How Manufacturers Can Rewrite the Rules of the Game
Selling online can certainly seem appealing to manufacturers. First, there are the growth opportunities. E-commerce sales already total more than $1 trillion worldwide—about 6 to 8 percent of all sales in major developed and emerging markets. Nearly every retail category is growing rapidly, with double-digit growth rates overall in the U.S., Europe, and mature markets of Asia, and even more impressive growth rates in China (25 percent) and India (57 percent), according to Forrester Research.
Selling online can be quite profitable as well. We estimate that manufacturers typically enjoy up to 10 percentage points of higher margins from e-tailers than from other channels. E-tailers’ focus on growth and their need to ensure supply from manufacturers result in less focus on price negotiations, while manufacturers enjoy a lower cost to serve the online channel.
It’s clear that a company making and selling branded consumer items cannot afford to miss out on this opportunity, which is already transforming the landscape, offering consumers lower prices, abundant time savings, and tremendous breadth and depth of selection from what has been called “the endless aisle.” At the same time, manufacturers must continue to serve traditional retailers, which enjoy much lower growth rates but still represent the bulk of manufacturers’ sales.
These competing needs combine to create intense channel conflict and powerful threats to a manufacturer’s brand and price positioning. At the heart of the issue: large online retailers have much lower operating costs than their brick-and-mortar counterparts, and, consequently, they can much more easily slash prices to fuel faster growth. (See “Digital’s Disruption of Consumer Goods and Retail,” BCG article, November 2012.)
Now more than ever before, manufacturers are selling products in a “multichannel” world made up of e-tailers, marketplaces of third-party sellers, brick-and-mortar stores, and hybrids that combine elements of each model. This commercial reality requires a much more strategic use of pricing and trade investments than was common in the past. Those that come late to the game will see their options narrow dramatically.
The central dilemma for manufacturers can be summed up this way: they need to expand sales online, but if they do so, they risk dealing with price-aggressive e-tailers, creating the threat of both brand deterioration and channel conflict. Navigating the opportunities requires a deeper understanding of the economics involved, while addressing the resulting threats necessitates examining the changed nature of channel relationships.
Although it’s not often the case, the operating economics of major e-tailers that have reached a certain scale can be far superior to the economics of brick-and-mortar retailers. After all, e-tailers spend nothing on store rent and shop floor personnel, invest less in advertising, and have no need to maintain inventories in multiple stores. Consequently, many e-tailers can survive on as little as one-third of the gross margins of brick-and-mortar retailers and still break even or make a small profit. For example, an offline mom-and-pop consumer-electronics store typically needs gross margins of 25 to 35 percent to cover its overhead costs. Although a big-box retailer might get that down to a 15 to 25 percent gross margin, an e-tailer might need only 10 percent.
E-tailers can pass their economic advantage on to shoppers in the form of a substantial price discount. But at the same time, a product’s brand equity and price positioning can deteriorate when consumers see a product online at heavily discounted prices. We have observed an average e-commerce discount of 25 to 40 percent across categories in Europe and the U.S, for instance, and industries such as consumer electronics offer markedly higher discounts. Even if online sales volumes are only a small part of total sales, a price gap that large has a significant impact on price and brand perception. Shoppers browsing online easily notice the price difference even if they do not yet make online purchases, and tools that scan the Internet for lower prices can make price comparison even simpler. Marketplaces have heightened this pricing transparency. Any retailer that can get the goods can put a branded product online at a discount—in many cases, independent of manufacturer control.
Even as they navigate these economic complexities, manufacturers face an even trickier task in managing their channel relationships. They must simultaneously tap into the attractive online growth opportunities mentioned earlier and foster the brick-and-mortar customers that can be the source of more than 80 percent of their revenues and that can provide the showrooms where consumers can touch and feel the products, experience the brand, and get sales advice. In addition, manufacturers must find a way to help their important offline customers embrace the online opportunity. To compete against pure-play companies, “click and mortar” hybrids that sell a product both online and offline may need the manufacturer’s assistance to make enough margin in both channels and avoid cannibalization.
Through our work with a wide range of companies, we have found that manufacturers choose three common strategies when they tackle these challenges. Each of the following strategies exists along a spectrum that ranges from a high to a low degree of control over the flow of products through various channels.
The remainder of this article focuses on the last option. In our work with a number of clients, we have seen smart manufacturers beginning to implement an approach to pricing that manages the channel, brand, and price-positioning conflicts that can result from operating in a multichannel world.
Embracing the multichannel opportunity requires a rethinking of “trade investments,” a vital pricing issue. Many manufacturers think in terms of “trade spend”—or the rebates, bonuses, and payments they give to a retailer for specific activities such as in-store promotions, advertising, shelf space, and adherence to defined performance targets.
We use a broader definition. At the simplest level, we see trade investment as the sum of the full trade margin—the difference between what a retailer sells a product for and what it pays for it, including all discounts, rebates, and bonuses—together with all the monetary investments such as logistics services, as well as nonmonetary trade investments such as training and merchandising that are not necessarily reported in the retailer’s P&L. Exhibit 1 shows a simplified view of the various components of retailer margin.
To fully capitalize on the multichannel opportunity, companies must differentiate their trade investment, rewarding retailers that increase brand support with discounts and nonmonetary investments. It’s important for manufacturers to answer four questions in order to make differentiation work.
With which customers do we want to win? At a basic level, companies should create a brand strategy that focuses on consumer segments offering the best growth and profit opportunities and that targets those segments through a particular set of channels. Effective companies combine similar trade customers—for example, discounters, hypermarkets, department stores, specialist chains, and e-tailers—into the same segment.
Antitrust rules and regulations require that a company treat similar trade customers alike. That means that the manufacturer must apply the same objective criteria to like channels and customers as a guide for differentiated trade investments by segment or company. For example, a company cannot arbitrarily decide that Safeway belongs in one channel and Kroger belongs in another simply because it wants to treat Safeway differently.
Segmentation allows manufacturers to define the priority channels for their business, in part on the basis of the channels’ strategic importance and in part on their economics. Each channel requires different levels of trade investment to be successful. For instance, a website that specializes in triathlon sporting goods may offer content and advice that could help a shoe manufacturer’s brand, warranting its inclusion in a channel that receives preferred trade investments.
How do we direct our trade investments toward the right channels? Companies should next rebalance their trade spending by channel. A manufacturer may want to invest a greater proportion in a high-priority segment, such as channels that help with the acquisition of new consumers. For example, a toy manufacturer must sell in brick-and-mortar toy stores where kids of the target age can examine the merchandise. A big-box retailer may not be as highly targeted. Naturally, a company may be more interested in investing in certain individual trade customers within a channel than in others, regardless of the overall channel priority.
It helps to group channels into strategic categories—for example, those that help a company grow the core at one end of the spectrum and those that require only opportunistic investments at the other end. (See Exhibit 2.) Then companies should map customers to each segment, depending on both the level of brand support provided by the channel and its strategic relevance.
How shall we best spend our trade investments? Third, manufacturers should look at the “currency” they use to compensate retailers for the services that help reach consumers and grow the business. Effective manufacturers pay for performance. They avoid passive or unconditional trade investments that are not tied to results.
The more specific, measurable, and achievable the investment, the easier it is to secure the retailer’s upfront agreement; and the more the investment is paid only after completion, the better. For example, a manufacturer and retailer might agree on the number of pages per year the manufacturer’s products will receive in the retailer’s catalog. The retailer would be paid only after all of those pages had been published. Without precision, there is the risk that the money could go somewhere unwanted. For example, an investment could contribute to the retailer’s general trade margin pool or, in the worst case, it could erode the brand’s price positioning. Now, with e-tailers frequently adding and changing new forms of trade spending programs, manufacturers must make as much effort to understand what is working for them online as they do offline.
How can we make our new approach stick? Finally, manufacturers need to roll out the new pricing and trade-investment strategy. They should start by looking at the list price, as this already includes a large part of the margin that goes to retailers. Then they need to restructure the full range of margin components presented in Exhibit 1 by channel, all the way down to the so-called net-net price, including all discounts and rebates. Manufacturers must ask themselves: On the basis of the support that a channel provides to the brand, which discounts and rebate elements should it get? How much should it get for each element to compensate for its efforts?
Manufacturers also need to put in place simple yet adaptive pricing capabilities that enable them to excel at multichannel pricing. This involves major adjustments to people, processes, and tools that will, among other results, make data understandable and helpful. Manufacturers have to equip their salespeople with the right messages—in a format that is easy to understand. In particular, manufacturers must also be prepared to design a pricing and trade investment scheme that works for themselves, as well as with the differing economics of their multichannel trade partners—for example, hybrids of brick-and-mortar and online channels, or wholesalers that service both mom-and-pop retailers and price-aggressive e-tailers and marketplaces.
Consider the experience of a European manufacturer of consumer durables, a maker of a globally known product perfectly suited to online retail. The manufacturer faced tremendous growth in its own online channel, but price discounting—as high as 20 percent—by some dominant online retailers was starting to erode brand perception and cause severe channel conflict with brick-and-mortar retailers.
The company decided to create pay-for-performance mechanisms that would reward a retailer for the support it provided in representing the brand and acquiring new consumers in the main target group. The rewards were based on a clear channel strategy that prioritized trade investments for the most strategic customer segments. The manufacturer then increased the list price for all retailers. Retailers that were completely in sync with the strategy ended up with about the same trade investment as before—in some cases more—but the investment was more closely linked to performance. However, those that were not fully in sync either had to live on a lower margin or had to be less aggressive in consumer price discounting to maintain margin levels. As a result, the manufacturer created profitable growth in its highest-priority and most brand-supporting channels, and it also resolved increasingly threatening channel conflicts.
Retailers are moving quickly to compete in today’s multichannel environment, and some manufacturers are seeing compelling results from their efforts to regain pricing control. Smart manufacturers will act now to recalibrate their platform for growth. They cannot wait until they see proof that their brand and price perception are suffering. Manufacturers that lag behind risk destroying the very heart of their business and leaving significant money on the table.