runcost pressures, and new technologies such as the Inter-net or mtiltimedia retail kiosks.

A company should assess what customers are seek-ing from channels by asking:'''• What service attributes do the target customers value?

SLOAN MANAGEMENT REVIEW/SUMMER 1997 ANDERSON ET AL. 67

• How can we use the differences in preferences to seg-ment customers with similar needs?• How well do the available channels meet the needsof the segments?

Selecting AlternativesWhen a firm is confronted with myriad possibilities,how should it choose a channel arrangement? It shouldrely on strategic design principles, subject to the con-straints of prior strategic commitments, resotirce avail-ability, and rigidities. The principles are consistent withour theoretical analyses, while recognizing that thechannel strategy mtist contribute to the business's over-all performance objectives.

1. Align channels with the overall competitive strategy, by:• Designing channels from the market back, so thechannel activities meet the anticipated requirementsof the target market.• Creating barriers to competitive response. To do so,the firm may have to pay the price of locking itselfinto an internal operation or into close ties with selectedchannel parmers, which usually obliges the parmer tolock in a chosen supplier and lock out competing sup-pliers.• Enhancing the delivery of superior customer value.The choice of a channel is also dictated by whether afirm elects to compete on operating excellence (e.g.,by emphasizing reliability and competitive pricing ofstandard products and services), customer responsive-ness (through some variant of mass customization orbusiness partitioning), or superior performance. Eachstrategic thrtist reflects the choice of a specific targetsegment, with distinct requirements and needs.2. Decompose and recompose channels into integratedcollections of fiinctions. Channel fiinctions are the basicbuilding blocks of the design process. While fiinctionscannot be eliminated, they can be combined creativelyto reduce cost and to improve responsiveness and bedispersed among several different players. It is essentialto take advantage of advancing IT capabilities to im-prove system coordination.3. Invest in learning. Firms in high-velocity environ-ments, where means-ends relationships are uncertain,shotild create a portfolio of options for coping withinevitable uncertainty. These options enable a firm toexplore channel design by trial and error. Some experi-ments will fail. However, the costs incurred — even

when there is a failtire — should not be viewed as loss-es but as investments in learning how to tinderstandand gain access to the market. As the market stabilizes,the firm shotild choose particular channels rather thancontinue to experiment.4. Translate strategic choices into programs, projects,and near-term plans and establish controls for monitor-ing channel performance. These controls define the in-formation collected, standards for performance, andways to quickly and graphically compare expectationswith results. Without this information, there is nobasis for learning, correcting mistakes, and adjustingassumptions to better fit reality. Thus the end of thisstep signals the beginning of another cycle in the de-sign process.

Conclusion

Many firms see distribution as peripheral to their com-petitive strategy. Increasingly, they have recognized thatbenign neglect is risky and wastes opportunities forcompetitive advantage. Under pressure from powerfulmarket trends and technological changes, they are vig-orously scrutinizing past practices, commitments, andrelationships.

How should firms deal with external forces thatdisrupt once-stable patterns of channel commitment,compress vertical systems, proliferate horizontalalternatives, while decomposing channels into distinctfunctions that are reassembling into new patterns? Achannel design process that follows sound design prin-ciples is needed to identify and select among the myri-

! ad of channel alternatives. Ultimately, a channel strate-gy is a series of trade-offs and compromises that align

' the company's resotirces with what it should do to satis-! fy its target customers and stay ahead of competitors. •

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