With annual online business-to-business transactions totaling hundreds of billions of dollars—and growing—value-added resellers question whether they can be profitable selling competitively to end users.

Indeed, pure play Internet resellers that outsource inventory, fulfillment and support can set their prices at less than 3% over cost, which is well below the margins required by traditional channel partners.

Further compounding the problem is that search engines, such as Google, make it easy for consumers to find the lowest price on a product, either through online comparison shopping sites or simply plugging in the name and model number of the desired product.

Because low-cost resellers often undercut the prices charged by value-added resellers, in a two-step system, suppliers now offer rebates which distributors pass through to the value-added reseller, to ensure they can sell competitively to end users at a reasonable margin.

While it is difficult for suppliers to require resellers to sell their product at a specific price, they can manage their discounts and “pass-through rebates” to distributors. Doing so ensures that after the low-cost reseller has added their margin, the price to the end user will be at or near the desired street price. The same rule goes for suppliers that sell directly to Internet resellers. Once consistent street level pricing has been achieved, value-added resellers can support their prices to end users because of the higher level of service and value they provide.

Determining an appropriate street level price requires a substantial amount of due diligence by the supplier. First, suppliers need to determine the target prices end users are willing to pay in a competitive market. This can be tricky, because a supplier not only has to evaluate the value of their brand, but whether the product in question can command a premium price or is more of a commodity.

While answering these questions require suppliers to conduct a competitive pricing and margin analysis, finding those answers becomes more difficult in a two-tier distribution channel where the distributor buys directly from the supplier and then sells to resellers.

Suppliers selling high value products to distributors supplying both low-cost and value-added resellers should consider raising the distributors’ price to a level so that after the low-cost reseller adds their margin, the price to the end users it is at or near the target street price. Failing to do so makes it possible for low-cost resellers to effectively sell to end-users at slightly above the wholesale price, a practice which can erode value-added resellers’ margins. Margin erosion can prompt channel partners to no longer support the supplier’s brand.

Some of the criteria to determine margin differentials across channels are whether local inventory is needed to sell the product, whether a sales representative is needed to sell the product and if technical support is a must after each sale.

If the answers to these questions are yes, then suppliers need to price high to distributors with a structure that compensates value-added resellers separately. This strategy is intended to protect value-added resellers that invest the time to educate prospective end users about the product and their services from having them opt to do business with a low-cost reseller after a quick Internet search.

If the product in question is a commodity then suppliers need to maintain more of a level playing field. By standing pat on price for a commodity, suppliers are effectively leaving the value-added reseller to fight it out on price with the low-cost reseller, because there is little to no value they can add to the product. This strategy is intended to allow the end user to get the benefit of the lowest price.

Raising prices so that low-cost resellers price their product at the street price can eliminate the need for minimum advertised price programs, which are complex, expensive to administer, and tough to enforce.

While a minimum advertised price, which is an agreement between suppliers and retailers stipulating the lowest price at which an item can be advertised, can prevent brand degradation and protect reseller margins, resellers can skirt the agreement by marketing the price as too low to advertise. Online resellers can also skirt the agreement by not showing the price of the item until it is placed in the shopping cart.

Loopholes that allow low-cost resellers to skirt the minimum advertised price can hurt a supplier’s relationships with value-added resellers. That can be costly to the supplier if their product requires one-to-one selling and high touch support and service. It is better then for suppliers to adjust their pricing to distributors and use minimum advertised price programs to supplement other pricing strategies as needed.

Channel Pricing Associates helps suppliers work through the process of gathering all the information necessary to arrive at an optimal street price for their product and that balances their profit and growth objectives with those of their distributors and channel partners.

For more information, contact Channel Pricing Associates at 847-681-0143 or shapiro@channelpricing.com.

Sometimes, suppliers get caught up in thinking that channel compensation consists solely of their back end rebate programs and market development funds (MDF). These programs have a high level of visibility since they show up clearly as line items on the supplier’s income statement. To really understand a channel’s overall compensation, a supplier needs to consider the front end margin that the channel earns in addition to the back end programs.

Take for example, a supplier with sales of $100 million. It is typical for suppliers across industries to provide back end rebates in the range of 3% to 5%. Of course, in some industries rebates can reach levels of 20% or higher. In addition, there are often market development funds or coop advertising programs that cost an additional 1%. At first blush, in our example, backend channel compensation for our supplier costs approximately $5 million on $100 million in sales.

If the channel adds a 20% front end margin to the supplier’s $100 million in sales, total channel sales are $125 million. When we add the $25 million in front end margin to the $5 million in back end programs, this supplier allows its channel partners to earn a total of $30 million on $100 million of its own sales. With the exception of special programs such as financing, fees or other less common approaches, this is a good baseline for determining whether a supplier is over or under compensating a channel.

What Motivates Channel Behavior?

Before we launch a discussion into the appropriate amount of compensation, we need to understand the role of compensation and its influence on channel behavior. This requires that we investigate factors that drive channel behavior.

Compensation is only one factor that drives channel behavior. A supplier could offer a distributor huge discounts and massive rebates with no impact at all on behavior. Without understanding what drives the channel’s behavior, the supplier is at risk of overpaying or underpaying the channel. Key factors, listed in order of importance, include:

• Customer Need – a reseller will source what its customers require. This gets to the heart of the channel’s role. Most channel partners are not out developing new applications. As a supplier, it is likely that you are wasting your resources if you are paying your channel to create need where none exists.
• Customer Demand – many suppliers have their own sales force or sales tools to generate demand that is then fulfilled by the channel. The best way to ensure that a channel partner supports your brand is to go out and sell it for them. A brutally honest distributor manager recently summed it up this way when he said to our client: “Why should we bring in your line if you’re not going to sell it for us!”
• Product and Service Business Model – product margins may be irrelevant to a channel that operates primarily a service business. The importance of a line to the channel’s business is a significant factor in determining how much compensation it will take to motivate behavior.
• Customer Preference – this is similar to Customer Demand however in this case, the customer is not pre-sold but indicates a brand preference. Dealers sell brands that their customers request. If a customer asks for Brand A, all things being equal, the distributor will sell brand A due to the switching costs.
• Inventory investment – distributors sell what they stock. It’s an old school axiom that a “loaded distributor is a loyal distributor.” Suppliers must carefully consider whether to drive inventory onto the shelf. Doing so increases the likelihood of sale as distributors seek to turn their inventory. Excessive loading, however, increases supply chain costs both for the channel and the supplier and erodes margins through forward buying.
• Relationships- these play an important role in determining the brands that a channel will support. A distributor may simply like to work with a friendly sales rep. A supplier may have good or strained relationships with its channel partners. It often comes down to a matter of trust. Suppliers can pay less if they maintain good and trusting relationships with their channel partners. In some cases, no amount of channel compensation will overcome a poor supplier-channel relationship.
• Price – channels go for the sure sale because their sales force compensation plans usually include large variable components. Most channel sales reps do not present a higher priced option if it puts them at risk of losing the sale. When designing a channel compensation system, it is necessary to determine whether the system must compensate for an offering that is priced too high or can reflect an offering that is priced too low.

Each supplier must clearly understand its own position relative to these factors. Only then can the supplier develop a channel compensation system that pays the right amount and drives appropriate behavior.

Four Key Questions

There are four key questions that suppliers should ask as they develop their channel compensation programs:

• Whom to pay?
• How much to pay?
• What to pay for?
• How to structure the pay?

Who To Pay?

Not all channel partners are created equal. Suppliers must determine whether to do business with many or a select few partners. In addition, the supplier must determine whether to do business with all types or just certain channels. For example, in construction products, should all suppliers do business with big box retail and specialty distribution? These questions are at the heart of a supplier’s channel strategy. A good first step in the development of a channel compensation program is to determine the right number and type of channel partners.

The number and type of partners that a supplier goes to market with impacts the amount of channel conflict in the system. Conflict has a direct impact on channel behavior since it impacts channel margins. As we’ve noted previously, channel sales representatives are compensated based on the margins that they return. A reduction in margin due to excessive channel conflict will erode selling effort by the channel. Other factors that impact levels of channel conflict include:

• Demand for the brand—channel partners will sell what customers ask for and therefore strong brands generate higher levels of conflict.
• Distribution costs—products with low freight costs are easier to ship across geographical boundaries and therefore can generate higher levels of conflict
• The Channel’s Business Model—some resellers apply low product margins in order to accelerate high profit service sales

When utilized effectively, compensation is an effective tool for managing channel conflict. Channel compensation manages conflict by paying partners that add value on behalf of a line and not paying partners that add little or no value. Compensation must be structured carefully as the wrong type can actually make channel conflict worse. This can be the case as when, for example, a supplier with a leading market share causes channel stuffing by using order quantity discounts.

Suppliers must coordinate their channel strategy and compensation. A supplier with too many or the wrong type of partners may end up using extra discounts and rebates to manage its own conflict. This is an expensive way to manage conflict and is a sure way to erode profitability.

How Much To Pay?

Suppliers continually question the discounts, rebates and allowances that they provide to their channel partners. “We must be paying that distributor too much—Look at that brand new Lexus!” Are the discounts too deep? Can or should we cut rebates? What will happen if we raise price?

An important first step in determining how much to pay a channel is to identify the “Target Street Price” (TSP). This is the price that a supplier needs in order to win or maintain the business with the end user. The TSP is based on the value of the supplier’s offering relative to competition. This is also the price that should be the starting point for channel discounts, rebates and other forms of compensation.

Once the Target Street Price is identified, the supplier can examine the following factors in order to determine appropriate compensation levels:

• Competition—a good starting point is the compensation programs that your competitors offer to the channel. Do not copy competitor programs however find out how much they pay.
• Market Power—a supplier with a strong brand can pay less for the same performance as a supplier with a weaker brand. To understand this, consider the discussion above as to why resellers or other channels sell what they do.
• Cost of Performance—we need to determine what we expect our channel partners to do in exchange for the compensation that they earn. If it costs a distributor 25% to sell to small customers, we will have a hard time motivating them with 15%. Cost however, is not the total picture. A supplier with a very strong brand can motivate the distributor to perform distribution functions while paying less than the cost of those functions. In this case, weaker brands end up subsidizing the channel’s cost. This is one of the key benefits of a strong brand.
• Switching Costs—channel partners often make large investments in a supplier’s line. These investments include physical inventory and years of accumulated support for a line. Suppliers should understand their channels’ switching costs in order to determine the amount of channel compensation to pay.
• Value—a supplier may value certain behaviors by its channel partners and pay for that behavior. For example, a supplier may target a certain vertical market and provide deeper discounts or bigger rebates on sale into that space.

What To Pay For?

A discount off of list price carries an expectation that a channel will perform certain functions in exchange for that discount. Typically, when a supplier provides a discount to a distributor, it expects that the distributor will sell, inventory, market and support the supplier’s line. There are cases, however, when a supplier does not need its distributors to perform all of these functions. If a supplier has a direct sales force that generates demand in the market and fulfills through distribution, the supplier does not need to pay the channel for the selling function. Likewise, a supplier does not need to compensate a distributor for carrying inventory when most sales are drop-shipped.

A supplier may choose to drive channel behavior with compensation. Channel partners are motivated by margin. Watch the increase in days outstanding when you change payment terms from 2% 10 days to Net 30. Compensation can influence the way channels buy, inventory, sell or support products or services. Typically, incentives built into a channel compensation system range from 0.5% to 3% for each activity. These incentives are often stacked so that programs can place as much as 5% to 15% or more at risk. These programs motivate channel behavior and create separation across channel members to manage conflict.

There are two places to look when considering what behaviors to motivate with a channel compensation system. The first place is to determine what end customers value. If, for example, end users value local inventory, then a supplier can pay its channel partners to stock inventory in the field. A second place to look is at the supplier’s own values. A supplier may value that its channel partners provide point-of-sale information or sell into selected vertical markets and pay for those behaviors.

Each value in the channel compensation system should be weighed against re-deployment of those resources. For example, is 1% in market development funds a better investment than using that 1% to hire more sales representatives? Suppliers need to identify their own values and then determine whether channel compensation is the most cost effective way to drive results.

How To Structure The Pay?

The last question is how to structure a channel compensation program to include the right mix of discounts, rebates and allowances in the right order. This is the part of the process that offers the highest potential for creativity and differentiation.

Since a key goal of the system is to motivate channel behavior, an effective channel compensation system matches the form of payment with the structure of the channel. Each form of channel compensation has a unique impact on different channel types and levels within a channel.

In order to determine the optimal compensation structure, it is necessary to identify degrees of influence in the channel. There are two key groups within the channel that are involved—management and sales. Management usually prefers incremental rebates over discounts since they can be hidden from the sales force, used to fund pet programs and pad profitability. When the supplier provides rebates however, it typically keeps prices higher or reduces discounts in order to cover the rebate cost.

How channels account for rebates is another important consideration relative to program structure. Rebates do not always make it to their intended target. Rebates issued to the channel at the corporate level may not make it to the branch. Even if distributors allocate rebates to individual branches, they may be lumped in with those from other suppliers and lose their impact.

Suppliers must also consider how channel partners deploy different types of channel compensation. Distributors can use rebates like cash. They can choose to invest this money in the supplier’s brand or conversely use it to support competing lines. Many channel partners simply choose to take rebate dollars out of the business. In contrast to discounts or rebates, marketing allowances or funds can be utilized to pay for specific activities that require an investment by the channel partner on the supplier’s behalf. Each of these factors should be considered in order to structure an optimal channel compensation system.

Summary

We understand that there are many factors that contribute to the development of an optimal channel compensation system. We often find that many suppliers simply tweak their current programs of play “follow the leader” due to the complexity of these factors. By carefully considering these key questions:

• Who to pay?
• How much to pay?
• What to pay for?
• How to structure the pay

Suppliers can fundamentally alter the playing field in ways that significantly accelerate their profit and growth.

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:

• Rebates average 15% to 25% in certain industrial markets
• Distributor discounts of 90% off list price in segments of the building material industry
• Promotional funds average 12% of sales for consumer packaged goods manufacturers

Most suppliers do not realize that after making the product, their highest cost of doing business is the discount that they pay to their distributors. Suppliers must consider the cost of these discounts in the context of their ability to sell direct. If the supplier sold direct, it would sell at the street price rather than at the net price to the channel. The distributor’s margin represents the cost that manufacturers incur by, in effect, outsourcing distribution to distributors.

Globalization intensifies the challenge. Suppliers must offer pricing structures that are coherent across geographical boundaries, trading blocs, and currencies. Suppliers that do not address these issues will suffer embarrassment and reduced profits as customers and channel partners exploit irrational channel pricing inconsistencies.

The Need to Manage Conflict among Channels with Different Value Propositions

Suppliers across industries go to market through a variety of channels including:

• Wholesalers
• Direct-buying retailers
• Dealers
• Distributors
• Catalogs
• Brokers
• Integrated suppliers
• Systems integrators
• Value-added resellers
• Consultants
• Online marketplaces
• Third-party logistics providers
• Agents
• Others

Each channel has a unique value proposition and role within the supplier’s go-to-market strategy. Each applies its margin or cost structure to most effectively serve the customer.

Suppliers must understand what they are dealing with when they experience channel conflict. There are cases where a low-cost channel has simply found a more efficient way to perform distribution functions than a higher-cost channel. If this is the case, it may be necessary for the supplier to simply allow channel Darwinism to occur.

Some partners, however, require high cost structures to take care of demanding customer segments, support technical offerings, or perform a bundle of value-added activities. A common type of channel conflict occurs when high-support channels educate customers who ultimately buy from low-cost, low-support channels. A pricing structure that pays high-support channels when their value-added services are required is an effective tool to enable a supplier to achieve its marketing objectives. A pricing structure that ignores the free rider effect or exacerbates destructive conflict will cause the supplier to lose the support of its value-added channels.

The Ability to Influence Behavior through Effective Channel Pricing Strategies

Channel partners, like most organizations or individuals, respond to financial incentives. Channel pricing motivates partners just as sales force compensation motivates the behavior of a supplier’s sales force. Executive compensation is tied to performance—suppliers should also tie channel pricing to performance in accordance with business objectives.

Channel pricing can have a dramatic impact on behavior. For example:

• After years of trying to convince resellers to place orders electronically, a 0.5% discount more than tripled a supplier’s EDI orders in the first year
• For a leading supplier of technical products, a 1% discount resulted in over 1,000 trained channel salespeople in less than four months
• A 2% discount increased a supplier’s average order size by 32%
• A 1% discount increased distributor promotional activity by 15%
• By leveraging volumes across product categories, a manufacturer was able to triple truckload orders and close eight of its 14 distribution centers

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.

• Direct costs—identify costs, as a percentage of revenue at street price, which the supplier would incur by selling to or providing functions directly to end users. The supplier should be willing to offer a discount that is equal to or less than the supplier’s own costs to serve the end user. If the supplier knows, for example, that it could sell direct through its own Web site or sales force for a cost of 20%, the supplier should not pay its channel partners a 25% discount off of street price
• Indirect costs—profile the channels’ costs to perform functions required by the supplier to satisfy end users. If the supplier utilizes distribution channels, the compensation or discount to the channel should not exceed the channel’s costs and a reasonable profit
• Suppliers can reduce the discounts that they offer to channel partners by under­standing the costs that those partners incur when they sell the manufacturer’s line. If the supplier knows that it costs the channel 20% to sell the product, the supplier should not pay the channel a 30% discount off of street price.
• Retained costs—assess the supplier’s retained costs under each channel option. This assessment will help the supplier determine channel profitability and investment. >From a pricing standpoint, this analysis establishes the baseline for pricing incentives such as volume, prompt payment, efficient ordering, and other discounts that lower these retained costs

Summary

In today’s economy, it is more important than ever before to get channel pricing right. It used to be that channel pricing simply consisted of volume discounts to one or two distribution channels. Today, the situation is far more complex. Many channels compete with each other and have different cost structures and value propositions. They are bigger, more powerful, and global. With e-commerce and advances in logistics, suppliers have new options to unbundle the functions that their distribution channels historically performed.

Sometimes suppliers should develop structures that differentiate them from their competition. In other cases, market leaders must drive entire industries to change. Under traditional pricing approaches, suppliers let fear and competition transfer profitability downstream. This profit transfer deteriorates the industry’s ability to invest in new products and services and ultimately harms the customer. To break out of this box, market leaders must introduce rational channel pricing strategies that transfer profits back upstream.

These challenges require that suppliers develop new channel pricing structures that provide flexibility to utilize channels strategically. New approaches pay for functions that channels perform and do not pay for functions that channels do not perform. They motivate partners to generate demand and lower supply chain costs. They pay for performance and results and do not drive inefficiencies. They are rational across channel partners, products, and geographical boundaries. Optimal channel pricing strategies are based on an in-depth understanding of costs, channel power, and conflict. This enables suppliers to respond strategically to partners that demand deeper discounts and to determine when it is best to follow the competition and when it is best to lead.

What is causing this upswing in the use of loyalty programs?

There are a number of factors causing manufacturers to increasingly use loyalty incentives to motivate their channel partners. These include:

• Industry consolidation – As manufacturers acquire additional brands, they use loyalty incentives to leverage their position. Often, they use strong core brands to leverage their sales of weaker brands or product lines
• New technologies – As new technologies emerge, previously dominant suppliers provide loyalty incentives to slow the acceptance of competitive market entrants.
• Import manufacturing – most product categories are under attack from low priced import lines. While priced lower, imported brands may not offer as consistent a source of supply over a broad range of SKUs as the domestic brand. Domestic suppliers use loyalty incentives to discourage cherry-picking
• Evolving channel roles – It used to be that a distributor would “go to bat” for a manufacturer. Increasingly, they are fulfillment channels that provide whatever brands the customer requests. Manufacturers use loyalty incentives to create a reason for the reseller to remain focused
• The Inefficiency of volume incentives – Historically, manufacturers used volume rebates, order quantity discounts or end of quarter deals to motivate channel partners. The old school philosophy was that a “loaded distributor was a loyal distributor.” While volume deals drive short term sales, over the long haul, they do more harm than good. They create false demand, lead to order spikes, stock outages and lower margins for suppliers and their channel partners. Loyalty incentives can provide the focus that suppliers desire without the negative behavior

Should you use a loyalty incentive?

First of all, unless you are a monopolist, if you can demand exclusivity, you should. If you have the clout, you should dictate that if your reseller takes on a competing line they will lose your line. Some suppliers have used this approach for years and should continue to do so. Others need to back off of this no “sharing of-the-shelf policy” and use a loyalty incentive to create the economic conditions that will motivate the channel partner to make the right decisions. In today’s marketplace, it is becoming increasingly unrealistic to expect that resellers will support only your brand exclusively.

You should strongly consider a channel loyalty incentive if you are a high share player in your industry and your product category is strategic to your channel. If you are a weak or new player in a market, don’t even consider a loyalty incentive it – you have nothing to leverage. You are going to have to win the old fashioned way.

You should consider a loyalty incentive when you launch a new technology or have a hot new product. Even though your new offering can “earn” loyalty at first, setting the expectation up front will help later when additional entrants join the market. Often, companies rely solely on their patent protection to defend their position only to scramble when their sales, shares and profits plunge once protection ends. By employing a loyalty incentive when they are “the only game in town,” a company can add an extra barrier to keep competitors out.

Types of Loyalty Incentives

There are many ways to structure a channel loyalty incentive. Suppliers must closely evaluate their channels and competitive situation to determine the optimal approach. Some of the most commonly used options include:

• Exclusivity – Easily measured – if the reseller carries competing brands they don’t earn the incentive. Generally used by high share suppliers trying to thwart new entrants.
• Full line – The reseller must support a supplier’s complete product portfolio to earn the incentive. Used by manufacturers to encourage resellers to add a new brand or product line by providing an incentive on the overall portfolio.
• Lead line –Requires that the reseller carry the supplier as the lead line in a category. Lead line may be the majority of the reseller’s business or the number one brand if the reseller carries multiple lines within a category. A lead line program can be combined with a full line incentive. This combination requires that the reseller carry the manufacturer’s brand as the lead line in each product category that the reseller participates.
• Share of account – The higher the supplier’s share of the reseller’s business, the higher the loyalty payment. This can be difficult to measure as resellers typically will not share the amount of business that they do with competing suppliers.
• Situation-specific – A supplier sees its reseller offering a competing brand on a bid or to a major account when the supplier’s brand would have been acceptable from a price and feature standpoint. After one or more occurrences of this type, the reseller loses the loyalty incentive. A “three-strikes-and-your-out” approach gives the reseller an opportunity to change the destructive behavior
• Frequent-buyer programs –We typically think of airline frequent flier programs. These programs measure loyalty based on usage or “volume.” Many suppliers use volume programs with their channel partners that emulate a frequent buyer approach. The more you buy, the better the deal.

How do you measure loyalty?

The first question that people invariably ask when considering a loyalty incentive is “how are you going to measure it?” It is a good question. If you can’t measure it, you can’t reward it. Loyalty is particularly difficult to measure in that most resellers prefer not to divulge their sales of competing suppliers. In addition, there is a general sense that loyalty is “something to be earned” and that you cannot buy it.

Often, the success of a loyalty program comes down to the question of whether loyalty is objectively measurable. There are different ways to measure loyalty and the correct approach will depend on the relationship that the supplier has with its channel partners. Measurement options include:

• 3rd Party Certification – The reseller provides 3rd party verification of the supplier’s share of the reseller’s account. Often, the reseller’s independent auditor is asked to certify the share-of-account percentage. We have found resellers surprisingly willing to participate in this type of program.
• Audit – the reseller divulges its sales of the supplier’s line and that of other brands. The supplier reserves the right to audit the data. Resellers that are unwilling to divulge the information do not earn the incentive.
• Public information – The supplier determines its degree of loyalty based on the reseller’s web site, catalog, marketing materials, bid documents or other publicly available information. The reseller may challenge the supplier’s estimate through an audit process.
• Point-of-sale information – Some suppliers have access to their reseller’s sales information because they have supplied the channel with point-of-sale terminals or have access to the point-of sale-information. This is a fool-proof method however few suppliers have access to this type of data.

Another challenge in measuring loyalty is the often conflicting perspectives that suppliers and resellers have regarding a supplier’s product line. Suppliers offer high and low end products, products priced competitively or at a premium, strong and weak categories. Often, resellers argue that a portion of a supplier’s offering is uncompetitive. The supplier of course takes the opposite view. The loyalty incentive can backfire if the supplier does not realistically assess its competitive power position. From a measurement perspective, it is critical to clearly define categories that are “core” and those where the supplier must “earn” the reseller’s loyalty.

The approach that you take towards measuring loyalty will have a significant impact on the relationship that your business has with your channel partners. Carefully consider the role of your field sales organization. You do not want to put your sales team in an adversarial position. Ideally, your channel marketing group will measure your channel’s loyalty.

How much should you pay?

Resellers have considerations other than pure economics when choosing their vendor strategy. Manufacturers need to realistically evaluate their brand strength and channel relationships. Even with a loyalty incentive, resellers will not convert business when:

• Their business strategy dictates being a “one-stop shop” for all major brands
• Customers expect any “real distributor” to carry a particular competitive brand
• Competing brands creating complementary sales or service opportunities
• Resellers don’t trust you
• Your company can’t deliver or invoice correctly

Conversely, a supplier may be able to convert more sales than pure economics would indicate these factors are working in its favor.

There are five common factors to consider when determining the amount of your loyalty incentive. These include:

• Your share of your reseller’s business
• The amount of the competitive business that you expect to be able to convert
• The gross margin the reseller can earn on your line
• The gross margin the reseller earns on the competing line
• Your sales through the channel

The following example calculates the amount that a supplier should pay to convert distributors that are “cherry picking” its line.

Your distributor sells $1.2M of a product category. This consists of $1M of your brand and $200K of the competitor’s

Each line generates a 25% gross margin for the distributor. This results in $250K in distributor gross margin on your brand and $50K on the competing line for a total of $300K.

The distributor’s cost-of-goods sold are $750K on your brand and $150K on the competitive line.

If the distributor switches completely to your line, they will be able to convert 50% of the formerly competitive volume. They will lose the other 50%.

By converting, the distributor gives up $25K in gross margin that they formerly earned on the competitor’s line. In total, the distributor’s new gross margin is $275K. Your loyalty incentive needs to make up the $25K in gross margin that the distributor lost. $25K is approximately 3% of your new sales to the distributor. In other words, the distributor breaks even with a 3% loyalty incentive.

How will your channel partners react?

A loyalty program rewards channel members that choose to work closely with their suppliers. Resellers who are “more loyal” will view the program as proof of your commitment to them. They will strongly support your program. Resellers on the cusp are likely to switch if you get the economics right and other factors are in your favor. Disloyal resellers will challenge your program. They will, however, at least understand the rules of the game and why they are at a disadvantage versus their competitors.

In summary, when you have the power, use it. Under the right circumstances, a correctly structured loyalty incentive can drive your channel’s behavior in the right direction. You owe it to your loyal resellers, you owe it to your shareholders and your company’s future managers who will otherwise need to deal with today’s inaction.

Unfortunately, DSR compensation plans that pay a flat percentage of the margin are out of touch with the economics of many industries.

Margin-based comp plans did encourage DSRs to sell products that optimized overall distributor profitability when manufacturer rebates were much lower than they are now. Today, rebates in many industries start at 5% and range as high as 20% or more. While these rebates seem good for the distributor, DSR compensation plans drive behavior that undermines the potential benefit.

We must analyze the way distributors account for rebates to understand these economics. Generally accepted accounting practices require that rebates reduce a distributor’s cost of goods sold. In effect, the rebates should increase the distributor’s gross margin. This margin increase should translate into higher DSR commissions on the rebated products. Many distributors, however, hide the rebates from their sales force by booking the rebates as other income. Some distributors even account for rebates as increased sales.

This situation sets up two distinct entities within the distributorship-the sales force and the “house.” The house guarantees its profits by hiding the rebate from the sales force. Under this model, the house is not overly concerned about street price because the compensation plan should encourage the DSR to sell at the highest price possible.

Unfortunately, DSR compensation plans can have the reverse of the intended effect. They may encourage DSRs to sell the least profitable products at the lowest available margins. Obviously, sales reps seek to maximize their own income. All things being equal, a sales rep will sell a product with a $250 commission over one that pays $200. A sales rep will also seek to minimize risk. The sales rep will support an item with a $200 commission and an 80% chance of sale over an item that has a $250 commission but only a 50% chance of winning. These risk assessments are usually made with incomplete information and DSRs often overestimate the risks associated with selling higher priced products.

The DSR faces competition on virtually every equipment sale and the DSR will sell at a price designed to minimize risk. Often this takes the form of a standardized mark-up of 10% – 15% over “cost.” The DSR will not try to sell an item at a higher price for fear that a competitor will come in with a lower bid. The house isn’t overly concerned because the rebate dollars on the back end ensure profitability.

The following example helps to illustrate the point. In the example, the DSR must choose whether to offer Product A or Product B:

A number of issues emerge from this situation:

• The DSR is unwilling to extract more than a standard 10% mark-up on either product due to fear of a competitive bid
• After adjusting for risk, the DSR is economically motivated to sell the lower-priced product
• The distributorship earns 35% less profit on product B compared to product A
• The customer may not get the best possible product for the job due to the DSR’s unwillingness to push the better quality item

An additional issue comes into play. Some distributors hide rebates from their DSRs while others do not. DSRs who work for distributors that hide the rebates are even less likely to promote a higher priced, highly rebated brand because they are frequently undercut by distributors that do factor rebates into the price. DSRs do not like to be embarrassed and if this happens more than once, the DSR may never support the brand with the higher rebate again.

It is clear that DSR compensation plans based on a percentage of the gross margin can undercut overall distributorship profitability. Distributors must develop compensation plans that optimize profitability in today’s rebate-intensive market. This means that distributors must link DSR compensation to the rebates that they earn on each product line.

A simple approach is to provide a base percentage of the margin commission plus a factor that is linked to the rebate rate. For example, a program that paid the DSR 10% of the margin plus 2.5X the rebate rate as a percent of the margin would have the following impact on the example demonstrated above:

Under this scenario, the DSR is motivated to push a higher priced item that not only pays a significantly higher commission but also a higher commission after the confidence factor. Motivating the DSR to push the higher priced, more profitable product in this case increases the distributorship’s overall profitability by over 40%.

Manufacturer rebates are an effective way to protect distributor profitability. Unfortunately, DSR compensation plans that do not factor rebates into the equation can seriously undermine a distributor’s return on investment. We understand the desire for distributors to hide rebates from their sales force. However by doing so, the sales force may be hiding profits from the distributor and stealing sales from the brands that provide the optimal customer solution.

Pricing in the construction industry continues to tighten as the housing sector slows, imports gain share and customer consolidation continues. In light of these changes, building product manufacturers must update their channel pricing strategies, including prices, discounts, rebates, promotions, terms, conditions and programs to optimize sales and profit margins.

The key to effective channel price decision-making is to understand the value in the channel between the manufacturer, distributor, contractor, builder and customer. Determining this value, and the impact of program changes, can be difficult due to the complexity of multiple product lines, channels, customer segments, programs and competitors. It is necessary to build sophisticated models based on fresh competitive research in order to make profitable decisions.

Pricing Pressures

Most manufacturers in the construction industry are under tremendous pressure to meet their business objectives in the face of increasingly difficult obstacles. Competition is getting sharper, the market is softening and margins are eroding due to competition from low price imports.

Raw material costs increased significantly and many companies have had spotty results increasing their price. Customers at the retail and builder levels continue to consolidate and demand back end rebates that seem to be getting out of control.

The availability of pricing over the Internet causes dealers to question whether to continue to support the traditional brands. Dealers complain that products are available online at prices lower than their cost. This pricing conflict leads dealers to find lower profile product lines on which they can earn higher margins.

These factors cause the field sales force to cut pricing deals to maintain their level of business. The complexity of multiple product categories, channels, prices, rebate, and promotional activity makes it seem impossible to effectively manage the situation. Many companies feel as if they are driving blind without accurate competitive or channel pricing information and that their pricing situation is out of control.

The Building Products Value Chain

An accurate assessment of value is required at multiple levels and layers within each level in order to develop profitable channel pricing systems. First, the supplier must determine how customers value its products relative to competition. This valuation includes an assessment of customer choices at different prices at the consumer, builder and contractor levels.

The supplier must then assess the value provided by its channel in support of the customer, and in support of the manufacturer’s own needs. This channel valuation identifies appropriate margin levels for each channel serving the customer. A further assessment, based on the relative degree of influence at the corporate, branch or sales person level, determines the degree to which channel margins should be paid in the form of discounts, back end rebates or other programs.

Finally, the manufacturer must assess its own value – what it brings to the table in order to differentiate itself from the competition to its customers and channel partners. Each of these valuations differs depending on the class of product class and the customer segment.

This evaluation helps manufacturers understand the choices that customers have in choosing among competing products at different price points and the choices that channel partners have in supporting competing brands under different margin scenarios.

The Channel Pricing Model

Pricing through multiple distribution channels is complex. The complexity is intensified when selling multiple product lines. Some products may be commodities while others may be highly differentiated. In order to effectively quantify the value in order to make effective pricing decisions, it necessary to construct a financial model that includes the key factors: value by product, customer and channel; and pricing, promotions, terms, discounts, allowances, channels, rebates and programs.

The financial model enables the supplier to predict the impact on profitability under multiple scenarios in a competitive environment.

For example, what is the likely behavior and profit impact if the manufacturer were to:

• Reduce the rebates paid to a particular channel?
• Increase the price on a certain product line?
• Change the criteria that distributors must meet in order to gain access to certain discounts?
• Reduce discounts on certain products to selected channels?
• Lock in pricing to selected accounts?

All of these options may be on the table. The goal is to determine the choices that will optimize price, margins and revenue in the face of competition and to most accurately predict the results of change.

A Model Built on Research

Sometimes we get locked into traditional ways of thinking after the market has changed. Companies must continually update their understanding of value in competitive markets. A channel pricing model will only be effective if the input data is current and accurate. In order to make effective channel pricing and value decisions it is necessary to get the most up to-date facts:

• What choices do your channel partners and customers have to select among competing products and channels?
• What is the current market price by customer and channel segment relative to competition?
• How much differentiation exists among your distribution channels and what is the appropriate level of margin?
• How do customers value your products relative to competition?

Putting it all Together

An effective channel pricing model, built on an understanding of the building products value chain, based on up to date market facts, can help manufacturers make the difficult decisions required to optimize financial results. This means making the right choices about when to raise prices, on what products, whether to alter rebate programs or adjust channel margins through the discount structure.

An effective channel pricing model will enable the manufacturer to establish programs and pricing that will motivate distributors, pay the channel for the value that it adds and to win or maintain the business at the right price.