Module-Marketing Channel Management PDF

Introduction to the Module
Marketing channel is a set of practices or activities necessary to transfer the ownership of

goods, from the point of production to the point of consumption. It is the way products and
services get to the end user, the consumer also known as a distribution channel. A marketing
channel is a useful tool for management, and is crucial to creating an effective and well-planned
marketing strategy. Marketing channel management is considered to be one of the areas that
provide competitive advantage to the firm. It is mainly concerned with creating, maintaining and
continuously improving the relationship a firm/ manufacturer / has with the entire stake holders
in the distribution channel so that goods, services and related information could move from the
point of production through the channel all the way to the final consumption in order to meet
customers’ requirements effectively and efficiently. In the meanwhile it also gives due emphasis
to meeting the needs/ objectives of the channel participants.
This module presents detail discussions to create complete understanding of what marketing
channel is; who are the participants in the channel; how they are supposed to interact; what
should the manufacturer do in order to maintain a mutually benefiting relationship in the
marketing channel; what are the interfaces between marketing channel and the marketing mix.
Further, the module also introduces logistics by mainly focusing on outbound logistics and
discusses the concepts of inventory management and transportation management.
Marketing Channel Management: Perpared by: Tewodors Mesfin & Andnet Worku AAU: School of Commerce (MAMM) 1
Module Objectives:
The general objectives of the module include the followings:

To provide students the knowledge to understand marketing channel management
concepts , principles and practices
To enable students to analyze the interactions in the marketing channel
To provide students the knowledge to analyze marketing channels and be able to manage
a channel for better competitive advantage
To assist students in acquiring skills to develop effective and efficient marketing channel
and maintain the same
To familiarize students with the concepts principles and practices of out bound logistics
Chapter 1
Marketing Channels Structure and Functions
1. Introduction to the chapter
This chapter begins with a managerial definition of the marketing channel and then discusses the
reasons for using marketing channels to reach the marketplace on the demand side as well as on
the supply side. Then basic concepts such as the functions and activities that occur in marketing
channels, membership in marketing channels, and how to identify members of a marketing
channel are discussed.
Learning objectives
After reading this chapter, learners will be able to:

Explain what a marketing channel is
Describe the major reasons for the increasing importance of marketing channels
Demonstrate why manufacturers choose to use intermediaries between themselves
and end-users
Analyze the principles of specialization and division of labor as well as contactual
efficiency in marketing channels
Explicate what marketing flows define the work of the channel
Examine the marketing channel structure and the ancillary structure
Describe who the members of marketing channels are and the flows in which they
can specialize
Explicate the evolution of marketing channels
1.1 An Overview of Marketing Channel
What is a marketing channel? There are different clarifications to what a marketing channel is
and these variations result in confusion. Consider some of the explanations that are given below:
A marketing channel refers to the path taken by the goods as they move from
the producer to the consumer.
A marketing channel is the route taken by the title to the goods as they move
from the producer to the consumer.
A marketing channel refers to “a lot of middle men” between consumers and
producers.
The above differences in the explanation for what a marketing channel is arise because of the
different perspectives of the ones doing the explanation. For example, the view point taken by
the producer is that a marketing channel is the route taken by the product as it moves from the
producer to the consumer. For the intermediaries the path for the title to the goods between the
producer and the consumer is marketing channel. Finally the consumers consider a marketing
channel as ‘a lot of middle men’ standing between them and the producers.
Definitions of marketing channel
Definitions are important to the marketing discipline in general. They may have particular
importance for channel management because much of channel management relates to
institutions, and institutions by their very nature relate to several disciplines. Thus we will
consider two definitions of marketing channels from two widely read sources:
In the book marketing channel a management view the author Burt Rosen Bloom provided the
following definition of a marketing channel:
“The external contractual organization that management operates to achieve its distribution
objectives”
Four terms can be noted from the above definition-these are external, contractual organization,
operates, and distribution objectives
External: This part of the definition indicates that a marketing channel exists outside the
organization. A marketing channel is inter-organizational management (that is managing
more than one firm). It is not intra-organizational management (that is managing one
firm).
Contractual: This part of the definition indicates that only those firms that are involved
in negotiation functions (like buying, selling and transferring title) are the only members
of a marketing channel.
Thus, firms that perform facilitating functions (like advertising agencies, public warehouses, and
transport companies) are not members of a channel. This is because the problems in channel
management encountered in managing firms involved in negotiation are different to the problems
encountered in managing firms that do not perform negotiation functions.
Operates: This part of the definition indicates the involvement of management in the
affairs of the channel. The involvement can range from initial development of channel
structure to day – to – day management of the channel.
Distribution objectives: The marketing channel exists as a means to achieve distribution

objectives.
In the book marketing channel Coughlan et al. provided the following definition of a marketing
channel.
“A marketing channel is a set of interdependent organizations involved in the process of making
a product or service available for use or consumption.”
Their definition of a marketing channel bears some explication. It first points out that a
marketing channel is a set of interdependent organizations. That is, a marketing channel is not
just one firm doing its best in the market—whether that firm is a manufacturer, wholesaler, or
retailer. Rather, many entities typically are involved in the business of channel marketing. Each
channel member depends on the others to do their jobs.
What are the channel members’ jobs? The definition makes clear that running a marketing
channel is a process. It is not an event. Distribution frequently takes time to accomplish, and
even when a sale is finally made, the relationship with the end-user usually is not over (think
about a hospital purchasing a piece of medical equipment and its demands for post sale service
to see that this is true).
Finally, what is the purpose of this process? The definition claims that it is making a product or
service available for use or consumption. That is, the purpose of channel marketing is to satisfy
the end-users in the market, be they consumers or final business buyers. Their goal is the use or
consumption of the product or service being sold. A manufacturer who sells through distributors
to retailers who in turn serve final consumers may be tempted to think that it has generated sales
and developed happy customers when its sales force successfully places product in the
distributors’ warehouses. The definition argues otherwise. It is of critical importance that all
channel members focus their attention on the end-user.
1.2 The growing importance of marketing Channels
Marketing has been described as the management of the 4Ps – product, promotion, price, and
place. While firms have emphasized price, product and promotion as strategic marketing tools,
"place" is considered as a "left over" of the more important strategic tools. However, this is
changing due to the following factors:
i. Greater difficulty in gaining sustainable competitive advantage;

ii. Growing power of distributors, especially retailers in marketing channels;
iii. The need to reduce distribution costs;
iv. The new stress on growth;
v. The increasing role of technology;
vi. Greater difficulty in gaining sustainable competitive advantage
1. Sustainable competitive advantage
A sustainable competitive advantage cannot easily be copied by rivals. However, if the

competitive advantage can easily be copied by rivals then the firm will move into a commodity
market – where its product will be seen as essentially the same as that of its rivals. Firms can
gain competitive advantage through their price, product, promotion, and distribution strategies.
Product Strategy: Global competition, rapid technologies transfer (the technology that
is available for the firm is may be available for its rivals) have made gaining sustainable
competitive advantage through product strategy difficult. Firms can easily achieve parity
in product features, quality, and design. In addition, rapid rate of new product failure and
shorter product life cycle have made gaining competitive advantage through product
strategy unsustainable.
Pricing strategy: Companies can gain the preference of customers through pricing
strategy. However, the advantage that companies will have through lowering price is
only short- term because rivals can easily match price cuts:
a. Move to low cost production areas

b. Global competitions
The above are examples of factors that made gaining competitive advantage through price
cutting strategies short run .
Promotion strategy: The competitive advantage that is obtained through promotion

strategy is not sustainable because of enormous clutter. For example the typical
American is exposed to over 3000 commercial messages/ days. Thus, as advertisements
are literally knocking each other out of the consumers mind any advantage through clever
promotion is short – term advantage . Technology, clever advertisement, and brief cost
advantages are the basis of the strategies for product, promotion, and price. But they can
easily be copied and hence they do not provide sustainable competitive advantage.
Distribution strategy: Place strategy can provide a company with a competitive

advantage that is sustainable because of the long term nature of distribution strategy.
vii. Growing power of distributors, especially retailers in marketing channels
Retailers have become gate keepers, keeping tight control on the flow of information.
Manufacturers have to use variety of techniques in order to get their offer past retailer to the
deciders (consumer). This requires having an effective channel strategy. Retailers have
increasingly become buying agents to customers rather than selling agents to the manufacturer.
Price cutting to win customers may result in price wars. This is disruptive type of competition and it makes the
advantage through the price cut only short run.
In attempt to make their advertisements unforgettable firms may use flashy ads. But the ad may be remembered
and not the message because it will be lost in flashiness
viii. The need to reduce distribution costs
Distribution often accounts for a significant part of the final selling price of a product. In some
cases as in packaged goods, distribution costs are more than the manufacturing costs and
materials costs. Efforts like downsizing, reengineering are aimed at reducing manufacturing
costs and internal operations. Now a new frontier of cost reduction is in the area of distribution.
This has to be done without compromising service level i.e. superior product availability.
ix. The new stress on growth
Firms try to be productive through employing cost cutting strategies like reengineering,
downsizing, etc. But obviously, these cost cutting efforts have to be complemented with growth
strategies. How does a company achieve growth in a market that is already mature and that is
growing slowly? By making dealers focus their effort and attention on the offer of the company
than the offer of rivals.
x. The increasing role of technology
The internet can be a means a company uses in order to sell its offer to consumers. There are
already companies that are prospering because of using this medium in order to reach their target
market. In short, a strong channel system is a competitive asset that is not easily replicated by
other firms and is, therefore, a strong source of sustainable competitive advantage. Further,
building or modifying the channel system involves costly and hard-to-reverse investments. This
means that making the effort to do it right the first time has great value and, conversely, making
a mistake may put the company at a long-term disadvantage.
Activity 1.1
Issue for discussion
Competition on a global scale has made the competitive environment much more intense. Having
a superior product, a clever advertising campaign, and reasonable prices may not be sufficient to
hold one’s share of a market in the twenty first century.
Discuss this statement in terms of how a focus on marketing channels might help.
Commentary: answer this question in terms of why channel strategy provides a sustainable
competitive advantage while competitive advantage through the other 3Ps is short-term
Why do Marketing Channels exist and Change
The fundamental questions here are why marketing channels exist and why they change. Why,
for example, all manufacturers do not sell all products and services that they make directly to all
end-users? Further, once in place, why should a marketing channel ever change or new
marketing channels ever emerge?
We focus on two forces for channel development and change, demand-side and supply-side
factors.
1. Demand-Side Factors:
Facilitation of Search: Marketing channels containing intermediaries arise partly

because they facilitate searching. The process of searching is characterized by
uncertainty on the part of both end-users and sellers. End-users are uncertain where to
find the products or services they want, while sellers are uncertain how to reach target
end-users. If intermediaries did not exist, sellers without a known brand name could
not generate many sales. End-users would not know whether to believe the
manufacturers’ claim about the nature and quality of their products. Conversely,
manufacturers would not be certain that their promotional efforts were reaching the
right kind of end-user.
Adjustment of Assortment Discrepancy: Independent intermediaries in a marketing

channel perform the function of sorting goods. This is valuable because of the natural
discrepancy between the assortment of goods and services made by a given
manufacturer and the assortment demanded by the end-user. This discrepancy results
because manufacturers typically produce a large quantity of a limited variety of
goods, whereas consumers usually demand only a limited quantity of a wide variety
of goods.
The sorting function performed by intermediaries includes the following activities:
a. Sorting: This involves breaking down a heterogeneous supply into separate stocks that
are relatively homogeneous (e.g., a citrus packing house sorts oranges by size and grade).
b. Accumulation: The intermediary brings together similar stocks from a number of sources
into a larger homogeneous supply. (Wholesalers accumulate varied goods for retailers,
and retailers accumulate goods for their consumers).
c. Allocation: This refers to breaking down a homogeneous supply into smaller and smaller
lots. (Allocating at the wholesale level is referred to as breaking bulk). For example,
goods received in carloads are sold in case lots. A buyer of case lots in turn sells
individual units.
d. Assorting: This is the building up of an assortment of products for resale in association
with each other. (Wholesalers build assortments of goods for retailers, and retailers build
assortments for their consumers).
In short, intermediaries help end-users consume a combination of product and channel services
that are attractive to them. Intermediaries can thus be viewed as creating utility for the end-user.
In particular, by having a product in their assortments in a certain place and at a certain time,
intermediaries can create possession, place, and time utilities that are all valuable to the target
end-user.
2. Supply-Side Factors:
a. Routinization of Transactions: Each purchase transaction involves ordering of,

valuation of, and payment for goods and services. The buyer and seller must agree on the
amount, mode, and timing of payment. These costs of distribution can be minimized if
the transactions are made routine; otherwise, every transaction is subject to bargaining,
with an accompanying loss of efficiency.
Moreover, routinization leads to standardization of goods and services whose performance

characteristics can be compared and assessed easily. It encourages production of items that
are more highly valued. In short, routinization leads to efficiencies in the execution of
channel activities. For example, continuous replenishment programs (CRP) are an important
element of efficient channel inventory management. First created by Duane Weeks, a product
manager at Procter & Gamble, in 1980 to automatically ship Pampers diapers to the
warehouses of Schnuck’s, a St. Louis grocer, without requiring Schnuck’s managers to place
orders, the system was brought to Wal-Mart in 1988 by Ralph Drayer (then P&G’s vice
president of customer services) and has spread since then. Under CRP, manufacturing and
retailing partners share inventory and stocking information to ensure that the right array of
retail products is stocked on the retail shelf and is neither understocked nor overstocked.
Shipments typically increase in frequency but decrease in size. This leads to lower
inventories in the system and higher turnaround, both sources of increased channel
profitability. A routinized and mature relationship between channel partners is a necessity to
make CRP succeed.
b. Reduction in Number of Contacts (contactual efficiency): Without channel

intermediaries, every producer would have to interact with every potential buyer in order
to create all possible market exchanges. As the importance of exchange increases in a
society, so does the difficulty of maintaining all of these interactions. As an elementary
example, a small village of only ten specialized households would require 45 transactions
to carry out decentralized exchanges (i.e., exchanges at each production point: 10 times 9,
divided by 2). Intermediaries reduce the complexity of this exchange system and thus
facilitate transactions. With a central market consisting of one intermediary, only twenty
transactions would be required to carry out centralized exchange in our village example
(10 plus 10).
Implicit in the preceding example is the notion that a decentralized system of exchange is less
efficient than a centralized network using intermediaries. The same rationale can be applied to
direct selling from manufacturers to retailers, relative to selling through wholesalers. Consider
Figure 1. Consider that in a certain market there is one producer and five customers. The number
of contacts needed by the producer to reach the target buyers without the use of intermediaries is
five, while with the use of intermediaries it is only one. So this reduces the cost to the producer
while increasing the benefit to the customer. On the macro marketing level the number of
contacts that the producers need (if for example there are 5 producers) to make to sell their offers
to five customers will be five times five. However with an intermediary the number of contacts
will be ten. Using the formula n (n-1)/2, where n stands for the number of households (end
buyers) 5(5-1)/2= 10. This reduces cost to the producer and increases the benefits to the
customer.
Customer 1
Producer
Customer 2
Customer 3
Customer 4
Figure 1.1: Selling directly to five contact lines

Customer 5
Figure 1.2 shows that selling direct involves twenty five contact lines at the macro level and the
figure shows that the number of contact lines is reduced to 10 when an intermediary is involved.
P1 C1 P1 C1
P2 C2 P2 C2
Intermediary
P3 C3 P3 C3
P4 C4 P4 C4
P5 C5 C5
P5
Figure 1.2: Selling directly and selling indirectly
Note that in this example we assume the cost and effectiveness of any contact—manufacturer to
wholesaler, wholesaler to retailer, or manufacturer to retailer—is the same as any other contact.
This is clearly not true in the real world, where selling through one type of intermediary can
incur very different costs from those of selling through another. Further, not all intermediaries
are equally skilled at selling or motivated to sell a particular manufacturer’s product, and this
certainly affects the choice of which and how many intermediaries to use. The example also
assumes that each manufacturer contacts each of the household. If a retailer prefers some
wholesalers over others, restricting the number of wholesalers used can prevent the manufacturer
from reaching the market served by that retailer, suggesting the value of using multiple
wholesalers.
Nevertheless, judiciously used intermediaries do, indeed, reduce the number of contacts
necessary to cover a market, and this principle guides many manufacturers seeking to enter new
markets without engaging in high-cost direct distribution with an employee sales force. The
whole trend toward rationalizing supply chains by reducing the number of suppliers is also
consistent with the concept of reducing the number of contacts in the distribution channel. It is
interesting in this context, then, to ponder how manufacturers can efficiently sell their wares
directly online because Internet selling implies disintermediation (i.e., the shedding of
intermediaries rather than their use). Indeed, companies like Levi Strauss, the jeans maker, once
sold direct online but discontinued doing so and now steer online shoppers to third-party retailers
such as Target and Wal-Mart both for efficiency reasons and to reduce channel conflict (by not
competing with their retailer partners for end-user sales). The benefits of interacting directly with
one’s end-users that direct selling brings (information on consumer demands and sources of
dissatisfaction, for example) must be counterbalanced against the incremental costs of doing so
(the cost of breaking bulk early in the distribution process and shipping many small packages to
many different locations rather than making large shipments to few locations).
Specialization and division of labor
The work on specialization and division of labor is generally attributed to Adam Smith. He
discussed the principle in his book the wealth of nations (1776). From a study on a pin factory
Smith noted that when workers perform all the tasks required to make pin individually- the out
put was less than, when workers were made to specialize on a particular task only- in which case
productivity improved.
That productivity can be improved if workers are made to concentrate or specialize on only a
particular task is a well established concept in manufacturing. The same concept of specialization
and division of labor can be applied in distribution. If distribution tasks (like providing
information, processing orders, storage, transportation, etc.) can be given to firms that have
specialized on them there will be more efficiency for the distribution channel. The distinction in
the specialization and division of labor in manufacturing and the specialization and division of
labor in distribution is that in the former it is intra organization management and in the later it is
inter organization management.
Figure 1.3 Specialization and division of labor principle: Production vs. distribution
W1 Manufacturing
Manufacturer Distribution
Works allocated tasks allocated
to
To workers on the Agent intermediaries
W2 basis of on the basis of
specialization specialization in
Wholesaler
performing
tasks
W3 Retailer
W4 Consumer
Result? Result?
More productivity in manufacturing More distribution efficiency
In summary, intermediaries participate in the work of the marketing channel because they both
add value and help reduce cost in the channel. This raises the question of what types of work are
in fact done in the channel. We turn next to this issue.
Activity 1.2
Consider a market where there are 4 manufacturers and 10 customers. How many contacts are
needed to achieve distribution objective of the manufacturer if the sales are made directly?
Commentary: use the formula
n(n-2)/2
1.3 What is the work of the marketing channel?
The work of the channel includes the performance of several marketing flows. We use the term
flows rather than functions or activities to emphasize that these processes often flow through the
channel, being done at different points in time by different channel members. In institutional
settings, one often hears of the need to carry inventory, to generate demand through selling
activities, to physically distribute product, to engage in after-sale service, and to extend credit to
other channel members or to end-users. We formalize this list in Figure 2, showing five universal
channel flows as they might work in a hypothetical channel containing producers, wholesalers,
retailers, and consumers. As the figure shows, some flows move forward through the channel
(physical possession, ownership, and promotion), while others move up the channel from the
end-user (ordering and payment). Still other flows can move in either direction or are engaged in
by pairs of channel members (negotiation).
i. Negotiation Flows
Manufacturer Representative Dealers Buyers
Product flow refers to the flow of the product through the channel. Product flow is a forward
flow moving from the manufacturer all the way to end user.
ii. Product Flows
Suppliers Shippers Manufacturer Dealer Buyers
Ownership flow shows the flow of title to the goods through the channel. Ownership flow is a
forward flow.
iii. Title flows
Suppliers Manufacturer Dealer Buyer
Information flow is flow in both directions.
iv. Information flow
Suppliers Shippers Manufacturer Dealer Buyers
Promotion flow is the presentation of persuasive information in the form of personal selling,
sales promotion, public relations, and advertising.
V.Promotion flow
Manufacturer Ad agency Wholesaler retailer consumer
Figure1.4: Flows in marketing Channels
Activity 1.3
The marketing channel for Mary Kay Cosmetics is called a direct selling channel. The company
uses a sales force of over 1,000,000 Independent Beauty Consultants around the world. These
consultants are not employees of Mary Kay Corporation; they buy cosmetics from the company
at a wholesale price and sell to end-users at a retail price. They maintain personal relationships
with their end-user consumers and deliver product to them after it is ordered; it is a high-service
purchasing relationship from the consumer’s point of view. Consultants thus act as both
distributors and retailers.
a. What functions or activities in the channel will an Independent Beauty Consultant likely
perform?
Commentary: consider this issue in light of the universal marketing flows?
1.4 Who belongs to a marketing channel?
The key members of a marketing channel are manufacturers, intermediaries (wholesale, retail,
and specialized), and end-users (who can be business customers or consumers). The presence or
absence of particular types of channel members is dictated by their ability to perform the
necessary channel flows to add value to end-users. Often there is one channel member that can
be considered the “channel captain.” The channel captain is an organization that takes the
keenest interest in the workings of the channel for this product or service and that acts as a prime
mover in establishing and maintaining channel links. The channel captain is often the
manufacturer of the product or service, particularly in the case of branded products. However,
this is not universally true, as the following examples show.
1. Manufacturers
By manufacturer we mean the producer or originator of the product or service being sold.
Frequently a distinction is drawn between branded and private-label manufacturing:
Some manufacturers brand their products and thus are known by name to end-users even
if they use intermediaries to reach those end-users. Examples include Coca-Cola, Saint
George Beer, or Sony.
Other manufacturers make products but do not invest in a branded name for them.
Instead, they produce private label products, and the downstream buyer (either a
“manufacturer” or a retailer) puts its own brand name on the products. For example,
company X can focus on making private-label products for companies Z and, company X
prides itself on research and development expenditures that make it valuable to the brand
companies (Z and Y) that hire it to make their products. Even branded-goods
manufacturers sometimes choose to allocate part of their production capacity to the
production of private- label goods; in some markets, such as the United Kingdom, where
private label accounts for half the goods sold in most leading supermarkets, private label
is a strong option for some manufacturers.
In today’s retail marketplace, the ownership of the brand can belong to the manufacturer
e.g., Mercedes-Benz or to the retailer.
All of the physical product manufacturers are involved in physical possession and ownership
flows until the product leaves their manufacturing sites and travels to the next channel member’s
site. Manufacturers also engage in negotiation with the buyers of their products to set terms of
sale and merchandising of the product. The manufacturer of a branded good also participates
significantly in the promotion flow for its product.
2. Intermediaries
The term intermediary refers to any channel member other than the manufacturer or the end-user
(individual consumer or business buyer). We differentiate among three types of intermediaries:
wholesale, retail, and specialized.
Wholesale intermediaries include merchant wholesalers or distributors, manufacturers’

representatives, agents, and brokers. A wholesaler sells to other channel intermediaries, such as
retailers, or to business end-users but not to individual consumer end-users. Merchant
wholesalers take both title to and physical possession of inventory, store inventory (frequently of
many manufacturers), promote the products in their line, and arrange for financing, ordering, and
payment with their customers. They make their profit by buying at a wholesale price and selling
at a marked-up price to their downstream customers, pocketing the difference between the two
prices (of course, net of any distribution costs they bear). Manufacturers’ representatives, agents,
and brokers typically do not take title to or physical possession of the goods they sell. The major
flows in which they take part are promotion and negotiation in that they work on selling the
products of the manufacturers they represent and negotiating terms of trade. Some of these
intermediaries (such as trading companies or import-export agents) specialize in international
selling, whether or not they take on title and physical possession flows.
Retail intermediaries assume many forms today, including department stores, mass
merchandisers, hypermarkets, specialty stores, category killers, convenience stores, franchises,
buying clubs, warehouse clubs, catalogers, and online retailers. Unlike purely wholesale
intermediaries, they sell directly to individual consumer end-users. Although their role
historically has focused on amassing an assortment of goods that is appealing to their consumer
end-users, the role of today’s retailers often goes much farther. As discussed above, they may
contract for private label goods, effectively vertically integrating upstream in the supply chain.
They may sell to buyers other than consumer end-users.
Specialized intermediaries are brought into a channel to perform a specific flow and typically are
not heavily involved in the core business represented by the product sold. These intermediaries
include insurance companies, finance companies, credit card companies (all involved in the
financing flow), advertising agencies (participating in the promotion flow), logistics and
shipping firms (participating in the physical possession flow), information technology firms
(who may participate in ordering or payment flows), and marketing research firms (generating
marketing intelligence that can be useful for the performance of any of the flows).
3. End-Users
Finally, end-users (either business customers or individual consumers) are themselves channel
members. We classify consumers as marketing channel members because they can and
frequently do perform channel flows, just as other channel members do. Consumers who buy in
bulk performing physical possession, ownership, and financing flows because they are buying a
much larger volume of product than they will use in the near future. They pay for the products
before they use them, thus injecting cash into the channel and performing a financing flow. They
store the products in their house, lessening the need for warehouse space at the retailer and thus
taking on part of the physical possession flow. They bear all the costs of ownership as well,
including pilferage, spoilage, and so forth. Naturally, consumers expect a price cut when they
shop at a wholesaler to compensate for the channel flow costs they bear when buying through
this channel relative to buying a single package of a product at the local grocer.
1.5 Channel structure
A channel structure refers to the group of channel members to which a set of distribution tasks
has been allocated. This definition suggests that a channel structure is the way in which the
distribution manager has allocated distribution tasks among channel members. So after the
allocation decision has been made if the channel structure appears as:
M W R C, then it means the channel manager has decided to allocate the
distribution tasks to his own firm, to the wholesalers, retailers and consumers. To determine
channel structure the basis are specialization & division of labor and contractual efficiency.
1. Ancillary structure
This refers to the group of institutions or facilitating agencies that assist channel members in
performing distribution tasks. Firms in the ancillary structure are performing non-negotiation
functions (such as transportation, storage, insurance, etc.) They are outside the channel design
decision and are having fewer stakes in the channel than channel members. The optimum
ancillary structure is determined by specialization & division of labor and contactual efficiency.
2. Channel Design: Segmentation
One of the fundamental principles of marketing is the segmentation of the market. Segmentation
means the splitting of a market into groups of end-users who are (a) maximally similar within
each group, and (b) maximally different between groups. But maximally similar or maximally
different based on what criterion? For the channel manager, segments are best defined on the
basis of demands for the outputs of the marketing channel. A marketing channel is more than just
a conduit for product; it is also a means of adding value to the product marketed through it. In
this sense, the marketing channel can be viewed as another production line engaged in producing
not the actual product that is sold but the ancillary services that define how the product is sold.
These value-added services created by channel members and consumed by end-users along with
the product purchased are called service outputs. Service outputs include (but may not be limited
to) bulk-breaking, spatial convenience, waiting and delivery time, assortment and variety,
customer service, and product/market/usage information provision.
End-users (be the final consumers or business buyers) have varying demands for these service
outputs. Consider, for example, two different buyers of books: consumers browsing for some
entertaining best-sellers to take on an upcoming vacation and students buying textbooks for
college. The vacationers highly value a broad assortment of books from which to choose, in-store
amenities like a coffee bar, and salesperson advice. But they do not care as intensely about bulk-
breaking (because they intend to buy several books), can easily shop among bookstores, and
have some time before vacation begins and thus are willing to wait to get some good books. The
student textbook buyers have almost the opposite demands for service outputs of the retail book
channel: They want just one textbook per class, cannot travel far to get it, and need it virtually
immediately. On the other hand, the students do not value the ability to browse (because the
professor has dictated the book to be bought) and, therefore, do not need information about what
book to buy; nor do they need customer service or in-store amenities while shopping.
Clearly, a different marketing channel meets the needs of these two segments of shoppers. The
vacationers will be well satisfied shopping at a large, well-stocked bookstore somewhere in
town, such as Mega bookstore. The students will favor bookstore close to campus that caters to
student book needs. Interestingly, in the developed countries, students with less intense demands
for quick delivery (perhaps because they plan ahead or know their reading lists in advance)
increasingly chooses to buy textbooks from online booksellers. These booksellers deliver to the
student’s home or college residence (thus providing an extremely high level of spatial
convenience), can do so in less than a week (thus providing a moderate, if not high, level of
quick delivery), and can deliver the exact number and titles of books the student needs (thus
satisfying demands for bulk-breaking and assortment and variety). They may not excel in
customer service or information provision, but because the college student does not intensely
demand these services, their absence is not missed. Note that the vacationer, who highly values
in-store customer service and information provision, might not find the online bookstore as
satisfying as a bricks-and-mortar shop (although online bookstores seek to counteract the
information provision problem by providing inside looks at many of their books online, so that
the buyer can resolve uncertainty about the book’s contents before purchasing it).
This example shows how different segments of end-users can demand the same type of product
with widely varying sets of service outputs, resulting in very different product-plus-service-
output bundles. An analysis of service output demands by segment is thus an important input into
a manufacturer’s marketing plan and can help increase the reach and marketability of a good
product to multiple market segments.
1.6 Evolution of marketing channels
Marketing channels always emerge out of a demand that marketplace needs be better served.
However, markets and their needs never stop changing; therefore, marketing channels operate in
a state of continuous change and must constantly adapt to confront those changes. From its
inception to its contemporary standing, the evolution of marketing channels thought can be
divided into four stages.
1.6.1 The Production Era and Distributive Practices
The origins of marketing as an area of study are inextricably tied to distributive practices. The
earliest marketing courses, in fact, were essentially distribution courses. Course titles like
‘Distributive and Regulative Industries of U.S. Distribution of Agricultural Products’ and
‘Techniques of Trade and Commerce’ abounded at Schools of Commerce during the early 1900s.
These courses addressed the ways in which marketing channels spawned middlemen who, in
turn, facilitated more efficient movements of goods and services from producers to users. As
American productivity and urbanization increased with each passing decade of the 20th century,
the demand for a variety of production resources to be used as manufacturing inputs naturally
followed suit. Rapidly growing urban centers demanded larger and more diverse bundles of
goods than had previously been available. By 1929, retailing accounted for nearly $50 billion of
U.S. trade. Modern-looking market channels emerged in response to the need for more cost-
effective ways of moving goods and raw resources. One description of marketing channels taken
from this era stated, ‘Transportation and storage are … concerned with those activities which are
necessary for the movement of goods through space and the carrying of goods through time.’
Increasingly, facilitating devices were needed to transport, assemble, and reship goods. Thus, the
origins of the modern marketing channel cannot be separated from purely distributive practices.
The Institutional Period and Selling Orientation
The Gross National Product of the U.S. grew at an extraordinary rate during the 1940s and this
industrial expansion contributed to the emergence of sizeable inventory stockpiles. The cost of
managing these inventories grew rapidly as well. Production techniques and marketing channel
processes each became more sophisticated during this period. Issues pertaining to distribution
primarily revolved around cost containment, controlling inventory, and managing assets.
Marketers were shifting from a production to a sales orientation. The attitude that ‘a good
product will sell itself’ receded as marketers encountered the need to expand sales and
advertising expenditures to convince individual consumers and organizations to buy their
specific brands. The classic marketing mix, or Four Ps, typology –product, price, promotion, and
place – emerged as a guiding marketing principle. Issues relating to distribution were relegated
to the place domain. The idea that relationships between buyers and sellers could be managed did
not yet exist as a topic of study.
Many new types of channel intermediaries surfaced during this period. For example, industrial
distributors emerged in the channel of distribution for most industrial products and consumer
durables. And by the late 1950s, sales by merchant wholesalers reached $100 billion. Producers
were continuously seeking new ways to expand their market coverage and distributive structures.
Several giant retailers had emerged by this time, and small retailers were increasingly
formalizing and specializing their operations to meet the needs of a more refined marketplace.
1.6.2 The Marketing Concept
In 1951, vice president of marketing at Pillsbury named Robert Keith introduced a seminal
marketing principle to the business world: the marketing concept. According to the marketing
concept, the customer is the nucleus of all marketing mix decisions. As such, organizations
should only make what they can market instead of trying to market what they have made.
The marketing concept is intuitively appealing because its focus is on the customer. In this sense,
however, the marketing concept paints a very one-sided approach to reconciling a firm's mission
with the markets it serves because it positions marketers as reactive exchange partners – adapting
channels of distribution to meet market needs.
Activity 1.4
Even though specialization and division of labor is the fundamental basis for allocating
distribution tasks, can the channel manager make decisions about allocating distribution tasks
among channel members solely on that basis?
Commentary: consider the criteria for allocating distribution functions
SUMMARY
Compared to price, promotion and product, marketing channels that make the product and
services readily available to customers when, where, and how they are needed had some time
taken a “back seat”. But in this chapter we have considered five factors that account for the
growing importance of marketing channels. Although there are a number of ways to view
marketing channels, a managerial viewpoint from the perspective of producing and
manufacturing firms is used in this text. The chapter has considered two reasons, one on the
demand side, and another on the supply side for the existence of intermediaries. The chapter
explains how channels work and what functions and activities are performed inside a channel.
The manufacturer and intermediaries between it and the end-user share the work of the channel,
sometimes specializing in the performance of certain channel flows to which they are uniquely
suited.
The history of distributive practice shows clearly that distribution methods and channels are
changing and a variety of influences make continuing change likely too. It pays to watch for
trends and changes, and perhaps to aim to keep ahead of them, certainly to keep abreast of them.
Self assessment questions
Part one: Multiple choices
1. Which of the following statements is incorrect about the marketing channel?
a. A marketing channel is Intraorganizational management
b. A marketing channel is Interorganizational management

c. Only those firms that are involved in negotiation functions are the only members of
a channel.
d. All
e. None
2. Which of the following statement is incorrect?

a. A channel structure refers to the group of facilitating agencies that assist channel
members in the performance of distribution tasks
b. Ancillary structure refers to the group of channel members to which distribution
tasks have been allocated
c. Organizations in the channel structure are not members of the marketing channel
d. All
e. None
3. A marketing channel is the route taken by the title to the goods as they move from the
producer to the consumer. This is reflecting the perspective of
a. The producer
b. The consumer
c. The intermediary
d. None
4. The primary interest of the marketing channel is

a. The physical flow of the product through the channel
b. The creation of time utility
c. The creation of place utility
d. The creation of possession utility
e. None
5. Assume that the diagram below shows vertically aligned institutions, then the diagram
can represent
Manufacturer Wholesaler Retailer Consumer
a. Risk bearing flow
b. Ownership flow
c. Negotiation flow
d. Product flow
e. None
Part Two: Answer true if the statement is correct and false if the statement is
incorrect
6. Retailers have increasingly become buying agents to customers rather than selling agents to
the manufacturer hence the power of distributors is increasing.
7. Direct channel is important because by avoiding intermediaries we can avoid the functions
played by them as well, which will lead to reduction in price.
8. From the consumer point of view a marketing channel is simply “a lot of middle men”
standing between them and the producer.
Part three: Short answer questions
9. On the demand side channel of distribution exists in order to resolve problems in exchange.
Identify and discuss two of these problems in exchange.
10. Why does a manufacturer not sale direct to the end user? What is the reason for using
intermediaries on the supply side? Identify the two reasons for using intermediaries on the supply
side
Part four: Discussion questions
11. Discuss the distinction between channel structure and ancillary structure
12. Discuss the distinction between interorganizational management and intraorganizational
management?
Chapter 2
The Environment of Marketing Channels
Introduction to the chapter
This chapter discusses the external environment which consists of all external uncontrollable
factors within which the marketing channel exists. These factors can affect the channel. In order
to give some semblance of order to this huge array of external uncontrollable variables, we will
categorize and discuss them in this chapter under the following 5 general headings.
1. The economic environment

2. The competitive environment
3. The socio-cultural environment
4. The technological environment
5. The legal environment
When analyzing the impact of the environment on the marketing channel, the channel manager
will have to consider the impact of the external variables upon the channel members (retailers
and wholesalers) because a marketing channel includes these independent firms. And also since
the effectiveness of the marketing channels is affected by the performance of non – channel
members, the channel manager should also analyze the effect of the environmental variables
upon facilitating agencies (like transportation, firms, and advertising agencies).
Learning objectives
Explain some of the major economic forces affecting marketing channels
Delineate the major types of competition in the context of marketing channel structure
and strategy
Explicate the impact of socio-culture on the marketing channel
Explain rapid changes in technology and be sensitive to how such changes can affect
market channels
Describe the basic anti-trust laws as they apply to marketing channel strategy
2.1 The economic environment
This variable that affects the marketing channel is significant because the economic variable
affects consumers buying power and almost all marketing activities are directed toward the
consumer. The economic environment includes the following stages of the business cycle:
i. Recession
A recession could be explained as any period in which the GDP is stagnant or increasing very
slowly. During periods of recession consumers’ buying pattern changes to emphasize the basic.
The marketing channel members (all of them) will feel this change in consumers’ buying pattern
in terms of decrease in sales and profitability. Marketing channel members or facilitating firms
with high level of inventory will feel the effect of recession more heavily even to the point of
bankruptcy. The channel manager may endeavor to help channel members by pursuing such
strategies as lowering price, increasing promotion, increasing customer’s service. The channel
manger will do these tasks in order to stimulate demand.
ii. Inflation
Inflation devalues money by reducing the product it can buy through persistent price increases.
The reaction of channel members in the face of inflation is dependent on the reaction of
consumers. Unfortunately consumers will react in unpredictable manner. Consider the following
two situations. Consumer will increase their purchase on the assumption that waiting for
tomorrow only means buying at a higher price. Or consumers may decide to hold on to their
money i.e. postpone purchase on the assumption that recession is just around the corner.
Inflation may make consumers a more prudent purchasers – for example, consumers may buy
less expensive brands (i.e. shift from purchase of high price products to low price offers), and
consumers may stop purchasing on impulse basis, etc. In the face of such prudent consumer
purchases retailers may be more demanding in terms of their requirement from the manufactures
– they may, for example, demand price concessions (reductions) and more promotional support.
The retailer may also desire to reduce inventory level.
The channel strategy in such circumstances could be to change the manufacturer’s product mix
from high price products to low price products in order not to lose shelf space. And in order to
help retailers reduce their inventory commitment by stimulating demand the manufacturer may
increase promotional support.
Activity 2.1
How does the impact of the environment on channel strategy differ from the other
major strategy areas of the marketing mix?
Commentary: note the peculiarity of the influence of the environment
2.2 The competitive environment
Competition is a critical factor to consider for all members of the marketing channel.
Types of competition
The channel manager has to consider the types of competition because these have an effect on
channel strategy:
i. Horizontal competition
This refers to the competition that occurs between firms that are of the same type. For example,
when two or more supermarkets are in competition with each other, or when two or more
automobile manufacturers are in competition compete with each other. This type of competition
is the most common and visible type.
M M
W W
R R
Figure 2.1: The same types of firms that are on the same level compete with each other.
Intertype competition
The second type of competition that affects channel strategy is intertype competition. This is the
competition between firms that are different but are on the same channel level.
E.g. the competition between office depot (which opens longer hours, sells office supplies at
rock bottom price and that offers a wide variety of products) and the traditional stationary is an
example of intertype competition.
Intertype competition
M M
W W
R R
Figure 2.2: different type of firms at the same channel level competing with each other.
Vertical competition
This is the competition between firms that are at different level of channel levels such as the
competition between a retailer and a wholesaler or a whole seller competing against a
manufactures. The competition between manufacturers of national brands versus retailer private
brands provides a good illustration of vertical competition.
Vertical competition
M
R
Figure 2.3: Channel members at different levels in the channel competing with each other.
Channel system competition
This refers to competition between a complete channel system and another complete channel
system. For channels to compete against other channels as complete units they must be
organized and cohesive organizations. Such channels have been called vertical marketing
systems and they are classified into 3 types: corporate, contractual and administered
1. Corporate channels: These occur when production and marketing facilities are owned by the
same company.
2. Contractual Channels: These occur when independent firms – manufactures, wholesalers,
and retailers are linked with formal contractual agreement.
4 Administered Channel system: This type of competition occurs when there is a strong
domination of one of the channel members (usually the manufacturer) over other channel
members.
Channel system competition
MM MM
M
M
M M
Figure 2.4: Complete channel systems competing with each others as units.
Scrambled merchandising
Scrambled merchandising is the selling of products through nontraditional outlets. Conventional

wisdom may detect as to who should hold what products. For example, sporting goods are sold
by sporting stores and automotive parts are sold through automotive stores, etc. But in the
Western hemisphere we see the mass merchandisers, discount department stores that hold all the
above products, that means, a buyer can find automotive parts, hard wares, sporting goods, etc. at
one store.
The implication of scrabbled merchandising is that the competitive landscape is changing, so that
manufactures have a wider option when selecting intermediaries and also the strategies for
dealing with intermediaries will have to be modified e.g. the strategy that is effective when
dealing with sporting stores may be ineffective when dealing with other channel members.
Activity 2.2
Discuss the economic environment in terms of its effect on various parties in the
marketing channel and its implications on channel management.
Commentary: comment in light of the effect business cycles on intermediaries
2.3 Socio-cultural factor
This factor – some channel analysts argue is a major factor that affects channel structure.
Consider the case of Tropical Africa; it is not unusual in some countries to find as many as 10
levels in the channel structure. Retailers deal in very tiny amount such as 1 or 2 cigarettes, a half
bar of soap, a handful of salt. The socio cultural conditions that may have led to this factor may
include:
Wide geographic dispersion of the population

Avery limited mobility of the consumer
A necessary traditions of hand to mouth buying
Given the above condition a Western style supermarket may be inefficient.
2.4 The technological environment
The internet
The channel manger has to monitor the technological environment in order to note developments
that will affect his or her firm and the channel participants and determine how these will likely
affect channel participation.
Although the internet was conceived primarily as an information exchange mechanism, it can
and already has been used as a kind of “electronic marketing channel” on which consumers and
organizations can go “shopping”.
Though the internet currently accounts for a small share of retail and wholesale sales, in the
future the internet might occupy a much larger share.
Scanners
Electronic scanners are devises that read prices and other information from product labels and
record them much more quickly and accurately than humans can. When coupled with the
Universal Product Code (UPC) now appearing on virtually all packaged goods, the speed and
efficiency of electronic scanners in processing consumer transactions are formidable.
But electronic scanners are now going well beyond simple reading of product labels. They can
be used to replenish inventory electronically without having to rely on manually produced
purchases orders. Using the checkout sales data from scanners the computer can tally items sold
and then automatically subtract these items from inventory records. A computer generated order
list of items falling below minimum inventory levels can then be transmitted to wholesalers and
manufacturers. Electronic scanners are thus, enabling retailers to improve their productivity by
making it possible for them to process larger volumes of transactions with less labor input.
Electronic Data interchange (EDI)
Electronic data interchange refers to the linking together of channel member information systems
to provide real – time responses to communication between channel members. For example, a
retailer’s computerized inventory management system is connected with and monitored by the
supplier’s (manufacturer’s or wholesalers’) computers. Ordering of merchandise can take place
automatically when the retailer’s inventory level of that supplier’s products reaches a certain
minimum reorder points. Thus, the retailer’s computer orders the products from the
manufacture’s or wholesaler’s computers without human intervention or paperwork of any kind.
There is little questioning that EDI technology enhances distribution efficiency, resulting in
substantial benefit to all channel members as well as final customers. The manufacturer benefits
through more accurate and timely production scheduling, while wholesalers and retailers save on
order processing and inventory carrying costs. The final customer benefits from the reduced
distribution costs made possible by EDI.
The main negative is that the channel members must share information openly for the EDI
system to work. So, for those channel members who feel they need control of what they believe
to be sensitive or confidential information about the sales of their products, EDI can go much of
its appeal.
Activity 2.3
How might the internet become an important electronic marketing channel?
Commentary: consider the effect of online transactions
2.5 The Legal Environment
This refers to the set of laws that affect marketing channels. The channel manager need not be
an expert on legal issues but need to at least have basic knowledge on issues related to the
following.
Dual Distribution
When a producer distributes the same product through two or more different channel structures
dual distribution occurs. If a producer is selling the same or similar products using different
brand names through 2 or more channel structure dual distribution occurs. Dual distribution may
lessen competition and foster monopoly. This is because a producer that distributes its offer
through 2 or more channel structures may also use its own outlet, and then, the outlet of the
producer may have unfair advantage by undercutting price. Through undercutting price the
producer’s outlet may drive out independent outlets giving the producer a monopoly position.
Exclusive Dealing
This is a situation where the supplier requires that its channel members sell only its product or at
least refrain from selling the offer of direct competitors.
If channel members refuse to observe the exclusive dealing arrangement they will be cut – off by
the supplier from selling its offer. The exclusive dealing arrangement my lessen competition and
foster monopoly because it provides protection for the supplier from competing companies.
Full-line forcing
This occurs when the manufacturer requires channel members to carry a broad range of its
products (full line) in order to have access to its other products. Under the above arrangement,
the channel members, in order to have access to the manufacturer’s "hottest” items need to
acquire the less desirable products of the manufacturer. This practice may lessen competition
and limit the choice that is available to the consumer, because the channel member’s capacity
can be severely affected, and as a result, they cannot carry the products of other suppliers.
Price Discrimination
When a manufacturer either directly or indirectly sells its offer to the same class of channel
members’ price discrimination occurs. Price discrimination may lessen competition favoring one
channel member over the same class of another channel member.
For example, if a manufacturer is giving promotional allowances (in the form of free catalogs
and display cases) to large chains but does not give this promotional allowance to smaller
channel members, then this is a form of subtle price discrimination.
Price Maintenance
This is a case where the supplier or the manufacture determines the final selling price of the offer
to the consumer. The supplier dictates the selling price of the offer to the buyer by the channel
member. The prices are not based on discretion of channel members in response to market forces
but rather based on the requirement of the suppliers.
Price maintenance is justified on the basis of the following reasons (even though it might be
considered as anti- competitive price fixing):
To prevent price wars
To protect the image of the product
To provide channel members with sufficient profit margin that will enable them provide
adequate pre and post sale service.
By fixing the price and dictating it upon channel members the situation of free riding can be
prevented. Free riding occurs when one channel member sells the product at a substantially
lower value than another channel member who is a full service dealer, because the former was
able to cut on the pre and post service given to customers but rides on the full service effort of
the dealer that sells at a higher price.
For example, a customer goes to a full service dealer to buy a camera. The sales person who is
knowledgeable provides the customer with adequate information, technical advice, and also
access to different type of cameras. However the customer goes out and buys the camera at a
discount store for a very low price. In this case the full service dealer did everything but make
the sale. The discount store is free riding on the effort of the full service dealer.
Resale restriction
This occurs when a manufacturer determines to whom the products will be sold to and where the
product will be sold. This might be considered as ant- competitive. However, resale restriction
might be advantageous to both the manufacturer and channel members.
To the manufacturer the advantage of dictating to whom channel members can sell to is to
maintain house accounts (the customers to whom the manufacturer can directly sale to) – by
preventing channel members from selling to these customers. To the channel members it
prevents intra brand competition (competition between channel members who sale the same
branded product of a particular manufacturer).
Tying agreements
When supplier sales an offer to the marketing channel member on the condition that the channel
member buys an offer from the supplier or refrain from buying form another supplier tying
agreement arises. Full line forcing is a form of tying agreement.
Tying agreements may place the supplies in a very advantageous position because the channel
member agrees to buy a product from the supplier, the channel member is not free to buy the
product from the open market and so the supplier has significant price leverage. The supplier
may dictate the terms of the sale upon channel members. This weakens competition; however,
the interest of the public is best served under competitive situations.
Tying agreements are common in franchising; the franchisor may require the franchisee to buy
products from it in return for the franchising agreement. The rationale for the tying agreement in
franchising is to protect the franchisors reputation and to protect the quality of the product.
Vertical integration
This simply means acquisition of ownership of upstream suppliers and downstream customers.
Vertical integration may raise legal issues if it weakens competition and foster monopoly.
Vertical integration may be made on such reason as
The desire to gain economies of scale
Greater control over price and sources of supply in a volatile raw material market.
Activity 2.4
CONCEPT CHECK
1. Exclusive dealing, full-line forcing, and tying agreements all have something in common.
What is it?
See the answer section
2. What do the concepts discussed under the legal environment such as price
discrimination, price maintenance, resale restrictions, vertical integration, full line
forcing, exclusive dealing, and tying agreement have in common.
See the answer section
Summary
Marketing channels develop and operate in a complex environment that is continually changing.
These changes can have a major influence on marketing channels. Channel managers must
monitor the environment within which the firm operates. The purpose is to develop strategies
that will enable the firm avoid threats or take advantage of the opportunities that are developing
in the environment.
While there are many ways to categorize the myriad of environmental variables, the following
five- category taxonomy was used in this chapter: (1). the economic, (2). the competitive, (3). the
socio-cultural, (4). the technological, and (5). the legal forces. In the chapter each of the above
forces were discussed in light of their effect on the marketing channel.
When dealing with any of these environmental categories the channel managers need to consider
the effects of environmental variables not only on their own firms and their firm’s target market,
but also on all the channel members and participants.
Part one: Multiple choice questions
1. Which channel strategy is appropriate during inflationary period?
a. Change of product mix from high price products to low price products
b. Reduce retailer’s inventory commitment

c. Intensify promotional support
d. All
e. All except A.
2. Suppose in a bid for buying stationary items, Mamco (the producer) and its two
distributors submit their documents. This kind of competition is called:
a. Horizontal
b. Intertype
c. Vertical
d. Intra-type
e. None
3. When a manufacturer requires channel members to carry a broad range of its products in
order to have access to its other products, it is known as:
a. Dual distribution
b. Price discrimination
c. Price maintenance
d. Resale restriction
e. None
4. When supplier sales an offer to the marketing channel member on the condition that the
channel member buys an offer from the supplier or refrain from buying from another
supplier, it is known as:
a. Dual distribution
b. Price discrimination
c. Tying agreement
d. Resale restriction
e. None
5. Which of the following reasons justify price maintenance
a. To prevent price wars
b. To protect the image of the product
c. To provide channel members with sufficient profit margin that will enable them
provide adequate pre and post sale service
d. All
e. None
incorrect
6. Price maintenance occurs when prices are based on discretion of channel members in
response to market forces rather than on the requirement of suppliers.
7. Corporate channels occur when production and marketing facilities are owned by the
same company
8. Contractual Channels occur when independent firms – manufactures, wholesalers, and
retailers are linked with formal contractual agreement
Part three: Fill the blank space

9. ____________is the selling of products through nontraditional outlets
10. ____________refers to the linking together of channel member information systems to
provide real – time responses to communication between channel members
Part four: discussion questions
11. Marketing channels reflect the socio-cultural environments within which they exist.
Explain this statement.
Chapter 3
Segmentation for Marketing Channel Design: Service Outputs
Marketing channel system design and management, like the management of any other marketing
activity, requires starting with an analysis of the end-user. This is true even for a channel
member that does not sell directly to an end-user. For example, a manufacturer selling through a
distributor to business-to-business end-users may book a sale when the distributor buys
inventory, but it is the end-user who holds the ultimate power of the purse, and therefore, the
manufacturer’s demand from the distributor is only a derived demand from ultimate end-users.
Only after first understanding the nature of end-users’ demands can the channel manager design
a well-working channel that meets or exceeds those demands. The most useful demand-side
insights for marketing channel design are not about what end-users want to consume but about
how end-users want to buy and use the products or services being purchased. We will thus take
as given a product’s viability for the market and concern ourselves with the understanding of
how to sell it rather than what to sell.
Learning objectives
After reading this chapter, learners will able to:

Describe the central role played by end-users and their demands in the design of
marketing channels
Explain what service outputs are and how to identify and analyze them
Divide a market into channel segments for the purposes of designing or modifying a
marketing channel
Evaluate when and whether to try to meet all expressed service output demands in the
short run in a particular market
Explicate the relationship between service output demands and solutions to overall
channel design problems
3.1 Service outputs
A framework for codifying and generalizing how the end-user wants to buy a particular product
was proposed by Bucklin as a basis for determining channel structure. We use his original theory
here as a foundation to our approach for segmenting the market for marketing channel design
purposes. Bucklin argues that channel systems exist and remain viable through time by
performing duties that reduce end-users’ search, waiting time, storage, and other costs.
These benefits are called the service outputs of the channel. Other things being equal (in
particular, price and physical product attributes), end-users will prefer to deal with a marketing
channel that provides a higher level of service outputs. Bucklin specifies four generic service
outputs:
i. Bulk-breaking,
ii. Spatial convenience,
iii. Waiting or delivery time, and
iv. Product variety. We add two other service outputs to this list:
v. Customer service and
vi. Information provision.
While this list is generic and can be customized to any particular application, these six service
outputs cover the major categories of end-users’ demands for different channel systems.
i. Bulk-breaking: refers to the end-users’ ability to buy their desired (possibly small)
number of units of a product or service even though they may be originally
produced in large, batch-production lot sizes. When the marketing channel system
allows end-users to buy in small lot sizes, purchases can more easily move directly
into consumption, reducing the need for the end-user to carry unnecessary
inventory. However, if end-users must purchase in larger lot sizes (i.e., benefit
from less bulk-breaking), some disparity between purchasing and consumption
patterns will emerge, burdening end-users with product handling and storage costs.
Consequently, the more bulk-breaking the channel does, the smaller the lot size
end-users can buy and the higher the channel’s service output level to them. This,
in turn, can lead to a higher price for the end-user to cover the costs of providing
small lot sizes.
The common practice of charging a lower per-unit price for larger package sizes in frequently
purchased consumer packaged goods at grocery stores is an example of this pricing phenomenon.
Consider how a family buys laundry detergent when at home versus when renting a house on
vacation. At home, the family is likely to buy the large, economy size of detergent, perhaps at a
supermarket or even at a hypermarket, because it can be easily stored in the laundry room at
home and there is no question that, eventually, the family will use up that large bottle of
detergent. Naturally, the large bottle is comparatively inexpensive per fluid ounce. But on
vacation for a week at a rental cottage, the family prefers a small bottle of detergent—even if it is
much more expensive per fluid ounce—because they do not want to end the week with a large
amount left over (which they will probably have to leave at the cottage). Most vacationers
are not at all surprised, or even reluctant, to pay a considerably higher price per ounce for the
convenience of buying and using a smaller bottle of detergent, and indeed, unit prices for such
products very commonly are much higher in resort towns’ supermarkets than in supermarkets or
hypermarkets serving permanent residents.
ii. Spatial convenience: provided by market decentralization of wholesale and/or

retail outlets increases consumers’ satisfaction by reducing transportation
requirements and search costs. Community shopping centers and neighborhood
supermarkets, convenience stores, vending machines, and gas stations are but a few
examples of channel forms designed to satisfy consumers’ demand for spatial
convenience.
iii. Waiting time: is the time period that the end-user must wait between ordering and
receiving goods or post-sale service. The longer the waiting time, the more
inconvenient it is for the end-user, which may require the end user to plan or
predict consumption far in advance. Usually, the longer that end-users are willing
to wait, the more compensation (i.e., the lower the prices) they receive.
Conversely, quick delivery is associated with a higher price paid.
The intensity of demand for quick delivery may also vary between the purchase of original
equipment (where it may be lower) versus the purchase of post-sale service (where it is
frequently very high). Consider, for example, a hospital purchasing an ultrasound machine. The
purchase of the original machine is easily planned for, and therefore, the hospital is unlikely to
be willing to pay a high price premium for quick delivery of the machine itself. However, if the
ultrasound machine breaks down, the demand for quick repair service may be very intense, and
the hospital may, therefore, be willing to pay a high price for a service contract that promises
speedy service. In such cases, the sophisticated channel manager prices the sale of product versus
post-sale service very differently to reflect the different concatenation and intensity of demands
for service outputs.
An example that offers combined insights into demands for bulk-breaking, spatial convenience,
and delivery time is the beer market in Mexico. Here, understanding market demands requires an
understanding of the market’s and consumers’ environmental characteristics and constraints. A
market with limited infrastructural development, for instance, usually will be characterized by
consumers with high demands for service outputs like spatial convenience (because the
consumers cannot travel very easily to remote retail locations), minimal waiting time for goods,
and extensive bulk-breaking (because consumers will not have sufficiently high disposable
income to keep backup stocks of goods at their homes in case of retail stock-outs). In the
Mexican market, major beer manufacturers sell through grocery stores, liquor stores, and
hypermarkets, as well as through restaurants. However, they also sell beer through very small
local distributors—apartment residents who buy a small keg of beer and resell it by the bottle to
neighborhood buyers who cannot afford a six-pack of beer. These buyers provide their own
bottles (frequently washed, used beer bottles) that the distributor fills. The manufacturer values
this channel because the other standard retail channels do not meet the intense service output
demands of this lower-end consumer.
iv. breadth of variety : the wider the breadth of variety or the greater the depth of
product assortment available to the end-user, the higher the output of the marketing
channel system and the higher the overall distribution costs, because offering
greater assortment and variety typically means carrying more inventory. Variety
describes generically different classes of goods making up the product offering,
that is, the breadth of product lines. The term assortment, on the other hand, refers
to the depth of product brands or models offered within each generic product
category.
v. Customer service: refers to all aspects of easing the shopping and purchase
process for end-users as they interact with commercial suppliers (for business-to
business [B2B] purchases) or retailers (for business to consumer [B2C] purchases).
vi. Information provision: refers to education of end-users about product attributes

or usage capabilities, or pre-purchase and post-purchase services.
3.2 Service Outputs as Determinants of Channel Structure
In general, the greater the level of service outputs demanded by meaningful segments of end-
users, the more likely it is that intermediaries will be included in the channel structure. For
example, if targeted end-users wish to purchase in small lot sizes, there are likely to be numerous
intermediaries performing bulk-breaking operations between mass producers and the final users.
If waiting time is to be reduced, then decentralization of outlets must follow, and therefore, more
intermediaries will be included in the channel structure. Intermediaries that are closer to the end-
user are also attractive additions to a manufacturer’s channel structure by virtue of their precise
targeting of specific desired end-user segments.
Service outputs are produced through the costly activities of channel members (i.e., the
marketing flows performed by them). As service outputs increase, therefore, costs undoubtedly
will increase, and these higher costs will tend to be reflected in higher prices to end-users.
End-users sometimes have a choice between a low-service-output, low-price channel on the one
hand and a channel offering high-service-output, high-price channel on the other. For example,
buying the product online versus buying it physically at a store where the buyer has the ability to
see, touch, and try on the product before buying them; advice and in-store service from the
physical store ; and easy returns. By contrast, the online store offers spatial convenience (how
much more convenient can shopping be than from home!) but fails to offer the service outputs
that the physical store offers. Because the online store does not bear the high costs of running a
chain of physical stores, it can afford to offer the shoe at a lower retail price.
The more service-sensitive buyer may, of course, be able to “free ride” on the high service
retailer by consuming pre-sale service such as seeing and touching the product before purchase
and then buying the product itself at a lower-priced outlet such as an online store. This is
common end-user behavior when consumption of valued service outputs is alienable from the
purchase of the product itself, as in the pre-purchase collection of product information. Free-
riding becomes difficult or impossible when consumption of key service outputs is inextricably
tied to, or inalienable from, the purchase of the product—as is true for post-sale installation,
consulting, or maintenance services. In the case product such as running shoes, many of the
valued service outputs are alienable from the shoe purchase itself (e.g., pre-purchase fitting
advice, the ability to try on shoes before buying, and pre-sales advice from professional runners
in the store), but others are not (e.g., easy returns and post-sale interaction with the professional
running community).
Note that price has not been listed as a service output. This is because price is what is paid to
consume the bundle of product plus service outputs; price is not a service that is itself consumed.
That said, end-users routinely make trade-offs among service outputs, product attributes, and
price and weigh which product/service bundle (at a specific price) provides the greatest overall
utility or satisfaction. Because of this trade-off, marketing researchers often do investigate the
relative importance of price along with service outputs and physical product attributes in
statistical investigations like conjoint analysis. This is consistent with our conceptual view of
price as something different from a service output—just as a physical product attribute is not a
service output yet still affects an end-user’s overall utility.
The six service outputs discussed here are wide-ranging, but may not be exhaustive in all
situations. Therefore, one should not be inflexible in defining service outputs because different
product and geographic markets may naturally demand different service outputs.
The Determination of Channel Structure (Figure 3.1)
Service output Lot Size End –user Demand for
level
Service Outputs
Waiting Time
Market
Decentralization
Product Variety
Organization of
the marketing
functions or
flows
Channel Structure
(institution and
establishment
arrangement
The more service outputs required by end-users, the more likely it is that intermediaries will be
included in the channel structure. Thus, if end-users wish to purchase in small lots, then there
are likely to be numerous intermediaries performing sorting operations between mass producers
and the final users. If waiting time is to be reduced, then decentralization of outlets must follow,
and, therefore, more intermediaries will be included in the channel structure. The same type of
reasoning can be applied to all of the service outputs. As service outputs increase, however,
costs will undoubtedly increase, and these higher costs will tend to be reflected in higher prices
to end-users.
End-users are usually faced with a choice between channel structures that provide few service
outputs bet relatively low prices and structures in which both service outputs and prices are high.
The more the end-users participate in the marketing flows (in terms of search, physical
possession, financing, and the like), the more they should be compensated for their efforts.
Where channel service outputs are low, end-users are supposedly compensated for their
additional efforts through the lower relative prices provided by such channel structures.
Thus, when construction machinery manufacturers purchase brake parts in carload quantities
from firms and are willing to wait several months for delivery from distant plants, they can
expect to pay lower prices than if they were to order the same parts from a local warehouse
distributor who is willing to ship in smaller quantities and to deliver the parts much more
quickly. The lower the level of service outputs provided, the greater the economy that can be
achieved by channel members, and vice versa.
The final structure that emerges is, therefore, a function of the desire of channel members to
achieve economies of scale relative to each of the marketing flows and the demand of consumers
for various service outputs. An optimal structure is one that minimizes the total costs of the
system (both commercial and end-user) by appropriately adjusting the level of the service
outputs. Within a channel, members can attempt to shift the degree of their participation in each
flow in order to provide the greatest possible service output at the lowest possible cost. But such
shifting calls for a tremendous amount of coordination and cooperation. This is one reason the
management of channel systems is so critical.
The more the level of service output desired the more complex the distribution structure and the
higher the price of the offer to the end users.
Distribution Cost
Total cost
Channel cost
Buyers cost
Channel service level
Ideal service level
Figure 3.2: Channel performance and cost diagram
The horizontal line in the above figure (2.2) represents service level. The higher the service level
the lower the cost to the buyer. We say lower cost to the buyer by comparing the cost of the
higher service level provided by intermediaries against the alternative of the cost the buyer will
incur if the buyer performs the task himself or herself. So the higher the service level required
the more need for intermediaries because the intermediaries are able to provide the service at a
lower cost than the buyer.
There is an inverse relationship between buyers cost and service level, that means as service
level increases buyers cost decreases and vice versa. So as the service level decreases buyers cost
increases proving the generalization that we have made earlier that is, the less the service level
required by the buyer the less need for intermediaries. Because the buyers can perform the tasks
at a lower cost than the cost intermediaries incur in doing the same tasks. The channel cost
increases as service level increases and so there is a direct relationship between channel costs
and service level. As one increases the other will increase also.
The point where channel cost and buyers cost meet is the point where ideal service level is
achieved, and where the total cost (i.e. the sum of buyers cost and channel cost is at its lowest).
But since minimum cost and ideal service level are moving targets achieving the best channel
structure is difficult.
An argument that is heard against the use of intermediaries is that longer channel results in
higher cost to the buyer. The basis of this argument is that, the longer the channel the higher the
cost to the buyer. But this should be seen in terms of the alternative, which is, buying directly
from the manufacture against purchasing of the same product through intermediaries.
Activity 3.1
For the scenario below, categorize the demand for bulk-breaking, spatial convenience,
waiting/delivery time, and assortment/variety as high, medium, or low. And then, explain
your answers.
A woman in a developing country of Africa wishes to buy some cosmetics for herself.
She has never done so before and is not entirely sure of the occasions on which she will
wear the cosmetics. She does not live near a big city. She is too poor to own a car but has
a bit of extra money for a small luxury.
Commentary: See the answer section
3.3 Marketing costs as a determinant of distribution functions (structures)
One methodology that can help in deciding whether to perform distribution function internally
(vertical integration) or externally (conventional channel of distribution) is the transaction cost
analysis (TCA).
i. Vertical integration
This offers the advantage of control over the fate of the product. However, it requires significant
financial investment.
ii. Traditional channel of distribution
This polar alternative of vertical integration offers less control over the fate of the product.
However, because of specialized labor as a result of using a specialized company, it theoretically
leads to efficient performance of the distribution functions which lower costs.
iii. “Make Vs Buy” decision
This is one frame work that is used in the analysis of the two options- vertical integration Vs
conventional distribution channels. A firm should “make” or perform the distribution function
internally if it is able to perform those activities more cheaply, in this case the option is
integration. However the firm will “buy” or have external firms perform the distribution function
if it results in efficiency, then the option is to use “conventional” distribution channel. This is
functionally spinning-off the distribution activities to external institutions.
But the external Vs internal options in performing distribution function is complex so that it is
not easy to approach it using the “make Vs buy” frame work.
TCA is a concept originally developed by Williamson. It can be a helpful concept because it

offers both economic and behavioral perspective in approaching the vertical Vs traditional
distribution channel issues. TCA states that the appropriate distribution structure is the one with
the lowest cost structure. If transaction costs are high then use vertical integration whereas when
transaction costs are low use conventional distribution channels.
Transaction costs are defined as those costs that are associated with bargaining, assembling
information, and monitoring performance of distribution activities. TCA states that under ideal
market conditions transaction costs are always minimized when contacting with an external firm.
So the question is why do firms choose vertical integration? Williamson has identified two
factors which inhibit or even prohibit the existence of ideal conditions in the market, which are
the human and environmental factors.
1. Human factors
When considering the above factor Williamson identified “bounded rationality” and
“opportunistic behavior” as affecting transaction costs.
Bounded rationality: Humans are limited in terms of their ability to handle large amount
of information and solve complex problems. In an ideal market there are many firms to
choose from and extensive information about these firms to analyze because of the
limitations that humans have the decision that they make after analyzing more
information than they can handle will be less than perfect. In addition it is difficult to
access the performance of external firms and determine how well they are performing the
distribution function- the alternative is vertical integration.
Opportunistic behavior: This is a pessimistic view of mankind. If it is possible and

profitable people will behave opportunistically. External firms doing distribution function
may withhold information or distort information, shirk their obligation and
responsibilities, fail to discharge their commitment to other parties in the channel relation
if doing so means to their advantage. If negative actions such as indicated above result to
their long term advantage they will do it. So the firm needs to invest in capacity to
administer and monitor performance of distribution function which will considerably
raise the transaction cost- the alternative is to vertically integrate.
2. Environmental factors
These are environmental uncertainty or complexity and number of alternative channel partners
available.
Environmental heterogeneity: such as multiple cultures, multiple political boundaries

increase complexity. Highly variable environment results in increase in uncertainty.
Conventional channel are best when environmental uncertainty is low.
Number of alternative channel partners: In a highly competitive environment with

huge potential for many channel partners the use of conventional distribution channel can
be appealing. However, less number of channel partners in an environment may result in
a higher transaction cost due to the possibility of those channel members to behave
opportunistically. The small-number channel partner situation may be heightened due to
the need for transaction specific asset like refrigerated truck to transport special food
items. In such a case because fewer transport companies might be inclined to invest in
such an asset, then the number of alternative channel partners may decrease. The
transaction cost will increase due to the tendency of those firms with transaction specific
asset to behave opportunistically.
According to Williamson firms should economize on bounded rationality and safe guard against
hazards of opportunism.
The above statement put in other words mean that conventional (traditional) channels of
distribution are more efficient when
environmental uncertainty is low
the need for transaction specific asset is reduced (reducing the small number situation)
Opportunistic behavior is reduced- because performance assessment is simple and
straight forward.
If the above 3 conditions are not met then vertical integration is more efficient.
3.4 Segmenting the Market by Service Output Demands
Service outputs clearly differentiate the offerings of different marketing channels, and the
success and persistence of multiple marketing channels at any one time suggests that different
groups of end-users value service outputs differently. Thus, to effectively apply the concept of
service outputs to channel design, we must consider the issue of channel segmentation according
to service output demands. This means segmenting the market into groups of end-users who
differ not in the product(s) they want to buy but also in how they want to buy them.
At the very high end of service valuation in any market is a (usually small) segment of buyers
who are both very service-sensitive and very price-insensitive and who can, therefore, be
profitably served through a specialized channel.
From a marketing research perspective, it is essential to generate a comprehensive understanding

of all the relevant service outputs demanded by different end-users. This is accomplished by
conducting qualitative focus groups and/or one-on-one exploratory interviews to generate an
unbiased list of all the service outputs that apply to the particular product and market in question.
This research results in a full set of service outputs that might be demanded by some or all
groups of end-users in the market.
Once the list of possible service outputs is identified, the market can be segmented in two
different ways. It can be divided into a priori segments (such as those often used in product or
advertising decisions) and then analyzed in order to see whether those segments share common
purchasing preferences. Alternatively, research can be designed and conducted from the start to
define channel segments that best describe end-users’ service output demands and purchasing
patterns. It is much better to follow this latter path because end-users’ preferred shopping and
buying habits rarely correlate highly with their preferences for product features, their media
habits, their lifestyles, or other common segmentation schemes that management and advertising
agencies usually employ. In general, the channel segmentation process should be carefully
designed to produce groups of buyers who (a) are maximally similar within a group, (b) are
maximally different between groups, and (c) differ on dimensions that matter for building a
distribution system.
Activity 3.2
Explain how the shopping characteristics for the following consumer and industrial goods
affect the channels for them:
CONSUMER GOODS INDUSTRIAL GOODS
Bread Computer printer ink cartridges

Breakfast cereal Cement
Women’s hats Photocopy machines
Commentary: use service outputs such as spatial convenience, waiting and delivery time,
bulk breaking, assortment and variety and others in providing the answer to this question.
3.5 Meeting Service Output Demands
One of the basic precepts in marketing is that the seller should seek to identify and then meet the
needs of its end-users in the marketplace. In the marketing channel strategy context, this means
creating and running a marketing channel system that produces the service outputs demanded by
targeted end-user segments. However, when designing marketing channel being responsive to
service output demands can be very expensive and time-consuming. The question arises whether
there are market conditions under which a channel manager can profitably serve a segment in the
market without fully meeting the service output demands characterizing them.
The answer has multiple parts by nature. The key factors determining whether and how quickly
to respond to knowledge about unmet service output demands include:
Cost: Sometimes it is prohibitively expensive (from a supply perspective) to meet

expressed service output demands. Channel members must then decide whether or not to
provide the service, and if so, whether to cover that cost for the consumer or to explicitly
charge the consumer for high service provided. If the channel covers the cost for the
consumer, its profit per sale drops, but if it charges consumers for the high cost of
providing high service levels, its customer base and sales volume are likely to drop.
Channel members have to decide which is the lesser of the two evils.
Competitive: The question here is whether existing competitors can beat this channel’s
current service output provision levels. It may be that no competitor currently in the
market exceeds this channel’s service output levels, and therefore, the added cost of
improving service would not lead to any change in market share from current market
sales for the channel in question (although it could lead to an increase in total market
sales by attracting new buyers who were not willing to buy at the previously lower
overall service levels).
Ease of entry: Competition comes not just from firms currently in operation but also
from potential competitors, or entrants to the industry. A channel that fails to meet end-
user segments’ demands for service outputs may find itself surprised by the incursion of
new competition with better technologies for meeting those demands. If entry is
somehow blockaded, the existing competitors can continue in their current channel
strategies. But if entry is easy, providing parity service to the market may not be
sufficient. This is precisely the challenge facing distributors of music CDs in today’s
market, where entrants offering online downloads of music provide not only quicker
delivery and more spatial convenience (downloads now, done at home), but also offer
precisely the assortment the consumer wants (it is possible to download just the song or
songs the consumer wants without having to buy an entire album). As a result, retail sales
of recorded music dropped from $13 billion in 1999 (when Napster was launched) to
approximately $10.6 billion in 2003; the Wherehouse retail chain and Tower Records
both filed for bankruptcy in the interim, while Musicland Group, the second-largest
retailer, closed more than 20 percent of their stores.
Other elements of excellence in the marketing offering: The marketing channel is one
part of the overall marketing mix. A truly superior product or a tremendously low price
can lead end-users to buy through a channel that does not quite meet their service output
demands. For example, even very time-constrained, wealthy consumers may spend large
amounts of time searching for just the right addition to their home décor. Such end-users
find it necessary to do so because of the lack of a good alternative means of buying the
specific products they want (i.e., a deficiency of assortment). However, the existence of
an unmet service output demand means that there is a potential threat to the channel that
offers some, but not all, elements of a marketing mix tailored to the target end-user’s
demands.
The key insight here is that none of these arguments alone is sufficient to guarantee protected
markets and sales if the channel fails to offer the level of service outputs demanded by target
end-users. Where there is a market opportunity, the chances are that rivals (either those currently
competing against this channel or potential entrants) will sooner or later figure out how to exploit
that opportunity. Thus, in the short run it certainly is possible to maintain a strong market share,
and even loyal end-users, with a less than stellar service output demand provision. But over the
longer run, the chances of success with this course of action diminish because of the
overwhelming incentive to compete for these end-users’ sales.
Summary
This chapter has focused on the demand side of the marketing channel design problem, first by
describing end-user behavior. In all markets, end-users will have differential preferences and
demands for service outputs that reduce their search, waiting time, storage, and other costs. The
chapter discussed about service outputs that are demanded by end-users, and how to identify and
analyze these service outputs. Grouping end-users in the market by demands for service outputs
(as opposed to preferences for physical product attributes, for example) helps us define potential
target market segments for which to design specific marketing channel solutions. The chapter
discussed segmenting channels for the purpose of developing a marketing channel from scratch
or modifying the existing channel. It then asked under what marketplace conditions it is most
important to meet all service output demands and how to link this demand-side analysis with the
supply-side decisions required when designing a channel.
Part one: Multiple Choices
Answer questions one to three based on the information that is given below. Consider two
different soft drink buyers: an office employee at work, looking for soft drink during her
morning coffee break, and a family of ten members buying for at home consumption.
1. Based on the information given above, the office employee has high demand for which of
the following service outputs?
a. Assortment depth and breadth
b. Variety
c. Spatial convenience
2. Based on the above data, the office employee may have moderate demand for which of
the following service out puts?
a. Bulk breaking
b. Waiting time
c. Delivery time
d. Product variety
3. Based on the information that is given above, the family has
a. The same pattern of service output demand as that of the office employee
b. Low service output demand level for product variety
c. Low service output demand for lot size requirement
Answer question number 4 based on the channel performance and costs diagram that is given
below.
Distribution
Cost
Channel service level (e.g. right quantity, etc.)
Ideal service level
4. Based on the information that is given above letter C represents

a. Buyers cost
b. Channel cost
c. Total cost
d. None
5. Identify the correct statement
a. If higher service level is required use intermediaries
b. If lower service level is required channel cost will increase
c. If less service is required by the buyer the need for intermediaries will increase
d. There is indirect relation between channel cost and service level
e. All
6. ___________offers the advantage of control over the fate of the product. However, it
requires significant financial investment
a. Traditional channel of distribution
b. Conventional channel of distribution
c. Vertical integration
d. None
7. Conventional (traditional) channels of distribution are more efficient when
a. Environmental uncertainty is low
b. The need for transaction specific asset is reduced
c. Opportunistic behavior is reduced
d. All
incorrect
8. Conventional channel are best when environmental uncertainty is high.

9. In a highly competitive environment with huge potential for many channel partners the
use of conventional distribution channel can be appealing
10. Vertical integration is appropriate if it is difficult to access the performance of external
firms and determine how well they are performing the distribution function.
Part three: Discussion question
11. It is often heard that distribution costs are higher when intermediaries are involved. The
more the number of intermediaries the higher the selling price of the product. Do you
agree or disagree with this statement?
Chapter 4
Channel Participants
This chapter begins by providing an overview of the institutional school of marketing thought. It
then proceeds by first identifying the difference between channel members and channel
participants, and then defining the distinction between retail sales and wholesale sales. Then, it
explains the operational characteristics that define retail position and the nature of retailing
competition. Finally, it considers some of the strategic issues currently facing retailers.
Learning objectives
Describe the institutional school of marketing thought

Describe the classification of the major participants in marketing channels
Recognize and appreciate the major types of distribution tasks performed by
the major types of wholesalers
Explain the major trends occurring in retail structure especially with regard
to size and concentration in retailing
Provide an overview of the distribution tasks performed by retailers
Institutional school
Marketing institutions refer to those who do the work of marketing, usually marketing
middlemen, including wholesalers, agents, brokers, and retailers. Sheth et al. (1988: 74) wrote:
‘L.D.H. Weld deserves credit as the founding father of the institutional school’ based on his
discussion of the value of specialized middlemen in performing marketing tasks. The foundation
of the institutional school is the emphasis on describing and classifying various types of
marketing institutions, and later explaining their interactions in ‘channel of distribution’.
Two books one in 1915 and the other in 1927 were credited with earliest discussion of the
development of retailing institutions wholesaling institutions respectively. Both books focused
primarily within the institution rather than discussing the linkages between institutions, further,
marketing institutions involve more than retailing and wholesaling middlemen.
There is a need to make a distinction between marketing institutions and middlemen that has
often been lost in historical discussions of the institutional approach. The distinction involves the
idea of ‘functional specialists’. Early in 1920 Duncan stated that ‘functionalized middlemen, or
those men, such as railroad men, insurance men, wholesalers, retailers, bankers, who devote their
effort to a specialized phase of business activity . . . may be called an institution’. Thus,
marketing institutions combine what would today be regarded as middlemen (wholesalers,
agents, brokers, retailers, etc.) with what was termed functional specialists or facilitating
institutions.
Two years later Clark dismissed this notion by including only middlemen in marketing
institutions and excluding facilitating institutions: ‘Functional specialists are agencies which
specialize entirely in transportation, storage, risk-taking, and financing. These are not
middlemen’. In 1934 Breyer similarly distinguished between: trading concerns engaged
primarily in selling and buying – producers, wholesalers, retailers, brokers, selling agents,
commission houses, etc. . . . in contrast to non-trading concerns engaged in [facilitating]
marketing activity, commercial banks, transportation and storage companies, insurance
companies, and so on.
The institutional school originally emphasized the description and classification of middlemen.
The school evolved from description and classification of marketing institutions to explaining the
economics and behavioral dimensions of channels of distribution1.
The basic dichotomy between channel memberships is based on performance or nonperformance

of the negotiatory functions (buying, selling, and transferring title). Participants who engage in
these functions are linked together by the flows of negotiation or ownership and are therefore
members of the contactual organization (the marketing channel).
The three basic divisions of the marketing channel depicted are:
1
For further discussion see the 2005 article “A history of school of marketing thought” by Eric H Shaw and Brain
Jones
1. Producers and manufacturers,
2. Intermediaries,
a. Wholesale and
b. Retail intermediaries
3. Final users
a. Consumer and
b. Industrial users
In the context of the management perspective we are using, it is more appropriate to view final
users as target markets that are served by the commercial subsystem of the channel. The
commercial channel, then, by definition excludes final users.
Since facilitating agencies do not perform negotiatory functions, they are not members of the
channel. They do, however, participate in the operation of the channel by performing other
functions. Six of the more common types of facilitating agencies are:
Transportation firms
Storage firms
Advertising agencies
Financial firms
Insurance firms
Marketing research firms.
4.1 Producers and Manufacturers
For our purpose producers and manufacturers consist of firms that are involved in extracting,
growing, or making products. This category includes forestry and fishing, mining, construction,
manufacturing, and some service industries.
The range of producing and manufacturing firms is enormous, both in terms of the diversity of
goods and services produced and the size of the firms. It includes firms that make everything
from straight pins to jet planes and that vary in size from a one-person operation to giant
multinational corporations with many thousands of employees and multibillion-Birr sales
volumes.
But even with all this diversity, a thread of commonality runs through producing and
manufacturing firms: All exist to offer products that satisfy the needs of markets. For the needs
of those markets to be satisfied, the products of producing and manufacturing firms must be
made available to those markets. Thus, producing and manufacturing firms must somehow see
that their products are distributed to their intended markets.
Most producing and manufacturing firms, both large and small, however, are not in a favorable
position to distribute their products directly to their final user markets. Quite often, they lack the
requisite expertise and the economies of scale to perform all of the distribution tasks necessary to
distribute their products effectively and efficiently to their final users.
1. Intermediaries
Intermediaries are independent businesses that assist producers and manufacturers (and final
users) in the performance of negotiatory functions and other distribution tasks. Intermediaries
thus participate in the negotiation and/or ownership flows. They operate basically at two levels:
At the wholesale and retail.
2. Wholesale Intermediaries
Wholesaling (wholesale trade, wholesale distribution) refers to business establishments that do

not sell products to a significant degree to ultimate household consumers. Instead, these
businesses sell products primarily to other businesses: retailers, merchants, contractors, industrial
users, institutional users, and commercial users. Wholesale businesses sell physical inputs and
products to other businesses. Wholesaling is closely associated with tangible goods; however,
these entities create their value added through providing services, that is, channel flows.
Although that value added is quite real, very little about wholesaling is tangible: It is the epitome
of a service industry. In a channel stretching from the manufacturer to the final household user,
wholesaling is an intermediate step.
How many people can readily list what wholesalers do? Most are quick to note that they gather,
process, use information about buyers, suppliers, and products to encourage transactions. This
function has traditionally been well compensated.
Wholesalers also add value by creating an efficient infrastructure to exploit economies of scope
(operating across brands and product categories) and scale (high volume). Effectively,
wholesalers share that infrastructure with suppliers (upstream) and customers downstream. This
advantage, due to specialization in channel flows, is why wholesalers can compete with
manufacturers on price, even though their cost structure includes the wholesale price to the
supplier. Manufacturers frequently underestimate the magnitude of the wholesaler’s efficiencies
in providing market coverage.
Many customers value the wholesaler’s role of absorbing risk for them by standing behind
everything they sell, pre- and post-sales. Of course, wholesalers provide time and place utility
(putting the right product in the right place when the customer wants it). Wholesalers filter the
product offering, suggesting appropriate choices and reducing the customer’s information
overload.
Types and Kinds of Wholesalers—the most commonly used classification of wholesalers is:
1. Independent middlemen
2. Manufacturer owned
Independent middlemen are in turn divided into
1.1 Wholesalers and
1.2 Agents, brokers and commission merchants.
The following figure provides a schematic diagram of these three types of wholesalers.
Schematic Overview of the Three Major Types of Wholesalers (figure 4.1)
All
wholesale
firms
Independent Manufacturer
Middlemen owned
Merchant Agents, brokers,

Wholesalers and
Commission
merchants
i. Merchant Wholesaler—are firms engaged primarily in buying, taking title to, usually
storing, and physically handling products in relatively large quantities and then
reselling the products in smaller quantities to retailers, to industrial, commercial, or
institutional concerns, and to other wholesalers.
They go under many different names, such as:

 Wholesalers,
 Jobber,
 Distributor,
 Industrial distributor,
 Supply house,
 Assembler,
 Importer,
 Exporter etc.
ii. Agents, Brokers, and Commission Merchants—are also independent middlemen who
do not, for all or most of their business, take title to the goods in which they deal, but
who are actively involved in negotiatory functions of buying and selling while acting
on behalf of their clients. They are usually compensated in the form of commissions
on sales or purchases.
Some of the more common types are known in their industries as:
 Manufacturers’ agents,
 Commission merchants,
 Brokers,
 Selling agents, and
 Import and export agents.
iii. Manufacturers’ Sales Branches and Offices—are owned and operated by

manufacturers but are physically separated from manufacturing plants. They are used
primarily for the purpose of distributing the manufacturer’s own products at
wholesale. Some have warehousing facilities where inventories are maintained, while
others are merely sales offices. Some of them also wholesale allied and
supplementary products purchased from other manufacturers.
Activity 4.1
Should advertising agencies and financial institutions be considered channel members?
Why? Why not? Is it more useful from a managerial perspective to think of consumers as
members of the channel or as end-users consuming the services of the channel?
Use the basic dichotomy between channel members and non channel members as well as the
concept of the marketing flows when commenting on this question.
4.2 Distribution tasks performed by merchant wholesalers
Merchant wholesalers serve manufacturers as well as retailers and other customers. They have
survived as intermediaries in the marketing channel because, as specialists in the performance of
distribution tasks, they can operate at higher levels of effectiveness and efficiency.
Modern, well-managed merchant wholesalers are especially well suited for performing the
following types of distribution tasks for manufacture
i. Providing for market coverage

ii. Making sales contacts
iii. Holding inventory
iv. Processing orders
v. Gathering market information
vi. Offering customer support
i. Market Coverage—is provided by merchant wholesalers to manufacturers because the

markets for the products of most manufacturers consist of many customers spread
over large geographical areas. To have good market coverage so that their products
are readily available to customers when needed, manufacturers have relied
increasingly on merchant wholesalers to secure the necessary market coverage at
reasonable cost.
ii. Sales Contact—is a valuable service provided by merchant wholesalers. For

manufacturers, the cost of maintaining an outside sales force is quite high. If a
manufacturer’s product is sold to many customers over a large geographical area, the
cost of covering the territory with its sales force can be prohibitive. By using
wholesalers to reach all or a significant portion of their customers, manufacturers may
be able to reduce substantially the costs of outside sales contacts because their sales
force would be calling on a relatively small number of wholesalers rather than the
much larger number of customers.
iii. Holding Inventory—is another crucial task performed by wholesalers for manufacturers.
Merchant wholesalers take title to, and usually stock, the products of the
manufacturers whom they represent. By doing so, they can reduce the manufacturers’
financial burden and reduce some of the manufacturers’ risk associated with holding
large inventories. Moreover, by providing a ready outlet for manufacturers’ products,
wholesalers help manufacturers to better plan their production schedules.
iv. Order Processing—performed by wholesalers is very helpful to manufacturers because

many customers buy in small quantities. Yet manufacturers both large and small find
it extremely inefficient to attempt to fill large numbers of small orders from
thousands of customers. Wholesalers, on the other hand, are specifically geared to
handle small orders from many customers. By carrying the products of many
manufacturers, wholesalers’ order processing costs can be absorbed by the sale of a
broader array of products than that of the typical manufacturer.
v. Gathering Market Information—is another task of substantial benefit to manufacturers.

Wholesalers are usually quite close to their customers geographically and in many
cases have continuous contact through frequent sales calls on their customers. Hence,
they are in a good position to learn about customers’ product and service
requirements. Such information, if passed on to manufacturers, can be valuable for
product planning, pricing, and the development of competitive marketing strategy.
Some wholesalers have even begun to use the Internet to provide information to link
suppliers and customers together.
vi. Customer Support—is the final distribution task that wholesalers provide for
manufacturers. Products may need to be exchanged or returned, or a customer may
require setup, adjustment, repairs, or technical assistance. For manufacturers to
provide such services directly to large numbers of customers can be very costly.
Instead, manufacturers can use wholesalers to assist them in providing these services
to customers. These extra support by wholesalers, often referred to as value added
services, plays a crucial role in making wholesalers vital members of the marketing
channel from the stand points of both the manufacturers who supply the and the
customers to whom they sell.
In addition to performing the six distribution tasks for manufacturers, merchant wholesalers are
equally well suited to perform the following distribution tasks for their customers:
i. Assuring product availability

ii. Providing customer service
iii. Extending credit and financial assistance
iv. Offering assortment convenience
v. Breaking bulk
vi. Helping customers with advice and technical support
i. Product Availability--providing for the ready availability of products, is probably the

most basic distribution task performed by wholesalers for customers. Because of the
closeness of wholesalers to their customers and/or their sensitivity to customers’
needs, they can provide a level of product availability that many manufacturers could
not easily match.
ii. Customer Service—customers often require services such as delivery, repairs, or

warranty work. By making these services available to their customers, wholesalers
save their customers effort and expense.
iii. Credit and Financial Assistance—is provided by wholesalers in two ways. First, by
extending open account credit to customers on products sold, wholesalers allow
customers to use products in their business before having to pay for them. Second, by
stocking and providing ready availability for many of the items needed by their
customers, wholesalers significantly reduce the financial inventory burden their
customers would bear if they had to stock all the products themselves.
iv. Assortment Convenience—refers to the wholesaler’s ability to bring together from a

variety of manufacturers an assortment of products, greatly simplifying customers’
ordering tasks. Instead of having to order separately from dozens or even hundreds of
manufacturers, customers can turn to one or a few general line or specialist
wholesalers who can provide them with all or most of the products they need.
v. Breaking Bulk—many customers do not use large quantities of products, or they may
prefer to order only a small quantity at a time. Many manufacturers find it
uneconomical to fill small orders and will establish minimum order requirements to
discourage them. By buying large quantities from manufacturers and breaking down
these “bulk” orders into smaller quantities, wholesalers provide customers with the
ability to buy only the quantity they need.
vi. Advice and Technical Support--many products, even those that are not considered
technical, may still require a certain amount of technical advice and assistance for
proper use, as well as advice on how they should be sold. Wholesalers, especially
through a well-trained outside sales force, are able to provide this kind of technical
and business assistance to customers.
4.3 Distribution tasks performed by agent wholesalers
Agent wholesalers do not take title to the products they sell. Also, as a rule, they do not perform
as many distribution tasks as a typical merchant wholesaler. Manufacturers’ agents (also
referred to as manufacturers’ representatives or “reps”), for example, specialize mainly in
performing the market converge and sales contact distribution tasks for manufacturers. In effect,
the manufacturers’ agents substitute for the manufacturer’s outside sales force. Thus, they are
especially valuable to manufacturers who are not capable of fielding their own sales forces, or to
supplement the selling efforts of those manufacturers who do have their own sales forces but
who find it uneconomical to use them for certain product categories or territories.
I, Brokers: are usually defined as a go-between, or a party who brings buyers and
sellers together so that a transaction can be consummated. In the strictest definition
sense, then, a broker would only perform one distribution task—providing market
information. Yet, in practice, some brokers may perform many if not most of the
distribution tasks, so that for all practical purposes there is little to distinguish them
from manufacturers’ representatives or selling agents.
II.Commission Merchants: they are of significance mainly in agricultural markets.

They actually perform a wide range of distribution tasks including physically holding
inventory (though not taking title), providing market coverage, sales contact, breaking
bulk, credit, and order processing. These distribution tasks are performed in the
course of the commission merchant’s acting on behalf of his or her principal
(producers or manufacturers). Essentially the commission merchant receives and
warehouses products, helps locate buyers, makes sales, extends personal credit,
processes orders, and may arrange for delivery. After completing the sale and
collecting the money from the buyers, the commission merchant remits it (less the
commission for services supplied) to the principals, who sometimes remain
anonymous to buyers.
Activity 4.2
Consider the following statement: “A wholesaling operation can be eliminated as an entity,

but someone must perform the wholesaling tasks.” Take a position on this statement, pro or con,
and offer support for your reasoning.
Commentary: can you eliminate a function of an intermediary?
4.4 What is retailing?
Commentary:
Staring See the is
a retail business answer section the real challenge is remaining in business, according
not challenging
to one source approximately 2 out of 4 retail businesses fail within the first year of business. So
it is important to know the art and science of retailing to be successful.
Definition
A retailer is any business establishment which directs its marketing efforts toward the final
consumer for the purpose of selling goods or services.
The important words in this definition are "the final consumer". A business can sell its offer to
two different types of customers. One customer may buy the product for personal consumption,
while the other may buy the offer to use it in his /her business, in the later case the sale is not a
retail sale. Hence, a sale is a retail sale if the customer buys the offer for personal consumption.
If the buyer buys the product for resale or to use in producing goods and services, then the sale is
not a retail sale but it is a business sale. In this instance, is the company selling to two different
buyers a retail company or not?
According to one authority, if a company’s sale to final users is dominating or if more than 50%
of sales are made to final users then the company is a retail company.
Although the distinction between retail and wholesale sales may seem trite, it is really very
important because buying motives are critical in segmenting markets. Companies that sell
personal computers to high-school students for doing their homework (or playing computer
games) are engaged in retail sales. Companies that sell personal computers to their parents for
use in a family business run out of a home office are engaged in wholesale sales. It is important
for them to understand the differences in serving these different market segments even though
they are served out of the same retail establishments.
Retailers’ growing power in marketing channels
The power and influence of retailers in marketing channels have been growing. This trend
follows three major developments:
Increase in size and buying power
Application of advanced technologies
Use of modern marketing concepts and techniques
Increase in size and buying power— retailers have become large in size and few in number this
has given them concentrated purchasing power. This consolidated purchase has increased their
capacity to influence the actions of other channel members.
Application of advanced technologies—the many technological innovations of recent years have

not gone unnoticed by retailers. Indeed, retailers have become astute followers and (more
important) ardent users of many new technologies that have made them more sophisticated and
demanding channel members.
Use of modern marketing concepts and techniques— the marketing concept that encourages
firms to stress on the consumer has been around since the 1950s. But it was not until the 1990s
that the marketing concept really caught on in retailing. Retailers had traditionally been more
supplier (vendor) driven than market driven. As the 1990s unfolded, however, more and more
retailers in many lines of trade discovered the marketing concept and the power of modern
marketing methods for surviving and prospering in fiercely competitive retail markets.
Distribution tasks performed by retailers
1. Expanding market coverage and increasing sales contact: Offering manpower and
physical facilities that enable producers/manufacturers and wholesalers to have many
points of contact with consumers close to their places of residence.
2. Promotion: Providing personal selling, advertising, and display to aid in selling
suppliers’ products.
3. Communication: Interpreting consumer demand and relaying this information back
through the channel.
4. Bulk breaking: Dividing large quantities into consumer-sized lots, thereby providing
economies for suppliers (by accepting relatively large shipments) and convenience for
consumers.
5. Storage: Offering storage, so that suppliers can have widely dispersed inventories of
their products at low cost and enabling consumers to have close access to the products of
producers/manufacturers and wholesalers.
6. Risk bearing: Removing substantial risk from the producer/manufacturer (or wholesaler)
by ordering and accepting delivery in advance of the season.
The Retail Level
Retailers are referred as "middlemen’’ or “intermediaries’’. This suggests that retailers occupy a
middle position between two other levels. In fact, retailers buy products from producers and
wholesalers and then sale these to final users. Producers in order to reach the final user can use:
i. The extended channel: In this instance producers will depend on wholesalers and
retailers to reach the final user with their output.
ii. Limited Channel: In this case producer uses retailers to reach the final user there by
eliminating the wholesaler. Manufacturers of “high price " products like furniture,
automobiles and producers of "Perishable " products like fresh foods usually use a
limited channel.
iv. Direct Channel: In this instance, producers market directly to end users, thereby
eliminating the use of wholesalers and retailers. To this effect producers may use
magazines, television and other techniques.
But a manufacturer or producer who eliminates an intermediary (retailer on wholesaler) will

assume the function of the retailer eliminated. In other words the producer can eliminate a
retailer but not the retailer’s function.
Activity 4.3
Wrigley is the world’s leading manufacturer of chewing gum, producing literally millions
of packages of gum every day. Its manufacturing technology for producing gum is state-of-the-
art, and it is a large and financially strong company. It sells its products to millions of gum-
chewing consumers all over the worlds. Still, Wrigley has never attempted to sell chewing gum
directly to consumers, but instead uses a wide variety of intermediaries at the wholesale and
retail levels.
Why do you suppose Wrigley has chosen to use intermediaries rather than sell direct to
consumers? Explain the underlying economics of the company’s policy.
Commentary: discuss the issue in terms of the distribution tasks performed by merchant
wholesalers and retailers.
4.5 The problem of Retailing
The retailer’s problem is how to match his offer to consumers’ need in order to make a profit.
Satisfying customers need at a profit is not a simple task; it requires the reconciliation of two
problems:
i. The retailer’s problem of the right blend.
This raise issues like
The right product
At the right place
At the right time
In the right quantity
At the right price
With the right appeal
ii. Consumer’s problem of the right choice

This includes
What to buy?
When to buy?
How much to buy?
Where to buy?
From whom to buy?
How much to pay?
For the sake of discussion let us consider one issue in the retailer’s problem of the right blend
that is what makes the right place?
Determining the right place requires consideration of factors like:
a. Market area
b. Market coverage
a. Market areas
A market is a place where buyers and sellers meet to transact. To find the right market
retailers must consider:
1) Regional markets
2) Local markets
3) Trading areas
Regional markets: To a retailer the regional market is the right part of the country? This decision
is already made for some, example, a man who inherits his father’s furniture business in Bahir
Dar. But for chains they have to select the part of the country where their new stores are to be
located.…
Local markets: This addresses ‘the right town ‘and ‘right part of town’ issues. Usually high
income and middle income customers cluster in suburbs, while low income customers live near
the inner city, so depending on the target the retailer wants to attract a decision about which ‘
part of town’ needs to be made.
Trading areas: When considering this factor that affects the ‘right place ‘decision, the retailer
will determine whether; to rely on its own ability to attract customers – go it alone, or to locate in
cluster, relying on the power of the cluster of stores to attract customers. For example, it would
be difficult to a store that sells only ties, to rely on its own power to attract customers. But if
located in a shopping mall, it will have the ability to attract many customers.
b. Market coverage
When determining the right place the retailer must decide whether to use:
(1). Intensive distribution: Here the retailer will use as many retail outlets as possible. This is
good for convenience goods (e.g. goods the consumers want to obtain with a minimum of effort
such as soft drinks.
(2). Selective distribution: The retailer will use few outlets in a given market. This is good for
shopping goods. Consumers purchase shopping goods such as cloths after comparing price,
style, or quality.
(3). Exclusive distribution: A single outlet will be used in order to serve a given market.
Specialty goods that consumers are willing to obtain through considerable effort require this
form of distribution.
PRODUCT TYPE STRATEGY

Convenience goods Intensive market converge strategy
Shopping goods Selective market coverage strategy
Specialty goods Exclusive market coverage strategy
Figure 4.2: A pictorial guide line of retailing market coverage strategies.
Summary
In this chapter a discussion is made about channel participants. Some firms are channel members
and these perform negotiatory function. While other firms do not perform negotiatory functions,
and are called facilitating agencies. The consumer is a member of a marketing channel but is
excluded from the commercial sector of the marketing channel.
The commercial sector of the marketing channel is made up of producers & manufacturers.
These channel participants are involved in growing, extracting, and making products. Since most
of the time they lack the skill and expertise to perform distribution function they rely on
intermediaries. Intermediaries operate at two levels; the wholesale and retail level. Retailers are
middle men that are in the business of selling products to households or individual consumers.

1. _________ is not a member of the commercial subsystem of the channel of distribution?
a. A manufacture
b. An industrial user
c. A retailer
d. All
e. None
2. In ________________ instance producers will depend on wholesalers and retailers to

reach the final user with their output.
a. The extended channel
b. The limited channel
c. The direct channel
d. None
3. __________________distribution strategy is appropriate for convenience goods.
a. Exclusive
b. Selective
c. Intensive
d. None
4. Intermediaries that physically possess the product deliver it to customers and after
receiving payment deduct whatever they deserve and then pay back to the producer.
a. Broker
b. Agent
c. Commission Merchant
d. Manufacturer’s sales office
5. Merchant wholesalers
a. Provide market coverage
b. Make sales contact
c. Hold inventory
d. All
e. None
6. The dominant method of conducting business in developing countries is
a. Indirect channel
b. Centralized exchange
c. Decentralized exchange
d. Traditional channel of distribution
7. ____________are also independent middlemen who do not, for all or most of their
business, take title to the goods in which they deal, but who are actively involved in
negotiator functions of buying and selling while acting on behalf of their clients
a. Agents
b. Brokers
c. Commission Merchants
d. All
8. ____________are owned and operated by manufacturers but are physically separated
from manufacturing plants. They are used primarily for the purpose of distributing the
manufacturer’s own products at wholesale
a. Import and export agents
b. Manufacturers’ Sales Branches and Offices
c. Selling agents
d. All
e. None
incorrect
9. Merchant wholesalers compared to agents do not perform many distribution tasks

10.Under the strict definition of brokers, a broker will perform only market coverage
function
Part Three: Discussion question
11. Why do you suppose the average costs of performing many distribution tasks are lower
for intermediaries and facilitating agencies than for producers and manufacturers?
12. Expertise and economies of scale in production do not automatically translate into
expertise and economies of scale and/or scope in distribution. Discuss this statement.
Chapter 5
Managing Marketing Channels
Introduction
Marketing channel management entails securing the channel members to interact for the mutual
all the stake holders. It is apparent that the members in the marketing channel to have differing or
even competing objectives and priorities that would result in channel conflicts. This chapter
discuss the dynamics in the marketing channel by specifically focusing on channel conflicts and
ways to handle them
Learning objectives:
After reading this chapter, learners should be able:

To visualize the systemic view of marketing channels
To analyze channel conflicts to manage channel relationship with minimal
conflicts
To analyze strategic options related to channel design to make viable decisions
To integrate strategic options with the firm’s channel objectives
To exercise leadership in channels through the effective use of power
5.1 Channel Management: An over view
Channel management can be defined as the administration of existing channels to secure the
cooperation of channel members in achieving the firm’s distribution objectives.
Three points should be particularly noted in this definition:
First, note that channel management deals with existing channels; that is, we are assuming that
the channel structure has already been designed (or it has evolved) and that all of the members
have been selected. Channel design decisions are therefore viewed as separate from channel
management decisions. Perhaps this distinction can be grasped best by thinking of channel
design decisions as concerned with “setting up” the channel, whereas channel management deals
with “running” what has already been set up.
The second point covers the phrase secures the cooperation of channel members. Implied in this
is the notion that channel members do not automatically cooperate merely because they are
members of the channel. Rather, administrative actions are necessary to secure their
cooperation. If a manufacturer enjoys substantial cooperation from channel members without
having to administrate, this is not managing—it is simply a matter of being lucky.
Third, distribution objectives are statements describing the part that the distribution comment of
the marketing mix is expected to play in achieving the firm’s overall marketing objectives. In
the context of managing the channel, carefully delineated distribution objectives are needed to
guide the management of the channel.
5.2 Conflict in the marketing channel
Conflict is derived from the Latin word for collide. Conflict occurs in marketing channels
because marketing channels are a social system and in all social systems conflicts are
inherent.
Channel Conflict arises when one channel member believes another channel
member is engaged in behavior that is preventing it from achieving its goals.
Causes of conflict
The following seven categories of underlying causes of channel conflict:
i. Role incongruities,
ii. Resource scarcities,
iii. Perceptual differences,
iv. Exceptional differences
v. Decision domain disagreements,
vi. Goal incompatibilities, and
vii. Communication difficulties.
i. Role Incongruities
A role is a set of prescription defining what the behavior of position members should be.
When applied to the marketing channel any given member of the channel has a series of
roles that he or she is expected to fulfill.
For example, a franchiser is expected to provide extensive management assistance and

promotional support to franchisees. In return, franchisees are expected to operate in strict
accordance with the franchiser’s standard operating procedures. If either the franchiser or
franchisee deviates from the given role (for example, if the franchisee decides to institute
some of his or her own policies) a conflict situation may result.
ii. Resource Scarcities
Sometimes conflict stems from a disagreement between channel members over the
allocation of some valuable resources needed to achieve their respective goals.
An example of resource scarcity as a cause of conflict involves site selections in franchised
channels. In this case, the resource is the market in which particular franchisees operate.
In any given market, existing franchisees serving that market can come into conflict with
the franchiser if the franchiser establishes new franchisees in that market that could take
business away from the existing franchisees. Some franchisees have gone so far as to
initiate lawsuits to prevent franchisers from establishing new franchisee outlets in what
they perceive to be “their” market.
iii. Perceptual Differences
Perception refers to the way an individual selects and interprets environmental stimuli.
The way such stimuli are perceived, however, is often quite different from objective reality.
In a marketing channel context, the various channel members may perceive the same
stimuli but attach quite different interpretations to them.
A common example of this in the marketing channel is in the use of point-of –purchase
(POP) displays. The manufacturer who provides these usually perceives POP as a valuable
promotional tool needed to move products off retailer’s shelves. The retailer, on the other
hand, often perceives point-of-purchase material as useless junk that serves only to take up
valuable floor space.
iv. Decision Domain Disagreements
Channel members explicitly or implicitly carve out for themselves an area of decision
making that they feel is exclusively theirs. In contractual channel systems, such as
franchise, these decision domains are quite explicit and are usually spelled out meticulously
in the franchise contract.
A traditional and pervasive example of this has been in the area of pricing decisions. Many
retailers feel that pricing decisions are in their decision-making domain. Some of the
manufacturers supplying these retailers, however, believe that they should have a say in
price-making decisions. Therefore conflicts might arise when the manufacturer tries to set
retail prices and the retailer feels his profit margin is not enough for the set price.
v. Goal Incompatibilities
Each member of the marketing channel has his or her own goals. When the goals of two or
more of the members are incompatible, conflict can result. Incompatible goals often arise
between channel members. For example the manufacturer has the objective of market
expansion and to meet this objective wants its products to be distributed by as many
retailers as possible and set lower prices (penetration prices) however this might not make
the retailers happy if their goal is to be considered as exclusive ( or at least one of the few
selected distributors) who can set higher ( premium) prices.
vi. Communication Difficulties
Communication is the vehicle for all interactions among the channel members, whether
such interactions are cooperative or conflicting. A foul-up or breakdown in
communications can quickly turn a cooperative relationship into a conflicting one.
5.3 Channel Conflict and Channel Efficiency
Channel analysts have postulated several possible relationships between channel conflict
and channel performance. The most common view is that the effects of conflict on channel
performance are generally negative and even a threat to the survival of the channel while
others have discussed possible positive effects.
The key question about the effects of conflict from the channel manager’s point of view is
how conflict affects channel efficiency. Does conflict reduce the efficiency with which
distribution objectives are achieved? Can it increase efficiency? Might it not have any
effect at all? While little empirical data on these questions are available, some conceptual
models have been presented on how conflict can affect channel efficiency. Before
discussing these relationships, however, we will define more precisely what we mean by
channel efficiency.
Channel efficiency may be defined as the degree to which the total investment in the
various inputs necessary to achieve a given distribution objective can be optimized in terms
of outputs.
The greater the degree of optimization of inputs in carrying out a distribution objective, the
higher the efficiency is, and vice versa. These inputs can include anything necessary to
achieve the distribution objective.
1. Negative Effect—Reduced Efficiency
A negative relationship indicates that the level of conflict increases when channel
efficiency declines. This conflict is dysfunctional conflict and it becomes manifest conflict.
Manifest conflict needs to be eliminated or at least reduced.
Channel
efficiency
Level of conflict
Figure 5.1 : Dysfunctional conflict
2. No Effect—Efficiency Remains Constant
The existence of conflict has caused no change in channel efficiency. Hence, the effect of
conflict on input levels necessary to achieve distribution objectives is insignificant.
Channel
efficiency
Level of conflict
Figure 5.2 : Conflict has no effect on channel efficiency
3. Positive Effect—Efficiency Increased
Here conflict is shown to cause an increase in channel efficiency. The conflict might serve
as an impetus for either or both of the channel members to reappraise their respective
policies.
Channel
efficiency
Level of conflict
Figure 5.3 : Functional or useful conflict
5.4Resolving Conflict
The following are conflict resolution strategies that channel members can use in order to
resolve dysfunctional conflicts or conflicts that have become manifest conflict.
Accommodating Collaboration
Party’s attempt
to satisfy
others concern
Compromising
Avoiding competing
Party’s attempt to satisfy own concern
i. Avoiding: This is diplomatically sidestepping the issue, by avoiding
threatening situation. Indifference to the concern of the parties involved is
observed here.
ii. Competing: This conflict resolution strategy seeks to maximize the benefit
for one party at the expense of the other. Interaction is seen as a win-loss
power struggle.
iii. Collaboration: In this case the party’s in the conflict will try to come up
with a solution that will maximize benefit to all involved.
iv. Accommodating: Here one party promotes the concern of another party at
its own expense. The interest here is peaceful co-existence with long-run
motive.
v. Compromising: Under this method the party’s in the conflict will seek to
have a middle ground solution. The solution falls short of full satisfaction
for all those involved in the conflict.
Activity 5.1
Ale whole sale enterprise is a public company established to distribute mainly

consumer products to retailers in a bid to minimize inflation and secure
accessibility and availability of consumer products. Thus it distributes the
products to retailers who are willing to sell to the public at the set prices by “
Ale”.
Discuss the possible areas of channel conflict that might arise between ‘Ale’
and its retailers.
Commentary
Consider the causes of channel conflict
5.5 Channel strategy
A strategy is representing (among other things) management’s answer to the question –how to
pursue competitive advantage (Thompson and Stickland, 2001).
Michael porter has three basic strategies a firm may follow to develop industry position and
generate superior profitability: cost leadership, differentiation, and focus. Each broad strategy
places different requirements upon marketing performance and necessitates differences in
channel structure. Each generic strategy is discussed in terms of channel requirements. Let us
consider them individually.
i. Cost leadership:
A cost-leadership strategy involves producing and distributing products at the very lowest per-
unit cost possible for price sensitive customer segments. The primary competitive advantage
achieved by cost-leadership is per-unit cost structure that yields high market-share and above-
average profitability. When this strategy is pursued the company will work hard to achieve lower
costs of production and distribution so that it can price its products lower than the competition
and achieve large market share.
This approach can be appealing when dealing with price sensitive customers.
ii. Differentiation
A differentiation strategy emphasis product or service uniqueness in a manner that is meaningful

to non-price sensitive customers. When this strategy is pursued companies will try to achieve
uniqueness in product and marketing programs to appeal to non-price sensitive customers. The
uniqueness can be achieved through design, performance, quality, or meaningfully differentiated
distribution networks and service offerings. A firm attempts to protect itself from competition by
developing high brand or customer loyalty through differentiation.
iii. Focus
A focus strategy involves concentration on a particular market segment in an industry. Whereas

the above two strategies have targeted an entire industry, a company that uses focus strategy will
concentrate on a few or narrow market segment. To serve the narrow market the firm may use
either differentiation or cost leadership strategy.
5.6 Channel objectives
Guided by the company’s strategy, operational channel objectives are developed. The
operational channel objectives must be developed in terms of the followings:
i. Market coverage and Distribution intensity
ii. Channel control, and
iii. Flexibility.
i. Market coverage and intensity of distribution
The company’s strategic positioning guides the market coverage and intensity of distribution.
There are 3 levels of market coverage that can be chosen from.
a. Intensive Distribution
Intensive distribution involves choosing as many outlets as possible in a given market in order to
serve that market. It is generally the preferred objective if the target market emphasis on low
price and convenience in purchasing and when a cost leadership strategy is employed by the firm
as its basic position.
For example when a manufacturer is producing and selling consumer convenient products ( like
sanitary supplies, groceries, pen , candy etc…) consumers want to buy the products from a
nearby store without bothering to shop around to get a particular brand. Their purchase behavior
is habitual to limited problem solving. Hence they will pick a brand which is available and might
be influenced by brand familiarity. Therefore, the manufacturer has to distribute its products
through almost every available outlets to secure maximum market coverage and sales revenue.
To meet this goal intensive distribution is the most preferable one. However, it should be noted
that intensive distribution will limit the manufacturer ability to control the marketing channel.
b. Exclusive Distribution
The other extreme of wide distribution is exclusive distribution. Exclusive distribution involves
selecting one distributor in order to serve a given market. This objective is appealing when the
firm wants to enhance its product image and obtain considerable level of reseller support.
Exclusive distribution is advisable when the manufacturer is a seller of specialty products and
customers are willing to devote all the effort and time to get the product from the direct source or
the dealer. For example a customer who wants to by power generator for a factory wants to get it
from the dealer to be sure that technical support and after sales services are available from the
same. Besides this exclusive distribution is applicable for B2B (Business-to-Business) selling
where the buyer and the seller have close contact and thus do not need to involve intermediaries.
Further, the exclusive agent will be in a better position to serve various requests of the business
buyers than large number of independent retailers.
However it should be noted that exclusive distribution will compromise the manufacturer’s
interest for larger market coverage by offering better channel control.
c. Selective Distribution
As noted earlier both intensive and exclusive distribution have their limitations and applications.
Therefore selective distribution is a midway between the two that will reduce their limitations
and shares their advantages. Selective distribution involves assigning ‘few’ selected distributors
to carry the manufacturers products. This is usually applicable for ‘shopping goods’ for which
customers want to make some effort to shop around the market before making buying decision.
Products like electronics, home appliance and apparels can be good examples. By distributing
this types of items through selective distribution the manufacturer can achieve better market
coverage while exercising some level of channel control. It is an appealing objective when the
company has selected differentiation strategy.
ii. Channel control
Channel control deals with the need of control the firm wants to have over a range of
distribution activities. Manufactures want to control middlemen in order to obtain greater selling
efforts or quality of after sale support. Intermediaries may desire to exert influence over
manufacturer’s activities in order to ensure continuous supply, product quality improvement, or
reduced prices. The degree of control desired over the range of distribution activities is also a
function of the company’s strategic positioning.
The choices related to market coverage objective are interrelated. For example, Intensive
distribution is not in agreement with channel control objectives. A firm that desires channel
control may find that, it (i.e. control over middleman activities) is consistent only with exclusive
distribution.
iii. Flexibility
Among channel participants a degree of commitment is required in order to develop distribution

channels. From the stand point of ensuring performance this commitment is required. But this
commitment may inhibit the ability of the channel participants to adapt to changes in market,
competition, or environmental conditions. Because of the dynamic nature of these forces,
flexibility has become an important objective in channel situation.
The choice of strategy-whether cost leadership, differentiation, or focus – is made only after
careful analysis of customer, competition, internal capabilities, and external environments.
5.7 Market segmentation and marketing channels
Segmentation is dividing the total heterogeneous market into smaller groups that are relatively
homogeneous and that can be approached by offers that match their unique needs.
There are various bases for segmenting the total heterogeneous market. A typical first approach
to segment a market is to divide it into the consumer market or the business market. The former
is made up of buyers that purchase a product for self-gratification or personal consumption; on
the other hand, the latter is made up of buyers that purchase an offer for reselling or for using the
offer in order to facilitate their business operation. The distribution channels required in order to
reach the above two types of buyers is, however, quite different.
But the broad basis of segmentation presented above is not useful in development of marketing
channels. Consumer markets can further be divided into smaller groups on the basis of criteria
like demographics, geography, & behavior patterns. Industrial market can be further divided into
smaller groups based on the type of organization (manufacturer, wholesaler, retailer,
government, etc.)
Customer size and use of the product criteria
Consumer’s Buying Behavior
After segmentation the company can design its marketing channel by obtaining answer to the
question below for each market segment identified.
Where customers buy the product?
When they buy it?
How they buy it?
The point of asking questions such as the ones above is in order to better understanding the
behavior of each segment (identified) that affects the marketing channel.
Louis Bucklin has suggested a very popular frame work for considering variations in consumer
segments and answers to the previous questions. The differences in buyer behavior can represent
an opportunity for further segmentation and development of channel strategies.
For example, one firm may choose to target consumers whose behavior is described as-those buy
most readily available brand at the most accessible outlet –then the distribution coverage is
intensive. On the other hand, if the behavior of a consumer is described as-loyal to specific store
but is indifferent to brand then selective /exclusive market coverage strategy is required.
i. Industrial Buyer’s Behavior
Let us consider the behavior of business buyers and how that affects channel decisions. Although
there are many competing models for understanding industrial buyer behavior, one useful model
is provided by Barbara B. Jackson. Simply put, there are two broad categories of behaviors by
business buyers i.e. Always-a-share and Lost-for-good
a. Always –a-share
These types of buyers prefer to maintain multiple sources of supply. These types of buyers
frequently switch from supplier to supplier. They may even purchase large quantities of a
product at one time from several different sellers. For example, to purchase 1000 units of
computer –an always-a-share buyer many buy 500 units from one vendor, and the other 500 units
from another vendor.
b. Lost –for-good
This type of business buyer makes all its purchase of a product over time from one vendor. This
type of buyer is committed to a single vendor as long as its needs are satisfied. But if the buyer is
unsatisfied, then the buyer will find a new vendor, then the buyer is lost-for-good to the original
vendor.
Determinants of behavior
The criteria for identifying the above 2 types of buying behavior among business buyers is cost.
The cost is the cost of switching suppliers. Included in the cost are:-
Risk: As experience with a particular vendor increases, then the perceived risk deceases.
Also personal risk for the individual involved in vendor selection is considered also and
it may decrease with experience.
Cost: Changing suppliers may necessitate change in business procedures, equipment,

etc.
Marketing Implications
The firm by identifying the behavior of the target segment it wants to serve can select an
appropriate strategy
Always-a-share: For these types of customers short term tactics like-price reduction,
advertising, etc. can be used because these types of customers are primarily influenced by
short term approaches like price.
Lost – for good : Long-term tactics like improvement in sales force, distribution and
product quality could be used to deal with lost –for-good type of customers. Lost-for-
good customers are aware of their vulnerability and because of it are more sensitive to
any failure from their vendors than are always –a- share buyers.
Activity 5.2
Abebe Teshome, the owner of Newvalue supply, a medium-sized
wholesaler of plumbing supplies, was furious. He had just gotten off
the phone with the sales manager of Bekele Industries, the
manufacturer of a very profitable line of high quality faucets that
Newvalue has had been selling for several years. “That man is now
going to start selling the big home center accounts directly,” fumed
Abebe Teshome to his son Yonatan. “We have worked real hard to
establish this line and then, when it finally gets going with some real
volume, Bekele wants to cut us out,” he continued.
Discuss the possible underlying causes of the conflict that seems to be
emerging in this situation.
Commentary
Consider the causes of channel conflict discussed above

5.8 Motivating the channel members
Motivation explains the reason behind goal oriented behavior. The manufacturer wants its
channel member to devote maximum possible effort to sell its products than any other
competitive brand. The question to ask and answer here is “why should they do sell my brand
than other competitive brands?”. Are we giving them enough reason ( motivation) to do what we
want them to do?
In this chapter we will examine one of the most fundamental and important aspects of channel
management—motivation refers to the actions taken by the manufacturer to foster strong channel
member cooperation in implementing the manufacturer’s distribution objectives.
The discussion is structured around three basic facets involved in motivation management in the
channel. These are:
i. Finding out the needs and problems of channel members
ii. Offering support to the channel members that is consistent with their needs and problems
iii. Providing leadership through the effective use of power
i. Finding out the Needs and Problems of Channel Members
Before the channel manager can successfully motivate channel members, an attempt must be
made to learn what the members want from the channel relationship.
Approaches for learning about channel member needs and problems
All marketing channels have a flow of information running through them as part of the formal
and informal communication systems that exist in the channel. This is one way that can help in
learning the needs and problems of channel members.
a. Research Studies of Channel Members
While it has become fairly common for manufacturers to conduct research studies dealing with
their ultimate customers—to learn the kinds of products that customers want, what their brand
preferences are, the kinds of shopping behaviors they engage in , and many other types of
information—research studies of channel member needs and problems are much rarer. Indeed,
most manufacturers—even large and sophisticated ones—never conduct such research at all.
However, this is another method that can help in knowing the needs and problems of channel
members.
b. Channel Advisory Council

This is a committee comprising the top management of the manufacturer and representatives of
the channel members. The council will periodically meet to discuss issues arising in the
distribution channel. Based on already established procedures and protocols the council will
work to improve channel relationships and resolve conflicts in the marketing channel. This
forum is also very helpful for the manufacturers to get feed back on the market from the channel
member who have direct contact with the customers.
ii. Offering Support to Channel Members
Support for channel members refers to the manufacturer’s efforts in helping channel members to
meet their needs and solve their problems. Such support, if properly applied, should help to
create a more highly motivated group of channel members. One good example of offering
support to the channel member is through Cooperative advertising.
When this approach is used the manufacturer will help the channel members by sharing in the
cost of advertising that the later have incurred in promoting the manufacturers products.
iii. Providing Leadership through the Effective Use of Power
The more indirect and longer a distribution channel the more need for coordination and direction
of channel activities. Each intermediary may have a goal that is in opposition to the goals of
other channel members. The result is conflict in the channel. A manufacturer may require the
intermediary to carry more of its product on its shelf; on the other hand, the intermediary may
reduce the level of the manufacturers’ inventory that it carries in an attempt to decrease the
amount of capital that is tied up with the inventory. The intermediary may have minimum
inventory objective. Intermediaries may feel that manufacturers are not giving enough
promotional support. The manufacturer may feel that the intermediaries are rarely selling the
manufacturer’s products aggressively. Retailers may on the other hand feel that they must spread
their selling effort over a wide range of products to stay in business. Finally manufacturers may
feel that retailers are not providing adequate information about the market, whereas retailers may
fear that if manufacturers obtain enough information about the market, then they will circumvent
them and sell directly to the customer.
This conflict results in a power play for the control of the channel system. All the companies in
the channel system have power but their power is not equal. The company with the greatest
relative power will become the channel leader or captain. The channel leader may direct and
make demands on other channel members. The leader may dictate sales, service quality, and
promotional efforts on the manufacturer, retailers or the distributor. The channel leader may
exert its influence over other channel members in order to facilitate its own performance or the
performance of the channel as a whole. The direction of the influence could be up stream
towards the supplier or back ward. Or the direction of the control could be downstream towards
the customer or forward.
Leadership is essential because without it the channel would be directionless, each channel
member pursuing its goal to the detriment of others. The presence of a leader avoids short term
pursuits that could harm the channel. In exercising effective leadership in the marketing channel
two important considerations shall be made i.e.. power advantage and tolerance of other channel
members.
a. Power advantage and sources of power

The following are sources of power that are applicable to distribution channels.
Reward power : depends on the ability of a channel member to influence the behavior of
another channel member by offering something of value. Retailers can offer
manufacturers preferred shelf space. By promising this retailers may influence
manufactures because manufacturers consider the reward to result in increased sales
level. Manufacturers may offer retailers discounts, lower prices, extended payment
terms, allowances, expedited shipment, etc. by the use of such incentives manufacturers
may exert influence over retailers’ behavior.
The effectiveness of the reward as a source of power depends on whether after the promise of
reward in return for the desired behavior, the promise materialized or not. After the promise
of the reward, the promise did not materialize then the reward as a source of power would be
weakened. However, after the channel member has shown the desired behavior the promised
reward is given, then the reward becomes credible and will be stronger as a source of power
in the future.
Coercive power: occurs when a channel member believes that punishment is

forthcoming if it fails to cooperate. When coercion is consistently applied, then the
channel member may be encouraged to terminate the relationship and also if coercion is
applied consistently to influence a channel member then conflict may arise because of
the tendency of the channel member to resist force.
Legitimate power: arises from contractual agreements. Legitimate power is legally

enforceable. For example when the manufacturer assigns an exclusive dealer in a given
market the dealer will agree not to carry a competitive brand which substitutes the
manufacturer’s product. They might also agree that the manufacturer will not assign
another dealer in that specific market. Therefore, this agreement will give legitimate
power to the manufacturer to control the dealer not to carry other competitive brand and
by the same token it will give the dealer legitimate power to resist the manufacturer’s act
to assign another dealer in the same market.
Referent power: results from ability to influence further action. A retailer might not
have heavy financial power or any contractual mandate to demand and enforce any thing
on the manufacturer. However, that specific retailer might have chain of contacts and if
is offended might use its contacts to defame the manufacturer brand which will severely
harm the manufacturer.
Expert power : Superior knowledge or information is the basis of expert power. When
one channel member has knowledge that the other channel members consider as
important, then it has expert as a source of power. But this source of power is unique in
that, once knowledge or information is given to channel members it cannot be
withdrawn.
b. Tolerance of other channel members
Leadership may emerge due to the tolerance of the other channel members. Channel members
may tolerate leadership because of
Strong dependence on the leader: For example, a rural retail store which
depends on a wholesaler to make deliveries may tolerate a wholesaler who
makes delivery to it because of strong dependence and lack of alternatives.
As a result the retail store may accept the wholesalers attempt to dictate its
behavior.
The perception that tolerance will lead to enhanced performance. On the
basis of this a channel member may give in to the leadership of another
channel member if it believes that this will result in improved performance
even though the two firms enjoy relatively equal power.
Activity 5.3
Salsa foods PLC ( an Ethiopian Firm) signed contract with Juba trading
enterprise ( South Sudanese firm agreeing that Salsa assigned Juba as
exclusive distributor of its products in South Sudan whereas Salsa agreed not
to assign another agent in south Sudan Juba agreed not to carry competitive
brand.
However, Salsa found out that Juba is also carrying other food brands in the
same market. Salsa wanted to take the case to court but considering the fact
that Juba is a local firm do not want to proceed.
Discuss the types of powers involved and suggest solution for the conflict
Commentary
Try to relate with every possible sources of power
Summary
This chapter has discussed conflict. Conflicts exist in channel management because marketing
channels are a social system. The chapter has indicated that conflict could occur due to reasons
like role incongruities, resource scarcities, perceptual differences, exceptional differences,
decision domain disagreements, goal incompatibilities, and communication difficulties.
The absence of conflict does not necessarily mean that the marketing channel is efficient but it
might, in fact indicate the opposite. The chapter has concluded by discussing some of the most
common methods of resolving conflicts.
Focus, differentiation, and cost leadership are alternative strategic options that a company can
pursue. Each of these alternatives has an implication on operational channel objectives. Guided
by the company’s strategy, operational channel objectives are developed. The operational
channel objectives must be developed in terms of market coverage and distribution intensity,
channel control, and flexibility.
The operational channel objectives were identified as: intensive, exclusive, and selective
distributions. The chapter has addressed the stages in the strategic management process and how
this is related to the channel management strategy.
This chapter has shown that the choice of strategy-whether cost leadership, differentiation, or
focus – is made only after careful analysis of customer, competition, internal capabilities, and
external environments. And also the chapter has indicated the stages that are involved in the
strategic management process.
In this chapter we have made examination of motivation. Motivation is the most basic and
important feature of channel management. It refers to the actions taken by the manufacturer to
foster strong channel member cooperation in implementing the manufacturer’s distribution
objectives. In order to maintain strong cooperation among channel members we have considered
the basic approaches in motivation.
Review questions
1. What are some of the underlying causes of conflict? Are these causes usually obvious?
Are issues over which conflict may develop the same as the underlying causes?
2. Could more than one cause be associated with the development of conflict in the
marketing channel?
3. Why is it necessary to use power in the development and management of the channel?
4. What are the bases of power in the marketing channel? Is it possible to rank these bases
according to their degree of effectiveness in influencing the behavior of another
channel member?
5. What are the differences among cost, differentiation, and focus strategies? Select an
industry and provide examples of three firms, each of which follows on of the three
generic strategies. Pay particular attention to the distribution strategies of the firms.
6. Describe the three-dimensional approach to market definition. Why is market definition
a difficult process in actual practice?
7. Describe intensive, selective, and exclusive distribution.
8. Discuss the concept of leadership as it applies to motivating channel members.

Toyota Motor Corporation took extraordinary care in developing the channel and selecting
the dealers for its Lexus luxury cars. The attention to detail in setting up the channel for
Lexus is reminiscent of the kind of care Toyota gives to the building of its cars. In fact,
standards for dealership cover such minute details as setting specifications for doorknob
designs and the grade of the rice paper for shoji screens used to decorate the dealerships. It
would seem that everything has been so carefully planned that the Lexus dealership should
virtually run them.
Comment on this situation in terms of the need for channel management and the motivation of
channel members
Self-Assessment Questions
1. The source of_____________ power is psychological
A. Expert
B. Coercive
C. Referent
D. All
E. None
2. __________ refers to the same type of firms that are on the same level competing with
each other
A. Vertical competition
B. Horizontal competition
C. Intertype competition
D. All E. None
3. __________ type of a complete channel that will compete against another complete
channel occurs when there is a strong domination by of one of the channel members over
other channel members.
A. Contractual channel systems
B. Corporate channel systems
C. Administered channel system
D. All
E. None
4. When a producer distributes the same product through two or more different channel
structures ___________ occurs.
A. Exclusive dealing
B. Dual distribution
C. Full-line forcing
D. All
E. None
5. A form of Tying Agreement is

A. Vertical integration
B. Full-line forcing
C. Price discrimination
D. All
E. None
6. The type of conflict that occurs when a channel member deviates from the expected role
is
A. Decision domain disagreement
B. Role incongruities
C. Goal incompatibilities
D. All
E. None
7. The conflict that occurs when the same environmental stimuli is interpreted differently is
Resource scarcities
Communication difficulties
Perceptual differences
All
None
8. Which of the following statements are incorrect about conflicts
A. Peaceful channels are the best channels
B. The most commonly held belief about conflict is that its absence results in more
channel efficiency
C. Functional conflicts are manifest conflicts
D. All
E. None
9. In order to motivate channel members the manufacturer might use one of the followings
to understand the needs of the members:
a. Research studies of channel members
b. Research studies by outside parties
c. Marketing channel audits
d. Distributor advisory councils
e. All
10. When a retailer influences the behavior of a manufacturer by offering the latter the
preferred shelf space, then this is ________ as a source of power.
A. Reward
B. Legitimate
C. Referent
D. All
E. None
Chapter 6
Developing the Marketing Channel Design
Introduction
The designing of a marketing channel involves the decision of the vertical and horizontal
integration of the channel structure. Horizontally the channel might have broad or narrow
structure and vertically it could be designed being long or short. The channel design decision
should be done by incorporating relevant variables related to the market, customers, product,
company and the intermediaries. In this chapter these concepts shall be discussed in detail.
Learning objectives
After reading this chapter, learners will be able:

To analyze various aspects of marketing channel design
To develop marketing channel design and
To modify them to meet best interest of the market and satisfaction marketing
goals
6.1 Channel Design
There is wide variation in the use of the term design as it applies to the marketing channel. Some
authors use the term as a noun to describe channel structure. Others use it to denote the
formation of a new channel from scratch, while still others use it more broadly to include
modifications to existing channels. Finally, design has also been used synonymously with the
term selection, with no distinction made between the two. Such variations in usage can lead to
confusion. Therefore, before proceeding further we will define more precisely what we mean by
design as it applies to the marketing channel:
Channel design refers to those decisions involving the development of new marketing
channels where none had existed before, or to the modification of existing channels.
The first key point to note in this definition is that channel design is presented as a decision faced
by the marketer. In this sense channel design is similar to the other decision areas of the
marketing mix, namely, product price, and promotion. In other words, when viewed from a
management perspective, the marketer must make decisions in each of these areas of the
marketing mix.
A second point is that channel design is used in the broader sense to include either setting up
channels from scratch or modifying existing channels. In fact, modification or redesign of
existing channels sometimes referred to in recent jargon, as reengineering the marketing channel,
is actually in practice a more common occurrence than setting up channels from scratch.
Third, when used in its verb form, the term design implies that the marketer is consciously and
actively allocating the distribution tasks in an attempt to develop an efficient channel structure.
The term is not used to refer to channel structures that have simply evolved. In short, design
means that management has taken an active role in the development of the channel.
Fourth, the term selection, as we will be using it, refers to only one phase of channel designs—
the selection of the actual channel members.
Finally, the term channel design also has a strategic connotation because channel design should
be used as an integral part of the firm’s attempt to gain a differential advantage in the market.
The using channel design as a strategic tool for gaining a differential advantage should be
uppermost in the channel manager’s thinking when designing marketing channels.
The channel design decision can be broken down into seven phases or steps.
1. Recognizing the need for a channel design decision

2. Setting and coordinating distribution objectives
3. Specifying the distribution tasks
4. Developing possible alternative channel structures
5. Evaluating the variables affecting channel structure
6. Choosing the “best” channel structure
7. Selecting the channel members
Phase 1: Recognizing the Need for a channel Design Decision

Determining the need for channel design decision is relatively easy if it is developing a new
channel structure from scratch but if it is about modification of the existing channel structure
then it might not be as easy. However, many situations can indicate the need for a channel design
decision. Among them are the following:
i. Developing a new product or product line. If existing channels for other products
are not suitable for the new product or product line, a new channel may have to be
set up or the existing channels modified in some fashion.
ii. Aiming an existing product at a new target market. A common example of this
situation is a firm’s introduction of a product in the consumer market after it as sold
in the industrial market.
iii. Making a major change in some other component of the marketing mix. For
example, a new pricing policy emphasizing lower prices may require a shift to
lower-price dealers such as discount mass merchandisers.
iv. Establishing a new firm, from scratch or as a result of mergers or acquisitions.
v. Facing the occurrence of major environmental changes. These changes may be in
the economic, socio-cultural, competitive, technological, or legal spheres.
Phase 2: Setting and Coordinating Distribution Objectives
Having recognized that a channel design decision is needed, the channel manager should try to
develop a channel structure, whether from scratch or by modifying existing channels that will
help achieve the firm’s distribution objectives efficiently. Yet quite often at this stage of the
channel design decision, the firm’s distribution objectives are not explicitly formulated,
particularly since the changed conditions that created the need for channel design decisions
might also have created the need for new or modified distribution objectives. It is important for
the channel manager to evaluate carefully the firm’s distribution objectives at this point to see if
new ones are needed. An examination of the distribution objectives must also be made to see if
they are coordinated with objectives and strategies in the other areas of the marketing mix
(product, price, and promotion), and with the overall objectives and strategies of the firm.
In order to set distribution objectives that are well coordinated with other marketing and firm
objectives and strategies, channel managers need to perform three tasks:
i. They should familiarize themselves with the objectives and strategies in the other
marketing mix areas and any other relevant objectives and strategies of the firm.
ii. They should set distribution objectives and state them explicitly.
iii. They should check to see if the distribution objectives they have set are congruent
with marketing and other general objectives and strategies of the firm.
i. Becoming Familiar with Objectives and Strategies
Whoever is responsible for setting distribution objectives should also make an effort to learn
which existing objectives and strategies in the firm may impinge on the distribution objectives to
be set. In practice, often the same individual(s) who set(s) objectives for other components of
the marketing mix will do so for distribution. But even in this case, it is necessary to “think
through” the interrelationships of the various marketing objectives and policies.
ii. Setting Explicit Distribution Objectives
Distribution objectives are essentially statements describing the part that distribution is expected
to play in achieving the firm’s overall marketing objectives. That is, to make products available
to the chosen/targeted market at the lowest possible cost.
iii. Checking for Congruency
A congruency check in the context of channel design involves verifying that the distribution
objectives do not conflict with objectives in the other areas of the marketing mix (product, price,
and promotion) or with the overall marketing and general objectives and strategies of the
company.
Pricing issue in channel management
Pricing in marketing channels is the mechanism by which profits are divided in the channel.
There are many approaches to set price one is the List price. List price is the quoted price; it is a
price that is rarely paid by the final user. It is used in the calculation of the Net price.
List price is set by the manufacture and it indicates the final price that buyers are going to pay for
the product. When setting the list price the manufacturer has to consider that the margin
necessary to compensate the retailers for the functions they perform is included.
However, it should be noted that the list price does not necessarily indicate the selling price to
the final buyer– but it may serve as a starting point in negotiation in the distribution channel.
Discounts
From the list price many forms of discounts are deducted. The following are the common forms
of discounts:
Quantity discounts: These are discounts given in order to encourage buyers to buy in larger
volume. When a buyer buys in large volume, the seller benefits in reduced costs: Costs of
transportation, paper work needed, etc .will decline. This is because the costs will be absorbed by
larger quantity. There are two forms of quantity discounts:
Cumulative discounts. This refers to discounts that are given to buyers after
adding the individual purchases made during the discount period.
Non cumulative discounts. If buyers can qualify for discounts based on the size
of the individual order, then this is a non cumulative type of discount . Discount
can be used by manufacturers in order to encourage retailers to directly buy from
wholesalers, rather than from the manufacturer. Because only few retailers can
meet the requirement of large volume purchase in order to qualify for discounts.
This discounts restructuring may give rise to retail cooperatives, in which retailers
pool their recourse to gather in order to qualify for discounts by buying in large
quantity.
Functional discounts: These are deductions from the list price. Trade discounts as
functional discounts are also called, are discounts given by a manufacturer to
intermediaries for the distribution function they perform. For example a producer may
indicate a list price of 1000 birr less 30%-10%. The 1000 birr is the suggested retail
selling price. The retailer deducts 30%from 1000 birr paying 700 birr. In turn, the
wholesaler can deduct 10% from the 700 birr (not from 1000 birr) and pay to the
producer 630 birr.
Seasonal discounts. This type of discounts that is given in order to encourage channel
members to purchase out of season merchandise, enable manufacturers to continue
production year-round with assurance that the product will be sold.
Cash discounts. These are discounts that are given in order to encourage prompt
payment. Few channel members actually pay in cash, they may take advantage of
seller’s credit terms of sale so in order to encourage quick payment cash discounts are
given. A common payment term would be “invoice, less 2/10, net 30” if the
purchaser makes payments within 10 days 2% can be deducted from invoice price.
Otherwise, the buyer must pay the full amount within 30 days.
b. Brand strategy
This is one aspect of a product that affects channel decision. It basically revolves around 2
issues: manufacturers’ brand and private – distributor’s brands.
Manufacturers’ brands: These are brands manufactured and owned by the producers.
There are numerous advantages associated with manufacturers’ brand: To the
manufacturers’ the advantages are more customer loyalty this can be built through good
quality control and promotion. In addition, intermediaries find manufacturers’ brand
desirable because the primary marketing effort is shifted towards the manufacturer.
The advantage to the intermediary of manufacturers’ brand is that resellers are assured of
quality.
Private-distributors brand: These are developed and owned by resellers (wholesalers and
retailers). The advantage of private distributors brand is that intermediaries find more
loyalty of customer. Customers will become loyal to the out let that is carrying the brand
as the brand is not available in other places.
Reseller pay lower price to private distributor brands than to manufactures’ brand resulting in
higher margin to the intermediary. This is because the supplier does not have to include the cost
of promotion when providing private-distribution brands.
Some manufacturers may refuse to manufacture products to intermediaries, but if one

manufacturer refuses to make the product to the intermediary another one will be manufacturing
it. Also manufacturing private brand will enable a manufacturer to utilize excess capacity. The
presence of the above types of brands increases conflict within the marketing channel.
c. Promotion through the marketing channel
There are two promotion strategies that are available to the manufacturer: push and pull strategy.
Pull strategy: The promotional effort of the manufacturer is focussed on the ultimate
user (household or industrial user). By focusing its effort on final user the manufacturer
will build demand at this level. This will make intermediaries feel that they are compelled
to carry the product of the manufacturer. The end- user demand created will pull the
product through the distribution channel. Advertising is a commonly used pull promotion
strategy
Push strategy: The manufactures will focus its promotional effort on the marketing
channel members rather than final user. Personal selling and other push promotion
strategies will be employed to encourage middleman to carry the manufactures product
and promote them to final users.
In reality only few firms employ pure push promotion or pull promotion strategies. An effective
strategy is one that uses a combination of both pull and push promotional strategies.
Pull Strategy Push strategy
Manufacture Manufacturer
2 3
1* Channel members
Channel Members
Final User Final User
Figure 6.1 : Pull versus Push promotional strategies.
Notes: * numbers indicate sequence of flows
Sequence of flows is simultaneous
A high quality objective in the product area, for example, would most likely call for a pricing
objective that would cover the probable higher costs of the product and enhance its quality
image. Promotional objectives would have to focus on communicating to the target market the
superior quality of the product. At the same time, distribution objectives would need to be
developed in terms of making the product conveniently available to the market in the types of
outlets in which targeted customers are likely to shop.
Activity 6.1
Shoa Bakery used to distribute its bread directly to customers through its bakeries.
Currently it is also distributing its bread through selected retailers in addition to its
bakeries.
Discuss the reasons behind the changes in the distribution channels of Shoa Bakery
Commentary
Indicate the possible reasons for channel modification
Phase 3: Specifying the Distribution Tasks
After the distribution objectives have been set and coordinated, a number of distribution tasks
(functions) must be performed if the distribution objectives are to be met. The channel manager
should, therefore, specify explicitly the nature of these tasks.
The kinds of tasks required to meet specific distribution objectives must be precisely stated, such
as the following to make the products readily available:
i. Promote product availability in the target market
ii. Maintain inventory storage to assure timely availability
iii. Transport the product
iv. Arrange for credit provisions, etc.
Phase 4: Developing Possible Alternative Channel Structures
Having specified in detail the particular distribution tasks that need to be performed to achieve
the distribution objectives, the channel manager should then consider alternative ways of
allocating these tasks. The allocation alternatives (possible channel structures) should be in
terms of the following three dimensions.
Number of levels in the channel
Intensity at the various levels, and
Types of intermediaries at each level
Number of Levels
The number of levels in a channel can range from two levels—which is the most direct
(manufacturer-user)—up to five levels and occasionally even higher.
The number of alternatives that the channel manager can realistically consider for this structural
dimension is often limited to no more than two or three choices. For example, it might be
feasible to consider going direct (two-level), using one intermediary (three-level), or possibly
two intermediaries (four-level).
These limitations result from a variety of factors such as the particular industry practices, nature
and size of the market, availability of intermediaries, and other variables. In some instances, this
dimension of channel structure is the same for all manufacturers in the industry and may remain
virtually fixed for long periods of time. In other industries it is more flexible and subject to
change in relatively short time periods.
Phase 5: Evaluating the Variables Affecting Channel Structure
Having laid out several possible alternative channel structures, the channel manager should then
evaluate a number of variables to determine how they are likely to influence various channel
structures.
Although there are a myriad of such variables, six basic categories can be formed in the analysis
of alternative channel structures: market variables, product variables, company variables,
intermediary variables, and environmental variables.
In the course of discussing the variables in these categories, we will often cite a number of rules
of thumb that relate these variables to channel structure. An example of one such heuristic is as
follows: If a product is technically complex, the manufacturer should sell directly to its user
instead of through intermediaries.
Such rules of thumb, which are commonly mentioned in the marketing literature, are only crude
guides to decision making. They should not be viewed as clear-cut prescriptions for choosing a
particular channel structure. They are useful only to the extent that they offer some rough
reflection of what would typically be expected given a particular condition, and thereby provide
a point of departure for the analysis of different channel structures.
i. Market variables
All of modern marketing management including channel management is based on the underlying
philosophy of the marketing concept, which stresses customer (market) orientation. In
developing and adapting the marketing mix, then, marketing managers should take their basic
cues from the needs and wants of the target markets at which they are aiming. Hence, just as the
products a firm offers, the prices it charges, and the promotional messages it employs should
closely reflect the needs and wants of the target market, so too should the structure of its
marketing channels. Market variables are therefore the most fundamental to consider when
designing a marketing channel.
Four basic subcategories of market variables are particularly important in influencing channel
structure. They are:
Market geography,
Market size,
Market density, and
Market behavior
Market Geography—refers to the geographical size of markets and their physical location and
distance from the producer or manufacturer. From a channel design standpoint, the basic tasks
that emerge when dealing with market geography are the development of a channel structure that
adequately covers the markets in question and provides for an efficient flow of products to those
markets. General rules of thumb for relating market geography to channel design can be the
greater the distance between the manufacturer and its markets, the higher the probability that the
use of intermediaries will be less expensive than direct distribution.
Market Size—the number of customers making up a market (consumer or industrial) determines

the market size. Very general rule of thumb about market size relative to channel structure is the
larger the market size, then, the better it is to use intermediaries. On the other hand, the smaller
the market size the better it is to use of intermediaries.
Market Density- The number of buying units in a per unit of land area refers to market density
In general, the less dense the market, the more difficult and expensive is distribution. As a result
the rule of thumb is the less dense the market, then the better it is to use intermediaries. On the
contrary, the greater the density of the market, then, the better it is to avoid the use of
intermediaries.
Market Behavior
This raises the following questions:
How customers buy,
When customers buy,
Where customers buy, and
Who does the buying?
The rules of thumb for how customers buy is, if customers typically buy in small quantities then
use long channels and vice versa.
The rules of thumb for when customers buy is, if customers buy seasonally then add
intermediaries to the channel to perform the storage function, thereby reducing peaks and valleys
in production.
The rules of thumb for where customers buy is, if customers buy at home eliminate wholesale
and retail intermediaries and sell direct.
The rules of thumb for who does the buying is, if many are the individuals that influence a
purchase decision, then, use direct distribution in order to successfully reach all parties affecting
purchasing decision.
ii. Product Variables
Product life cycle: The product life cycle is a model that shows the stages a
product must pass and the sales pattern during each stage. It is a concept that is
discussed in most marketing texts. Here we will limit our discussion of the
product life cycle in view of its implication on channel design decision.
Sales curve
Profit curve
Growth Maturity Decline

Introduction Maturity
Figure 6.2: The product life cycle
During the introductory stage profit is non-existent because of high costs in promotion and
production. The growth stage will see increment in both profit and sales level as the figure above
shows. The maturity stage shows that sales begin to decrease because the market becomes
saturated. Profit increases up to a point and then declines during maturity stage because of heavy
selling costs that are incurred due to the tough competition. Profit touches zero and sales
decrease during the decline stage.
a. The introductory stage and channel management
There are two major activities during the introductory stage for channel managers
Ensuring that channel members can provide adequate market coverage.

Ensuring that adequate supply can be made to channel members.
During the introductory stage a company incurs heavy costs in promotion- advertising in order to
build demands for the product. All of these expenditures in money will be to nothing, if the
product is not readily available at the point of sale.
However the task of ensuring that the product is available at the point of sale is not an easy one
as it require a great deal of planning and coordination.
Break-down in coordination & planning are common. For example, a product might be in short
supply from the moment it was introduced. Retailers and wholesalers may not get enough of the
product forcing the company to allocate the limited supply among many intermediaries.
One might argue that the above situation indicates a good problem as the company has more
demand than it could supply. All the company has to do is to increase its supply by
manufacturing more of the product. However setting up new production facilities might be
necessary (to meet the excess demand) & this may require considerable lead-time & also the
technology that is needed to make the product might be complex.
This shortage infected introduction stage (if not corrected within a reasonable time) might
undermine the future of the potentially successful product.
b. The growth stage & channel management
The tasks the channel manager has to perform at the growth stage include:
Ensure that channel members are able to provide adequate market coverage. Ensuring
product availability is an important task at this stage as the market is as expanding rapidly.
Monitor the effect of the competitor’s production on channel members.
The expansion in market that occurs during the growth stage is bound to attract rivals which
would be seeking the support of the same channel members that the firms is after.
This requires anticipation and preplanning of strategic moves by the company. For example, at
the introductory stage the company can plan to increase distribution intensity in order to
foreclose the market from competitors.
c. The maturity stage and channel management
During the maturity stage sales begin to decline, the implication of this on channel management
is:
Make the product more appealing to channel members.

As sales begin to decline channel members may stop ordering the products in order to avoid
being stuck with a product that nobody wants. In order to reduce the severity of the above
problem the channel manager can try to enhance the profitability of the product by having more
liberal returns policy, giving advertising allowance and trade discounts.
A more comprehensive channel strategy is, however, to find a way of extending the life of the
product. Extending the life of the product might require change or modification in channel
structure. The company will attempt to extend the life of the product by finding a new target
market for the product. Starting to sell in international markets (which means bringing in new
channel participants) is an easy way of extending the life cycle of a product.
d. The decline stage and channel management
At decline stage sales decrease absolutely and profit reach zero for the product. The important
decision facing channel managers at this stage are
Should marginal out lets be dropped to avoid future erosion in profitability?

Can the product be dropped without further eroding profitability?
Maintaining distribution intensity is difficult at this stage. Some channel participants may
already have dropped the product (as their strategy requires high-volume products). Others may
still be carrying the product but because they may be low volume, it may necessitate change in
distribution policy. All channel members are faced with the decision of which strategy to
employ.
Some of the other most important product variables are:
Bulk and weight,

Perishability,
Unit value,
Degree of standardization (custom-made versus standardized),
Technical versus non-technical, and newness.
Bulk and Weight: Heavy and bulky products have very high handling and shipping costs relative
to their value. The producer of such products should therefore attempt to minimize these costs
by shipping only in large lots to the fewest possible points. Consequently, the channel structure
for heavy and bulky products should, as a general rule, be as short as possible—usually direct
from producer to user.
Perishability: Products subject to rapid physical deterioration (such as fresh foods) and those
that experience rapid fashion obsolescence are considered to be highly perishable. The necessary
condition of channel design in this case is rapid movement of the product from production to its
final user to minimize the risks attendant to high perishability.
Unit Value: In general, the lower the unit value of a product, the longer the channels should be.
This is because the low unit value leaves a small margin for distribution costs. Such products as
convenience goods in the consumer market and operating supplies in the industrial market
typically use one or more intermediaries so that the costs of distribution can be shared by many
other products that the intermediaries handle, thus creating economies of scale and scope.
Degree of Standardization: Custom-made products go directly from the producer to the user, but
as products become more standardized, the opportunity to lengthen the channel by including
intermediaries increases. For example, totally custom-made products such as industrial
machinery very often are sold directly from the manufacturer to the user. Semi-custom products
such as accessory equipment in the industrial market and furniture in the consumer market will
often include one intermediary. On the other hand, highly standardized products such as
operating supplies in the industrial market and convenience goods in the consumer market will
frequently include more than one intermediary.
Number of intermediaries
Several intermediaries
No intermediary
Custom made Standardized
Figure 6.3 : Degree of standardization affecting channel structure
Technical Versus Nontechnical: In the industrial market, a highly technical product will
generally be distributed through a direct channel. The overriding reason for this is that the
manufacturer needs sales and service people who are capable of communicating the product’s
technical features to potential customers and who can provide continuing liaison, advice, and
service after the sale is made. In consumer markets, relatively technical products such as
personal computers are usually distributed through short channels for the same reasons.
New product development : Many new products in both consumer and industrial markets
require extensive and aggressive promotion in the introductory stage to build primary demand.
Usually, the longer the channel, the more difficult it is to achieve this kind of promotional effort
from all of the channel members. Consequently, in the introductory stage, a shorter channel is
generally viewed as an advantage for gaining product acceptance. Further, the degree of
selectivity also tends to be higher for new products because a more carefully selected group of
intermediaries is more likely to provide more aggressive promotion.
In this application new product means the selling of products that the firm has not marketed
before. The introduction of a new product will affect the existing channel structure. Most
manufacture chooses not to introduce new products that are in compatible with the existing
distribution structure. In fact for most manufacturers the existing channel structure is a key
determinant of which new products will ever be considered.
Wholesalers and retailers that consider extending the depth or breadth of their product
assortments must also consider the implication of this on the channel arrangement.
The decision to add a new product by an intermediary may mean new channel arrangement, new
sources of supply must be found, new relationships developed, and existing products in the
assortment restricted or even deleted.
iii. Company Variables
The most important company variables affecting channel design are:
Size,
Financial capacity,
Managerial expertise, and
Objectives and strategies.
Size: In general, the range of options for different channel structures is a positive function of a
firm’s size. The power bases available to large firms—particularly those of reward, coercion,
and expertise—enable them to exercise a substantial amount of power in the channel. This gives
large firms a relatively high degree of flexibility in choosing channel structures, compared to
smaller firms. Consequently, the larger firm’s capacity to develop channel that at least approach
an optimal allocation of distribution tasks is typically higher than for smaller firms.
Financial Capacity: Generally, the greater the capital available to a company, the lower is its
dependence on intermediaries. In order to sell directly to ultimate consumers or industrial users,
a firm often needs its own sales force and support services or retail stores, warehousing, and
order processing capabilities. Larger firms are better able to bear the high cost of these facilities.
Managerial Expertise: Some firms lack the managerial skills necessary to perform distribution
tasks. When this is the case, channel design must of necessity include the services of
intermediaries, which may include wholesalers, manufacturers’ representatives, selling agents,
brokers, or others. Over time, as the firm’s management gains experience, it may be feasible to
change the structure to reduce the amount of reliance on intermediaries.
Objectives and Strategies: Marketing and general objectives and strategies (such as a desire to
exercise a high degree of control over the product and its service) may limit the use of
intermediaries. Further, such strategies as an emphasis on aggressive promotion and rapid
reaction to changing market conditions will constrain the types of channel structures available to
those firms employing such strategies.
iv. Intermediary Variables
The key intermediary variables related to channel structure are: Availability and costs.
Availability: in a number of cases, the availability of adequate intermediaries will

influence channel structure.
Costs: the cost of using intermediaries is always a consideration in choosing a channel

structure. If the channel manager determines that the cost of using intermediaries is too
high for the services performed, the channel structure is likely to minimize the use of
intermediaries.
v. Environmental Variables
Environmental variables may affect all aspects of channel development and management.
Economic, socio-cultural, competitive, technological, and legal environmental forces can have a
significant impact on channel structure. Indeed the impact of environmental forces is one of the
more common reasons for making channel design decisions.
Activity 6.2
Selistu PLC is introducing a new detergent brand packed in a small plastic package
(100gms) by mainly focusing on lower income group. It also has a plan to launch varieties
of detergent products (having bigger package sizes ex. 1 kg and above) targeting middle
income group.
Discuss the type of marketing channel design it needs to have to serve the market.
Commentary
Consider introduction stage and growth stage, also incorporate product variables to make
channel design decision.
Phase 6: Choosing the “Best” Channel Structure
In reality, choosing an optimal channel structure, in the strictest sense of the term, is not possible.
To do so would require the channel manager to have considered all possible alternative channel
structures and to be able to calculate the exact payoffs associated with each alternative structure
in terms of some criterion (usually profit). The channel manager would then choose the one
alternative offering the highest payoff.
Why is this not possible? First, as we pointed out in the section on Phase 4, management is not
capable of knowing all the possible alternatives. The amount of information and time necessary
to develop all possible alternative channel structures for achieving a particular distribution
objective would be prohibitive. Moreover, even if management were willing to expend this time
and effort, it would have no way of knowing when it had actually specified all of the possible
alternatives.
Second, even if it were possible to specify all possible channel structures precise methods do not
exist for calculating the exact payoffs associated with each of the alternative structures.
Nevertheless, even though no exact methods for choosing an optimal channel structure exist,
some pioneering attempts at developing more exact methods do appear in the literature. We will
discuss some of these briefly because they provide insight for making good (if not optimal)
choices of channel structure. Specifically, the approaches and methods that will be discussed can
help to sharpen the channel manager’s ability to evaluate variables affecting channel structure.
Armed with this knowledge, the channel manager is then better prepared to choose channel
structures that at least approach an optimal allocation of distribution tasks.
Phase 7: Selecting the Channel Members
As a general rule the greater the intensity of distribution, the less the emphasis on selection. On
the other hand, if the channel structure stresses more selective distribution, the prospective
members should be much more carefully scrutinized and selection decisions become more
critical.
Activity 6.3
Pick any product of interest to you in the consumer or industrial market
and see if you can trace through its channel structure in terms of the three
dimensions of channel structure: (1) the number of levels through which
the product passes, (2) intensity of its distribution, and (3) the types of
middle men selling it. Why is it distributed that way? Might it be
distributed more logically through some other channel structure?
Commentary
Relate your analysis with the determinants of channel structure
Summary
Channel design refers to those decisions involving the development of new marketing
channels where none had existed before or the modification of existing channels.
Channel design is very important aspect of the firm’s overall marketing strategy because it
can be a key factor in helping the firm gain a differential advantage (sustainable
competitive advantage). Thus the quest to gain differential advantage should underlie the
design of marketing channels.
Channel design can be viewed as a seven –phase process, also referred as channel design
paradigm. These phases were discussed in this chapter. The chapter has also discussed the
major categories of variables that should be considered when evaluating alternative channel
structures and the difficulties involved in attempting to choose an optimal channel
structure.
This chapter has also made analysis of the implication of the strategies for the three elements of
the marketing mix on channel management. The strategy a firm has on channel management has
to be congruent to the strategy for the other elements of the controllable. This chapter has
considered different areas of the product strategy, pricing strategy, and promotion strategy and
their implication on channel management.
Review questions
1. How would the product’s life-cycle stage impact its distribution channel structure? To
support your conclusions give examples of products in each stage.
2. Differentiate between “always-a-share” and “lost-for-good” buying behavior. Why is there a
trend in the industrial market to reduce their number of suppliers?
3. Consider the attributes of the following products, what type of distribution channel would
you predict?
a. Power Generators
b. Soft drinks
c. Fax machines
Self Assessment Question
1. __________ refers to the same type of firms that are on the same level competing with each
other
A. Vertical competition
B. Horizontal competition
C. Intertype competition
D. All
E. None
2. __________ type of a complete channel that will compete against another complete channel
occurs when there is a strong domination by of one of the channel members over other
channel members.
A. Contractual channel systems
B. Corporate channel systems
C. Administered channel system
D. All
E. None
3. When a producer distributes the same product through two or more different channel
structures ___________ occurs.
A. Exclusive dealing
B. Dual distribution
C. Full-line forcing
D. All
E. None
4. The conflict that occurs when the same environmental stimuli is interpreted differently is
A. Resource scarcities
B. Communication difficulties
C. Perceptual differences
D. All
E. None
5. If you were the marketing manager of a soft drink company which of the following channels
structure you would prefer?
A. Selective distribution
B. Exclusive distribution
C. Intensive distribution
D. Direct distribution
6. When a product has relatively lower unit value the most likely channel arrangement would
be:
A. Zero level channel
B. Exclusive dealership
C. Longer channel
D. Direct channel
7. Which of the followings is not right?
A. The longer the geographic distance between point of production and point of
consumption the longer the marketing channel
B. The heavier a product weight is the shorter the channel
C. The more standardized a product is the wider the channel
D. The more perishable a product is the longer the channel
8. If the primary objective of the firm is to exercise higher channel control which of the
following channel design is more advisable?
A. Selective distribution
B. Direct distribution
C. Zero level
D. B and C
9. Which of the followings channel structure is suitable for a firm with scarcity of resources and
expertise?
A. Long channel
B. Zero level channel
C. Exclusive Distribution
D. B and C
10. At the introduction stage of a product life cycle :
A. A firm uses selective distribution to penetrate into the market
B. A firm uses direct distribution if it could not find suitable middle men
C. A firm assigns exclusive distributor to limit access to its product
D. A and B
Chapter 7
Vertical Integration in Distribution
This chapter concerns the most fundamental question to ask when structuring a delivery system:
Should only one organization do the work, thereby vertically integrating into the distribution
stage? In other words, who should perform a channel flow? Should it be a single organization
(e.g., manufacturer, agent, distributor, retailer—all rolled into one company)? Or should
distribution flows be outsourced (upstream looking keeping separate the identities of
manufacturers and downstream channel members?
To integrate is to become one, or singular. When the manufacturer integrates a distribution

function (making sales, fulfilling orders, offering credit, etc.), the manufacturer’s employees do
the work and the manufacturer has integrated forward, or downstream, from the point of
production. Vertical integration also occurs from the retailer, can produce its own branded source
of product, thereby integrating backward.
Whether the manufacturer integrates forward or the downstream channel member integrates
backward, the result is that one organization does all the work. The channel is said to be
vertically integrated. In this chapter, we will cover the circumstances that make such a move
economically viable, as well as some common rationales that are economically debatable.
Learning objectives

Explain vertical integration as a continuum from make to buy rather than as merely a
binary choice
Diagnose the reasons why channel players (such as manufacturers, wholesalers, or
retailers) often integrate forward or backward with great expectations, only to divest
within a few years
Frame the vertical integration decision in terms of when owning the channel or some of
its flows improves long-term return on investment
Explain six reasons why outsourcing, not vertical integration, should be the starting point,
the preferred choice, contrary to intuition
Explain how three situations change this starting point so that vertical integration comes
to dominate outsourcing in distribution
Explain and analyze six categories of company-specific capabilities and distinguish
specificity from rarity
Trace how these categories become general purpose over time
Trace the impact of a volatile environment on the returns from forward integration
7.1 Make or Buy: A Critical Determinant of Company Competencies
The vertical integration decision is not a channel structure decision per se, but rather, a decision
that should be made channel flow by channel flow. The implication of thinking in this way is that
a channel member, given sufficient power, can decide to vertically integrate some subset of all
the channel flows in a way that creates a channel that looks decentralized (not vertically
integrated), yet exhibits the best combination of make and buy together in one channel structure.
In marketing channels, make-or-buy decisions (vertically integrate or outsource) are critical
strategic choices. This is because the firm’s decision to own some or all of its marketing channel
has an enduring influence on its ability not only to distribute but also to produce. The
manufacturer becomes identified with its marketing channels, which influence its base of end
customers and form their image of the manufacturer. In addition, the manufacturer gains much of
its market intelligence from its channels: What the manufacturer knows (or can learn) about its
markets is heavily conditioned by how it goes to market.
Hence, the decision whether or not to vertically integrate forward helps to determine what the
manufacturer currently does and what it could learn to do. This decision, once made, is difficult
to reverse because it involves making commitments that are not always easy to redeploy. Thus, a
firm’s vertical integration choices in distribution are enduring and important. These structural
decisions should be made carefully, with emphasis on how they influence the firm’s future
performance path.
As for downstream channel members, their decisions to integrate backward consume resources,
put them into conflict with their other suppliers, and jeopardize their ability to offer unbiased
advice to their customers. Moving up the value chain looks appealing (Why let the producer have
the margins when it’s the downstream channel member who understands demand?). But
integrating backward can be hazardous, as we will see.
Activity 7.1
The vertical integration decision is not a channel structure decision per se. Do you
agree or disagree with this statement?
Commentary: is vertical integration a channel flow decision?
7.1.1 The costs and benefits of vertical integration in marketing channels

To appreciate the hidden costs and benefits of vertical integration, imagine that you are a
manufacturer looking downstream at the set of flows that your customer is willing to pay to have
performed. The vertical integration decision, make or buy, do it yourself or outsource, should be
made for each function or set of functions involved in distributing a product or service. The
choice is not really binary. Make versus buy is a continuum that shows how the costs, benefits,
and responsibilities of doing the work are split between two organizations. Figure 1 on page 141
presents these options in the abstract terms of make (vertical integration) versus buy
(outsourcing), with relational governance as a midrange option.
i. Degrees of Vertical Integration
When outsourcing under classical market contracts (the epitome of the buy mode),
manufacturers and downstream channel members:
Are interchangeable
Deal with each other in a completely independent and impersonal fashion (arm’s length
contracting)
Negotiate each transaction as though it were the only one
Begin and end their transactions based solely on the merits of the current set of offerings
At the extreme of buy, manufacturer-distributor arrangements involve no sharing (of risk, of
expertise, of image, etc.), no distinction, and no continuity. This buy model (outsource each flow
or bundle of flows) is a useful baseline in thinking about distribution. However, many, if not
most, arrangements with third parties exhibit some degree of relationalism, meaning that the
manufacturer has a greater share of the costs and benefits than is the case under strict delegation
to a third party (classical market contracting)
Relational governance means compromising between the make-buy extremes by creating
channels that have some properties of both owned and independent channels. Relational
governance can be created many ways. Along the continuum of degree of integration, the
fundamental issue is how the work of the channel is done. When your organization’s employees
carry out the flow, you have vertically integrated (the buy option).
Buy Make
Classical Market vertical integration Quasi-Vertical
Integration
(Relational Governance)
Third party does it How does the work You do it

(for a price) get done?
Their people Your people

Their money The costs Your money
Their risk Your risk
Their Your responsibility
You and third party
responsibility share costs and
Their operation benefits
(control) Your operation
Their gain or loss (control)
The benefits Your gain or loss
Figure 7.1 the continuum of degrees of vertical integration
In short, vertical integration is not a binary choice but a matter of degree. Degrees of integration
form a continuum anchored by the extremes of classical marketing contracting and vertical
integration. Buy is a large zone of outsourced relationships with third parties, and some of these
relationships operate in a manner that resembles a single firm. Indeed, customers often believe
they are dealing with the manufacturer when they are actually dealing with a committed third
party in the marketing channel.
Where the argument for integration is strong, but not entirely compelling, relational governance
should be considered instead as a way to simulate vertical integration without assuming its
burdens.
In principle, every distribution arrangement is unique and can be placed somewhere along the
degree-of-vertical-integration continuum as a function of the relationship’s operating methods
and the nature of the contract (if any) between the parties. In practice, certain common
institutional arrangements tend to correspond to regions within the continuum.
ii. Costs and Benefits of the Choice to Make
What changes when you choose the make option over the buy option? If you are a manufacturer,
your organization assumes all the accounting costs of distribution, which include all personnel
costs as well as the costs of all other channel flows. Your organization also bears the risk of the
distribution operation and is responsible for all actions. These costs (e.g., warehousing) are
substantial and are frequently underestimated, particularly by firms that are accustomed to
production but not to distribution. All too often, the result is that vertical integration forward not
only fails to improve market share but actually reduces return on investment.
Many manufacturers find the heaviest of these costs to be the opportunity cost of the personnel.
Manufacturers often have no one available to be diverted from the core activity of
manufacturing, and as they do not know the market for expertise in distribution, these firms find
it difficult to hire qualified personnel to meet service output demands economically. The top
management of the vertically integrated firm is responsible for ensuring distribution and often
finds that it does not have sufficient managerial resources to give attention to the distribution
responsibility. (Of course, this and every other argument can be reversed for downstream
channel members integrating upstream—this is a useful mental exercise.)
These costs can only be justified by substantial benefits. The fundamental reason firms give to
integrate forward into distribution is to control the operation. However, from an economic
standpoint, control per se has no value whatsoever. Control is beneficial only if the firm’s
managers can use it skillfully to improve overall economic results. Manufacturers integrate
forward (and resellers integrate backward) when they believe it will increase their profits.
Control is psychologically appealing to managers (because they direct a larger enterprise) but
goes against the interests of shareholders unless it improves profits.
Sometimes this means merely appropriating the returns from the performance of marketing
channel flows themselves to add to the returns from production. In this sense, vertical integration
is a business opportunity like any other. A firm seeking to grow might consider taking on more
of its current value chain if these other elements are attractive as a business proposition in and of
themselves.
Some capital equipment manufacturers, such as IBM and General Electric, have moved into their
downstream operations. For them, manufacturing is losing appeal as a business proposition.
Competition has obliged producers to become efficient in production and more effective in
marketing. The next logical place to find revenues and cut costs is the channel, not the factory.
Further, much of the profit of capital equipment is not in its sale but in its maintenance. By
integrating downstream, producers tap into a steady flow of maintenance contracts for the
products they manufacture, many of which are very long lived.
From this perspective, it is actually surprising that vertical integration is not even more common
in channels than it really is. It is appealing to think that know-how from one part of the value
chain could be amortized by applying it upstream or downstream. Downstream and upstream
activities, however, are very different and conform to different financial models. These
fundamental differences drive firms to grow and diversify into other (perhaps related) businesses
but often at the same level of the value chain (e.g., production or wholesaling or logistics or
retailing, but not all of them—wherever their expertise and expectations lay). More often,
appropriating returns from channel functions means directing the performance of channel flows
for the purpose of improving sales and margins obtained at the integrator’s level of the channel.
The retailer integrating upstream is more interested in improving returns from retailing than in
running a profitable production operation in and of itself. The manufacturer integrating
downstream is more interested in using the channel to improve production results than in running
a profitable marketing channel operation in and of itself. In other words, the integrator is
prepared to sacrifice returns at one level of the value chain to improve returns at another level.
In theory, the integrated entity is better off financially, weighing total returns against total assets
employed, adjusting for the risk assumed. All too often, this scenario fails to materialize. The
integrator underestimates the difficulty of assuming the new function and overestimates the
benefits of control.
iii. The Choice to Buy Distribution: Terms of Payment to
Third Parties
The manufacturer who wishes to focus solely on production, for whatever reason, will turn to the
market place for distribution services. Here, it will seek a third party, an outside organization,
and will contract with that organization to perform channel flows in return for some economic
consideration, normally a price. The price is usually expressed as a margin (the difference
between the price paid to the manufacturer [the reseller’s cost of goods sold] and the price
obtained by the reseller), as a commission (a fraction of the resale price), or as a percentage of
the reseller’s business (a royalty).
These are the most common ways to price the performance of channel flows. However, many
variations are possible, such as paying the third party a flat fee or a lump sum or reimbursing
some of the reseller’s expenses (e.g., through a functional discount). The third party may also
agree to work in return for some future consideration, such as the rights to future business or a
percentage of equity in the manufacturer. Such arrangements are particularly common for
entrepreneurial start-ups, new firms that are often poorly capitalized.
For example, fulfillment houses (which take orders generated by a seller, compose a package
from warehoused goods, and ship the package) may agree to process the orders of a new mail-
order firm without charge for a limited time in return for the rights to that firm’s paying business
after it becomes established. Here, the fulfillment house is not only carrying out the ordering
flow for the manufacturer but is also performing the backward risking and financing flows.
These arrangements (that is, anything other than a commission or a gross margin, which are paid
when the business is done) are not unusual. However, they are not the norm because they are
risky. Paying a reseller a fee or reimbursing expenses subjects the manufacturer to the risk of
moral hazard (i.e., being cheated after the arrangement has been put into place) because it is
difficult to verify that the paid-for activities have been performed or that the expenses are not
inflated. Hence, the manufacturer may be reluctant to pay in this manner.
As for the manufacturer’s agreeing to pay in future business or in equity stakes, it is the
downstream channel member who is assuming risk and who is likely to be reluctant to accept
payment in this manner. The future business may never materialize, or the equity stakes may turn
out to be worthless—or even a liability, if the manufacturer cannot cover its obligations. For
every success story (for the supplier, getting in on the ground floor of what turns out to be a
successful store, catalog, or Internet startup, and for the downstream channel member, getting in
on the creation of the next successful producer), there are plenty of failures. Of course, everyone
involved trumpets the successes and hides the failures, creating the impression that this deferred
payment strategy is less risky than it really is.
This is not to say that channel members do not operate on deferred payment. For example,
French boulangers (artisan bakers), having finished their apprenticeships, often start operations
in a small town. As these artisans typically bring only their skills to the task, and as start-up
capital is limited in Europe, the tiny new bakeries are frequently financed by producers of flour.
Millers supply flour on extremely generous credit terms, on the understanding that they will be
preferred suppliers if and when the boulangerie builds a clientele. There is no legal obligation to
do so: The understanding is based on the norm of reciprocity in the industry.
Outsourcing shifts all the costs (accounting costs, including personnel, plus the risk of failure and
the responsibility for action) to the third party. In return for assuming costs, the third party
benefits by controlling the operation. This in itself is of no benefit in economic terms unless the
third party can use that control to generate profits over and above the costs of distribution (both
accounting and opportunity costs).
7.1.2 Deciding when to vertically integrate forward: an economic framework
It may seem that vertical integration is always desirable, for who would wish to be without
control? Obviously, the decision must be more complex. This section presents a decision
framework for determining when a greater degree of forward vertical integration is economically
(as opposed to psychologically or politically) justifiable as a function of the characteristics of the
decision maker and its choices. This framework is stylized, designed to cut through the confusion
in systematic fashion by prioritizing the issues. Not every consideration is covered.
In the stylized approach outlined in this section, the decision maker begins by taking a
preliminary decision not to vertically integrate forward. This starting-point decision is then
examined. First, all the supporting arguments are marshaled. Then the preliminary outsource
decision is challenged to see if the logic of outsourcing holds under the firm’s circumstances and,
if not, whether it should be overturned and replaced with vertical integration. The decision maker
is asked to reason first as an advocate of the presumption of the superiority of outsourcing; then
as a critic, who attacks the outsourcing argument; and finally as the arbitrator, who determines
whether the advocate of outsourcing has been compellingly overturned. If not, the outsourcing
decision carries the day.
The reader may find this exercise arbitrary, as the line of argument goes first all the way in favor
of one side, then all the way in favor of the other. However, at the last (judging) phase, balance is
(finally) achieved.
i. Return on Investment: The Usual Criterion
The premise of this section is that the organization’s goal is to maximize the firm’s overall return
on investment in the long run. Overall return on investment does not refer to any single flow or
product. In deciding whether to integrate forward into distribution (the manufacturer’s choice) or
backward into production (the downstream channel member’s choice), the appropriate question
is whether taking on this flow increases return on investment and does so more than some other
use of the resources needed to provide the flow.
Why select this criterion? It is not always appropriate: Other criteria sometimes carry the day.
(These will be discussed in the last section of this chapter.) But return on investment matters, and
matters a very great deal. Why? Return on investment is the ratio of results obtained (roughly,
operating performance: revenues minus direct costs) to the resources used to obtain them
(roughly, overhead, reflecting the amortization of fixed investments). In the short term, the firm
may be able to sustain losses or tolerate mediocre results (the numerator). Or the firm may be
able to justify dedicating inordinate resources (the denominator) for the results achieved.
Providers of resources (investors, corporate headquarters), however, will not permit this situation
to last indefinitely. There comes a day of reckoning when the returns to resources will matter.
For our purposes, the relevant terms are the revenues, direct costs, and overhead incurred under
vertical integration (make), compared to those incurred under outsourcing (buy). We use these
terms in a conceptual sense only. The decision maker usually cannot create proper and precise
accounting estimates for the situation. Fortunately, for purposes of channel decision making, this
is not necessary. It is enough to focus on situational factors that drive revenue up and costs or
overhead down.
Conceptually,
(Revenues – Direct costs)/overhead = Net effectiveness/Overhead= Efficiency
Return on investment is the ratio of net effectiveness to overhead (results to resources). Net
effectiveness is the revenues that accrue under vertical integration minus the direct (variable)
costs incurred after integrating. For vertical integration to be efficient, it must somehow increase
revenues more than it increases variable costs in order to improve net effectiveness. It is not
enough merely to improve net effectiveness. Vertical integration is certain to encumber
resources, thereby increasing overhead. The use of these resources must be justified by the
increase in net effectiveness.
Two circumstances preclude vertical integration forward, even if it would add to return on
investment. One is that the firm does not have and cannot obtain the resources to integrate
forward. The other is that the firm has other priorities that contribute even more to return on
investment and that exhaust the firm’s capacities. The manufacturer should pursue these other
actions instead, even if vertical integration has a positive payoff that earns a return on overhead
exceeding the firm’s hurdle rate returns on resources employed (e.g., capital).
ii. Outsourcing as the Starting Point
A very substantial body of research suggests that any manufacturer should begin with the
seemingly artificial premise that the distribution flow should be outsourced. Why should
outsourcing, that is, market contracting, be the default option for the distribution flow? The
fundamental rationale is that under normal circumstances in a developed economy, markets for
distribution services are efficient.
This does not mean that markets for distribution services function perfectly or even that they
function well. It means that given current environmental conditions, technology, and know-how,
it is difficult for a given manufacturer to get better operating results than can be delivered by the
level of third-party services available to the manufacturer. It is noteworthy that the argument is
strictly comparative, not absolute. And it does not mean that there is no room for improvement;
however, improvement, under current environmental conditions, would require the manufacturer
to introduce new technology or know-how that would change prevailing methods. Thus, the
manufacturer would need to take on substantial risk.
This is happening now in China, which suffers from highly inefficient distribution, a heritage of
decades of government regulation of the distribution sector. Change is happening fast, as
exemplified in the auto industry, where leading Chinese (e.g., Legend) and foreign (e.g., Honda)
firms partner with other Chinese firms to create new distribution entities. These new fusion
companies bring the best attitudes, technology, and methods in channel management and adapt
them to market conditions. Within a matter of years, Chinese distribution is likely to advance
radically. In the meantime, manufacturers are indeed taking on very substantial risk. They must,
because the caveat “under normal circumstances in a developed economy” does not yet apply.
The efficient markets argument does not mean that all manufacturers will receive the same
downstream services. Superior manufacturers offering superior rewards will attract better
providers of marketing channel flows or will obtain the best level of service a given provider can
offer. Other manufacturers will obtain what is left.
In sum, efficient markets for third-party marketing channel services means the manufacturer will
be hard pressed to improve on the results it can obtain in the marketplace for marketing channel
flows. Why should this be so?
Activity 7.2
According to Bucklin, the issue of channel performance focuses on the conflict between two
major dimensions of channel performance. On the one hand, consumers and users are
concerned primarily with lowering the costs of the goods and services sold and, therefore, with
reducing the costs of distribution. On the other hand, buyers want to benefit from and receive
some marketing services in conjunction with the good or service they purchase. However,
provision of these services increases the cost of distribution. Compare and contrast vertical
integration and outsourcing relative to the performance dimensions mentioned by Bucklin.
Which would tend to be superior overall?
Commentary: consider the issue in light of the distribution cost the buyer incurs when he or
she obtains the offer direct with less channel services visa vise the cost the buyer will incur if
the offer is obtained with high channel service.
7.2 Six Reasons to Outsource Distribution
A firm has six reasons to outsource the performance of a channel function to an outside party.
Focusing on downstream functions for the moment, these are:
i. Motivation
ii. Specialization
iii. Survival of the economically fittest
iv. Economies of scale
v. Heavier market coverage
vi. Independence from any single manufacturer
Motivation
Outside parties have high-powered incentives to do their jobs well because they are independent
companies accepting risk in return for the prospect of rewards. Both positive motivation (profit)
and negative motivation (fear of loss) spur the third party to perform. Sales agents, for example,
are often more willing to prospect for customers, more persistent, and more inclined to ask for
the sale (attempt to close a negotiation successfully) than are company salespeople (this is one
reason why financial services, such as insurance, are often sold by third parties). An outsider is
attracted by entrepreneurial rewards and driven by fear of losses.
Part of motivation is the willingness to operate within a certain financial model.
Downstream operations are frequently detail-oriented businesses that operate on narrow margins
and focus on inventory turnover and cost management. For a producer, this mode of thinking is
often alien, and the risk-adjusted returns may not appeal.
Key to the motivation advantage is that outside parties are replaceable, hence subject to market
discipline by their principals. For example, if a distributor is underperforming, the manufacturer
moves to another distributor. The mere threat of such a move is credible and, therefore, gives the
distributor an incentive to attempt to meet the manufacturer’s demands or to find an acceptable
compromise. These demands include sharing distribution cost savings with the manufacturer,
placing sales efforts on particular products, presenting products in a particular way, advertising,
carrying more inventory—the possible requests to make of a third party are without limit.
Distributors are thus under constant pressure to improve operating results, which includes both
increasing sales and decreasing costs. In contrast, a company distribution organization cannot be
so readily terminated or restructured, and precedent makes it difficult to make substantial
changes to incentive systems. Internal politics shields employees, making it more likely that an
integrated distribution operation will become an unresponsive, inefficient bureaucracy. This is
particularly the case where labor law makes it difficult to terminate employees, as is true in much
of Europe. However, even in countries such is the United States, where employment is
traditionally at the will of the employer, firing a single employee, let alone an entire division, is
administratively difficult. Replaceability is the key to making the buy option work.
Specialization
Another advantage of outsiders is specialization. For wholesalers, distribution is all they do—
they have no distractions. The reverse is true for manufacturers. Specialization engenders and
deepens competence. This is why Whirlpool has been a pioneer for decades in the outsourcing of
logistics. Kenco is a large logistics provider, deeply versed in the intricacies of storage, shipping,
and delivery. Outsourcing allows each party to stick to their specialties. This advantage has
always existed. Increasing competition has made firms appreciate it more. A generalized move to
identify and strip down to core competencies—and only those core competencies— is behind
many decisions to outsource channel flows.
Survival of the Economic Fittest
If specialists fail to do their functions better than their competitors, they do not survive (which,
of course, helps reinforce the above motivation factor). Distribution in most sectors has low
mobility barriers: The business is easy to enter and easy to exit. Such businesses attract many
entrants and readily eliminate the lesser performers among them because they can exit swiftly.
This argument is connected with specialization, for an incompetent marketing channel member
cannot stay in business by subsidizing its distribution losses with gains in other sectors, such as
production.
Economies of Scale
Outside parties pool the demands of multiple manufacturers for marketing channel flows. This
allows them to achieve economies of scale by doing a great deal of one thing (a set of
distribution flows) for multiple parties. In turn, these economies of scale enable the outsider to
perform flows that would otherwise be uneconomical to do at all. By offering many brands in a
product category, a distributor can do enough business to amortize the fixed costs of distribution
facilities, logistics software, and the like. Similarly, a retailer that specializes in a single category
of merchandise (such as appliances) pools the demand of many manufacturers for retailing
services. The retailer’s deep brand assortment, albeit in a narrow category of products, attracts
customers. The customer base in turn justifies the existence of the specialty store or the category
killer, which would otherwise be uneconomical.
Heavier Coverage
Heavier market coverage stems from the independent’s ability to call on many customers,
including small customers, and to call on them often. This advantage is based on providing more
assortment to end-users. For example, a manufacturers’ representative (or independent sales
agent) can create a portfolio of products and services meeting related needs. Via this portfolio,
the rep can justify the activity of making a call on a prospect that is a small account—for any
single brand of any single product. By meeting multiple needs for that customer, the rep can sell
multiple brands and products on a single call, converting a small prospect (for a brand) into a
large prospect (for the salesperson).
Further, by being able to meet many needs at once, the reps can induce time pressed purchasers,
who value one-stop shopping, to meet with them and to spend enough time for the reps to learn a
good deal about the customers. The reps can then parlay this deep customer knowledge into more
compelling sales presentations of a greater range of offerings. The sale of one item leads to the
sale of another; that is, the rep creates selling synergy within the portfolio of offerings.
Similarly, by meeting multiple needs, distributors are able to draw customers to their locations,
Web sites, or catalogs. Once there, customers spend time making purchases, and one purchase
often encourages another. For example, in office supplies, the prospect orders standard white
paper for a printer, then remembers to order toner, then thinks of the need for nonstandard paper
or colors, and so forth. The astute salesperson uses this interchange to learn about the customer’s
installation, information that is useful when it is time to replace the printer itself.
In short, sales mount in a pyramid if the intermediary has composed an appealing assortment of
goods that represent related purchase occasions to the buyer. It is difficult for most
manufacturers to duplicate the thorough coverage afforded by third parties, for few
manufacturers can match the breadth of related products and services the third party can
assemble. Some manufacturers do have very broad product lines, as broad as a distributor’s;
however, the distributor is free to select only the best products from a variety of manufacturers,
bypassing the “weak links” in any manufacturer’s offerings. Few broad-line manufacturers are
uniformly strong in all elements of their product line.
Key here is that the independent can realize potential synergies that a vertically integrated
manufacturer cannot reproduce. Why? Because the vertically integrated manufacturer may offer
to carry the lines of its competitors in order to duplicate the independent’s assortment, but
competitors and sellers of complementary goods and services will hesitate to sell their products
through the manufacturer’s distribution arm. They fear the sales force will favor its own products
at their expense. This is why a manufacturer’s acquisition of a distributor often provokes the
distributor’s other principals to terminate their contracts and seek representation elsewhere. It is
also one reason why downstream channel members do not integrate backward into production
more often.
The ability to amortize the cost of a call, then, creates a powerful advantage by allowing the
independent to cover a market much more thoroughly (i.e., to make calls more often, to more
influencers, in smaller accounts, even in pursuit of a low-probability sale) than can most
vertically integrated manufacturers. The importance of this fundamental point is often
understated. The sheer arithmetical advantage afforded by superiority of coverage cannot be
overlooked when reasonable estimates are incorporated in a spreadsheet analysis of the make-or-
buy choice.
Independence from a Single Manufacturer
For their customers, diversified outside providers of channel flows can serve as a sort of
independent counsel, an impartial source of advice that does not come from a single
manufacturer. A major drawback of Internet travel agents is that their independence from
suppliers is dubious. Many outside specialists are local entities. Therefore, they are stable entities
with the same personnel serving the same customer set year after year. They have the
opportunity to know their customers well, forging strong customer loyalties.
Many manufacturers disagree that neutral status is an advantage. Indeed, they consider
independence (i.e., obstinacy or conflict of interest) as one of the biggest drawbacks of
outsourcing. They desire vertical integration so that they can resolve their differences of opinion
by giving orders to subordinates; however, this represents a rather optimistic view of how things
actually get done inside vertically integrated firms. The manufacturer’s distribution arm, just like
a third party, will seek to avoid carrying out orders it considers misguided.
It is worth considering why an independent would resist doing what the manufacturer desires. An
independent acquires substantial information about the marketplace. If the independent has
reservations about the manufacturer’s ideas, it behooves the manufacturer to listen and to engage
the channel member in a dialogue. The downstream channel member is analogous to a test
market for a new product. If the test market results are poor, the appropriate reaction is to make
modifications and test it again.
Vertical integration forward when competition is low
At this point, you may be thinking this sketch of independents is idealized and overly favorable.
If so, you are right. It is time to change orientation and to become the critic of one’s preliminary
decision to outsource. It is not enough, however, merely to criticize third-party distribution. The
critic must also make the case that a vertically integrated firm would do the job better (i.e.,
contribute enough to revenue or reduce direct cost enough to offset any other increases in direct
cost and to justify the increase in overhead that will be necessary). This goes back to a
foundation of marketing channels: You can eliminate the channel intermediary, but you cannot
eliminate the functions it performs.
Two caveats open the discussion. First, vertical integration always involves substantial set-up
costs and overhead; therefore, it is only worth considering if a substantial amount of business is
potentially at stake. Second, it is only worth considering if the firm is prosperous enough to be
able to muster the necessary resources—and does not have a better use for them.
The economic advantages of outsourcing distribution are variations on a familiar theme:
Competitive markets of any kind are efficient.
Company-Specific Capabilities
The first and most frequent noncompetitive scenario is that of small-numbers bargaining arising
from company-specific capabilities. Consider the following hypothetical and prototypical
example.
Atlas Electronics is a distributor of electronic components. Atlas is one of many distributors in its market area, for
electronic components is a fiercely competitive industry. Atlas’s salespeople are electrical engineers, well versed in
their industry, its products, its customers, and the applications they make of the products.
Jupiter Semiconductors is one of the many manufacturers that Atlas represents. Jupiter is a differentiated
manufacturer whose products are unique. Over the years, Atlas salespeople have learned the myriad idiosyncrasies
of the Jupiter product line, including how it functions in conjunction with other brands of electronic and electrical
components. They have learned how their customer base applies Jupiter products. Atlas management estimates that,
even though Jupiter provides training at their factory, Atlas salespeople still require two years of on-the-job
experience selling Jupiter to master this knowledge. These two years are necessary even though the salespeople are
skilled and knowledgeable about the industry in general.
The key word here is idiosyncrasies. Because Jupiter products are quite different from competing
semiconductors, even a salesperson who knows the industry requires substantial training and on-
the-job experience to master them. That mastery, in turn, is an asset: It is of considerable value in
selling Jupiter products—only. This knowledge is a company-specific capability, the company
being Jupiter.
The greater the value of company-specific capabilities, the greater the economic rationale for the
manufacturer to vertically integrate forward into distribution. This is because the holders of the
capabilities (here, the salespeople, and by extension, their employer, Atlas) become so valuable
that they are irreplaceable. If it takes two years to bring a salesperson to the mastery level,
salespeople with at least two years of Jupiter experience are very expensive to replace. Not only
must the replacement be trained, the less-effective sales effort during the recruiting and training
period causes an opportunity cost. Thus, Jupiter is in small-numbers bargaining with Atlas.
Jupiter cannot replace their sales quickly, even if it spends enough to hire very competent
salespeople with generalized industry experience.
Small-numbers bargaining destroys the fundamental premise of competitive markets. It does so
by destroying the presumption of market discipline. Because only small numbers of people
possess company-specific capabilities, only small numbers of organizations are truly qualified to
bid to perform the function (in this case, selling) in later periods. If the firm cannot readily find
qualified bidders, it cannot credibly threaten to move its business (terminate the contract with
Atlas) when it is dissatisfied. Notice that Jupiter does not start out (ex ante) with small-numbers
bargaining— small-numbers bargaining emerges ex post. That is, the distribution relationship
that was founded initially on a basis of large-numbers bargaining (choosing one from many
available distributors) gradually becomes difficult to manage because the process of
accumulating distribution relationship-specific investments will turn the initial large numbers
situation into a small-numbers situation.
Thus, Jupiter cannot count on ex ante competitive markets to ensure efficient outcomes ex post.
Atlas salespeople may now engage in such behaviors as shirking, misrepresenting the product,
unethical behavior, falsifying expense accounts, and demanding more compensation to do the
same work. This is called opportunism, which is self-interest seeking in a deceitful or dishonest
manner.
In these circumstances, Jupiter needs to step in and replace the market mechanism in order to
prevent opportunism. The invisible hand of the market can be replaced by the visible hand of
Jupiter management. By vertically integrating forward, the manufacturer creates an
administrative mechanism (thereby increasing overhead). It can use that mechanism to direct
activities for which the market would not otherwise provide the correct incentives.
How does this solve the problem? After all, it is really the salespeople who are irreplaceable.
Whether they are employed by Atlas (outsourcing) or employed by Jupiter (vertical integration),
they can still do great damage by leaving their jobs or by shirking or failing to cooperate.
The answer is that Jupiter gains more control over the salespeople directly. As Jupiter
employees, salespeople have only Jupiter products to sell. They draw their income from a single
principal rather than from third party gathering revenue from multiple principals. Salespeople
report to a Jupiter manager whose sole concern is their performance on behalf of Jupiter and no
other principal and no other organization. After Jupiter-employee-salespeople make these
idiosyncratic investments, they do not pose a strong threat to the company because those
company-specific skills and assets have relatively little outside market value. Thus, salespeople
are now highly dependent on Jupiter.
Jupiter also has the ability to employ negative sanctions against employees directly as well as to
offer positive incentives, such as a salary, bonus, or commission.
Jupiter not only controls monetary compensation but also controls nonmonetary compensation.
Thus, it can build employee loyalty via its personnel practices. Finally, Jupiter has the right to
demand detailed information on what the salespeople do (the right of audit, or monitoring). In
contrast, Atlas management would act as a buffer, refusing to allow a single principal to direct its
personnel.
In short, Jupiter gains much more power over the salespeople by eliminating a third party and
employing the holders of the critical resources directly. This is not to say these irreplaceable
salespeople will be easy to manage. They can still practice opportunism against Jupiter. Vertical
integration will never eliminate shirking, dishonesty, and the like. However, opportunism will be
lessened. In comparative return-on investment terms, the manufacturer is better off. With less
opportunism, revenues should increase (because salespeople are working more and performing
more effectively) and direct costs should decline (e.g., lower costs due to lower expense account
claims). Thus, net effectiveness should increase.
The value of company-specific capabilities, however, must be very high to justify vertical
integration. Only when these idiosyncratic assets are very valuable is there much room for
opportunism. By integrating, the firm greatly increases its overhead. Further, the manufacturer
gives up some of the third party’s coverage and economies of scale, which decreases net
effectiveness. Therefore, vertical integration may actually decrease return on investment unless
the potential for opportunism is so substantial as to constitute a greater threat than the cost of
overhead and the lost benefits of dealing with an outsider.
You may wonder why Jupiter needs to intervene at all. If the problem is opportunism by
salespeople, why not charge Atlas (their employer) with controlling opportunism rather than
employing Atlas’s salespeople directly? Jupiter cannot credibly threaten to terminate Atlas as its
distributor, but does not Atlas itself have an interest in satisfying Jupiter, therefore, in controlling
salesperson opportunism? After all, if Jupiter, the manufacturer, really does vertically integrate,
Atlas, the distributor, will lose its own investment. Atlas cannot redeploy the know-how it has
acquired about Jupiter products and customer applications to the service of another principal.
This know-how has zero salvage value (i.e., it has no alternative use). Thus, Atlas loses its
investment in knowledge, as well as in the customer relationships it has built serving Jupiter
customers. Because Jupiter products are unique, converting these customers to another
principal’s products will be difficult. Should not Atlas, contemplating the long-run prospect of
losing Jupiter, undertake voluntarily to use its own influence as an employer to control the
opportunism of its salespeople? In rational terms, it would appear that the mere threat of vertical
integration should allow Jupiter to pressure Atlas to simulate the outcome of market forces;
however, there are two counterarguments. One is that it is not only the salespeople who can
practice opportunism but Atlas itself. The irreplaceable nature of its salespeople puts Jupiter in
small-numbers bargaining with Atlas itself after the onset of the distribution relationship. The
distributor may then use Jupiter’s vulnerability to demand more (e.g., better margins) while
doing less to earn it (e.g., holding lower inventories). The second argument is that Jupiter cannot
justify vertical integration until Atlas’s opportunism becomes very substantial. If Atlas stays
within certain latitude of abuse, Jupiter will find it cheaper to be the victim of opportunism than
to vertically integrate. (The same rationale explains why insurance companies tolerate certain
degree of claims fraud: To a point, it is cheaper to pay false claims than to pay the costs of
detecting and fighting false claims.)
Let us alter the scenario, taking it back in time. Jupiter is contemplating selling in Atlas’s
territory and has no representation. Should it sign up Atlas as its distributor or should it vertically
integrate, setting up a distribution branch to serve Atlas’s market? Knowing that its products are
idiosyncratic, Jupiter may foresee the scenario of getting into small-numbers bargaining with
Atlas or any other distributor that sells its products. If the idiosyncratic assets involved are
sufficiently valuable, Jupiter is better off, in return-on-investment terms, by vertically integrating
to begin with. A good deal of field research demonstrates that Jupiter is highly likely to do just
that.
Vertically integrating in response to the mere prospect of company-specific assets has two major
advantages. First, the producer can make sure its employees really do make the investments and
acquire the needed capabilities. Second, the producer can show potential customers and other
constituents (such as investors) that it is dedicated to the market and its products. Vertical
integration is one way to establish credibility. By investing in its own operation, the firm makes a
visible, credible commitment. This is particularly important when customers see the purchase as
risky and fear the producer will abandon the market if problems arise.
This is not to say that a manufacturer cannot work efficiently with a third party where
idiosyncratic assets are at stake. To do so is very difficult, however, and requires careful
structuring of the arrangement to achieve relational governance.
In short, the prospect of accumulating company-specific assets creates an economic rationale to
vertically integrate. These assets go by many labels. Economists call them idiosyncratic assets or
transaction-specific assets because they are customized (specific) to a business relationship
(transaction). They are also called idiosyncratic or transaction-specific investments because
effort, time, know-how, and other resources must be expended to create them.
Typically in marketing channels, these capabilities grow slowly over time, often without the
realization of either party, until a crisis or an opportunity forces the parties to take stock of the
assets they have accumulated. The key concepts here are (a) assets: tangible or intangible, they
can be used to create economic value and
(b) specific: that is, made to specifications, customized, tailored, particular to, or idiosyncratic.
Specific assets cannot be redeployed to another application without significant loss in value.
Activity 7.3
What is meant by vertical integration, backward vertical integration and forward vertical
integration?
Commentary: what is vertical integration?
7.3 Six Types of Company-Specific Capabilities in Distribution
In distribution, most of the company-specific capabilities of great importance are intangible. (In
contrast, vertical integration upstream from production turns on physical assets, such as
customized parts and assemblies.) Six major forms of company-specific capabilities accrue in the
distribution arena. These are:
i. Idiosyncratic knowledge
ii. Relationships
iii. Brand equity that derives from the channel partner’s activities
iv. Customized physical facilities
v. Dedicated capacity
vi. Site specificity
Idiosyncratic knowledge is not merely knowledge of the manufacturer, its products, its
operating methods, and the applications its customers make of these products. It is that
part of this knowledge base that cannot be readily redeployed to another principal. There
is a great deal to know about a company that makes standard products, uses operating
procedures that are generic in its industry, and whose customers use the company’s
products as they would use those of another company in the same industry. Downstream
channel members make investments to acquire this knowledge, which is indeed an asset.
It is not an idiosyncratic asset, however. It is a general-purpose asset, meaning it can be
put to the service of another principal without loss of productive value. Only when a
principal makes unusual products or has its own unique methods of operation or has
customers who make customized uses of the products does the downstream channel
member acquire information that is idiosyncratic, hence a company- specific capability.
Ordinary principals do not need to vertically integrate downstream: They can generate
efficient distribution outcomes if they use the market for distribution services, given the
market is competitive. A principal that requires company- specific capabilities is at least
moderately exotic.
Relationships are connections between distributor personnel and the personnel of the
manufacturer or the manufacturer’s customers. The existence of a relationship implies the
ability to get things done quickly and correctly and to make oneself understood swiftly.
For some transactions, relationships are essential. For example, just-in-time supply
arrangements involve exquisite coordination. For a manufacturer to replenish a
downstream channel member’s supplies just at the time it becomes necessary requires
very close cooperation between the manufacturer and the channel member. This demands
relationships, and the cost (accounting cost and opportunity cost) of a failed supply
arrangement makes these relationships essential.
Brand equity is a critical idiosyncratic investment in the manufacturer’s brand name.

Here we can distinguish two cases. In one case, the brand name enjoys substantial brand
equity with consumers independent of the downstream channel member’s actions. In this
case, vertical downstream is not only unnecessary but wasteful. The manufacturer can
instead use brand equity as a source of referent power over channel members. Here, the
manufacturer does not need to integrate forward in order to exert considerable influence
over the channel. In the second case, downstream channel members do have a critical
impact on the firm’s brand equity. Brand equity is not created in a manner largely
independent of their actions. For example, channel members have a great influence on
brand equity when:
A sales force is required to create a credible image for the brand. This is often the
case for industrial products.
The brand’s strategy demands it be stocked, displayed, and presented in a
particular manner but allows for too low a downstream margin to invite the
channel member to provide the support itself. This is why perfume makers
sometimes rent dedicated space from department stores and pay the salespeople.
The brand’s strategy demands a level of cooperation that completely overrides the
decision-making discretion of a third party.
A brand-specific support service, before or after sales, is required to make sure
the branded product is properly installed and used, so that the customer is
satisfied and positive word-of-mouth is created.
In all these cases, brand equity is created and maintained via customer experiences, which are
driven by marketing channel activities. If the brand name can be made truly valuable, it can be a
substantial asset, one that is, of course, specific to the manufacturer. The more valuable this
asset, the more the firm is better off if it vertically integrates. For assets that are somewhat
valuable but not valuable enough to justify taking ownership of a flow or flows, the firm may
protect its investment by forging close relationships downstream, by franchising, by imposing
vertical restraints, or by seeking other means of influencing its channel members. Close
relationships are a way to simulate vertical integration in circumstances that do not justify the
make option but that are poorly suited to the classic buy option (arm’s-length market contracts).
Brand equity derived from channel member activity is behind much of the increase in private
label activity by North American supermarkets. They are not simply putting their name on what
a manufacturer would be making anyway. The new style of private label is to use one’s
knowledge of the product category to design a new product and to work with manufacturers to
figure out how to make it.
At a high enough level of value, the manufacturer is justified in trading influence for more
control by vertically integrating forward. An example of this phenomenon is the ongoing rivalry
between Coca-Cola and Pepsi Cola.
Know-how, relationships, and brand equity (when driven by downstream activities) are the major
categories of company-specific capabilities that justify vertical integration forward. They are all
intangibles. Several categories of tangible assets also play a role. Customized physical facilities
can be an important transaction-specific asset. For example, Amazon, the online bookseller,
outsourced its warehousing and shipping for years; however, book wholesalers operate on a
model of sending many books at a time to one easy-to-find location (a bookstore). Picking one
book to send to any private address was ruinously costly. Amazon did not become profitable
until it invented a radically new way to stock and select books and built its own highly
idiosyncratic warehousing and information system.
The same scenario occurs in maritime shipping when the shipping vessel is specific to a narrow
use for which there are very few users (such as shipping liquefied nitrogen). A ship may even be
specific to a single user (some vessels are fitted to handle a particular brand of car). Redeploying
these ships to appeal to a broader group of users requires extensive retrofitting (the brand of car)
or may be impossible (liquefied nitrogen). The key factor is that the assets (the ships) are
difficult to redeploy to the service of multiple users, thereby creating contracting hazards. The
carrier hesitates in fear of the manufacturer’s opportunism, while the manufacturer also fears the
carrier’s opportunism. Although rationally it may appear that the “balance of fear” should make
all parties act reasonably, the reality is that neither side is eager to enter into small-numbers
bargaining with the other. Vertical integration is a viable solution.
Dedicated capacity is distribution capability (warehousing, transportation, selling, billing, and so
forth) that is not customized but has been created to serve a manufacturer and which, by itself,
represents overcapacity. Thus, if the manufacturer terminates the business, the downstream
channel member has excess capacity that it cannot redeploy without sacrifice of productive value
(i.e., losses). Unlike customized physical facilities, this capacity could be put to use in serving
another manufacturer— if there were demand for it, which there is not.
A forward-looking channel member will hesitate to incur these obligations, fearing the
opportunism of the manufacturer once the capacity has been put in place. Channel members may
refuse to add the capacity or may require very high compensation to do so. It may be worthwhile
in return-on-investment terms for the manufacturer to integrate forward. Conversely, once the
capacity is in place, the downstream channel member is vulnerable and may be economically
justified in protecting its investment in dedicated capacity. It can do so by vertically integrating
backward— acquiring the manufacturer—in order to hold the business.
A manufacturer may need site-specific marketing channel flows performed in a location that is
well suited to its needs but ill suited to the needs of other manufacturers. A channel member that
creates a facility (for example, a warehouse) near the manufacturer has created a general-purpose
asset if the manufacturer is near other manufacturers whom the warehouse could serve. If the
manufacturer is in a location remote from other suppliers, the warehouse will be difficult to
redeploy. Its value is specific to the manufacturer (it is worth little or nothing to other
manufacturers).
An example occurs in maritime shipping of cargo. For many products, raw materials are mined
in remote parts of the world and shipped from one obscure port to another obscure port for
processing in a refinery that is specially built to handle the output of the originating mine. Cargo
carriers may refuse to offer service on such routes because few other customers desire to ship in
either direction. Thus, manufacturers are sometimes obliged to integrate forward into shipping.
Alternatively, they may form alliances with shippers.
The common thread uniting all of these factors—idiosyncratic knowledge, relationships, brand
equity, customized physical facilities, dedicated capacity, and site specificity—is their
production of firm-specific assets that have very low value in any alternative outside use. The
ensuing difficulties (and/or cost) a manufacturer may have in convincing a high-quality channel
partner to take on these investments, therefore, often lead the manufacturer to integrate vertically
forward (or backward) to perform those functions and flows itself.
Specific Assets Can Change to General-Purpose Assets
Many specific assets gradually lose their customized nature and become general purpose assets.
Usually this happens when the reason for specificity is innovation. Whenever a manufacturer
brings an innovative product, process, or practice to a market, that innovation is, by definition,
unique. No bidders will be qualified to distribute the new product or capable of carrying out the
new process or practice. The manufacturer will have to train an organization. Assuming the
manufacturer can find an organization willing to make the investment, the manufacturer will of
necessity enter into small-numbers bargaining. Foreseeing this situation, the manufacturer may
choose to integrate vertically. For example, when entering foreign markets, manufacturers tend
to set up their own distribution arms to sell unusual products in spite of the expense and
uncertainty involved.
But the novelty of the arrangement often disappears over time. Practices diffuse. Products and
processes are copied. Competitors enter with similar methods. The market for providing these
once-specific services expands as more providers acquire the requisite know-how, relationships,
sites, and physical facilities. The day may come when the manufacturer no longer needs to be
vertically integrated. An example occurred in the nineteenth-century United States.
What was once specific becomes general. Small-numbers bargaining then gives way to large-
numbers bargaining, and the competitiveness of the marketplace is restored. A manufacturer
entering the market at that point would do well to outsource; however, it may not follow that the
vertically integrated manufacturer would do well to dismantle its vertically integrated
distribution operation.
Switching Costs
Changing from a vertically integrated distribution operation to outsourcing involves switching

costs. Switching costs are the one-time losses incurred in taking down the current operation and
setting up a new operation (here, from vertical integration to outsourcing, though switching costs
are incurred in either direction of the switch). These include accounting costs, opportunity costs,
and psychological costs associated with terminating or displacing the operation that is being
dismantled, as well as recruiting, relocating, and training personnel and setting up infrastructure
associated with the new operation. Note that these are one-time costs of set-up and take-down.
Switching costs should not be confused with the operating costs of the new system once it is in
place.
The switching costs of going from a company operation to a third party are particularly painful
because they involve terminating the positions of employees. Terminating positions, however,
need not mean terminating the employees or their relationships. Some manufacturers shift these
employees to other positions in their firm. Indeed, innovative firms often have pressing needs for
experienced personnel and welcome the opportunity to free them from distributing what have
become standardized products through standardized processes. Failing transfer of personnel,
progressive employers realize that former personnel possess company-specific knowledge and
relationships of value and, if handled correctly, retain a loyalty to their former employer. Thus,
manufacturers often arrange for their new third party to hire their former personnel (this is
particularly the case under European labor laws, which frequently encourage, even demand, this
practice).
A creative solution involves actually setting up former employees in business as third-party
providers of distribution services (sales agencies, franchisees, dealers, distributors, export agents,
etc.). For many manufacturers, this is a way to ensure exclusive representation of their products
and services. However, exclusivity is not essential. Some firms set up truly independent
agencies, supporting them by training, secured bank loans, and promises of representation for a
guaranteed number of years. Indeed, rather than viewing this practice in altruistic terms as a
humane way to dispose of excess personnel, some firms view it as a proactive solution to the
problem of finding good representation in markets where the capable third parties already are
locked in with their competitors.
These are means of minimizing switching costs. The switching-costs concept itself is easy to
discuss in theory but difficult to estimate in practice. Research shows that firms contemplating
switching are often conscious of those costs that accountants can track (such as recruiting costs).
This is particularly the case in the United States, where surveys of such costs incurred by firms
are regularly conducted and easily available. Other costs, such as the opportunity cost of lost
business during the disruption of the transition or the psychological cost of the change, are often
overlooked or misstated.
Indeed, the nature of switching costs is so fluid that managers manipulate their estimates, often
unconsciously, to justify decisions they have made on other grounds. For example,
manufacturers who are satisfied with the performance of their manufacturers’ representatives
become desirous of retaining them and estimate the one-time costs of switching to a company
sales force to be very high. In otherwise similar circumstances, however, if they have reasons to
go direct (including dissatisfaction with performance) they will estimate the switching cost to be
low.
The presence of switching costs in distribution is a major reason why late movers in a market or
an industry often have an advantage over established firms. Late movers can enter directly with
outsourced distribution in industries or markets that have lost their specificity (have become
ordinary). Incumbents are left to struggle with the obstacles to switching and may find them so
great that they must either carry excessive overhead (by staying vertically integrated) or exit the
business due to inability to distribute effectively and efficiently.
Rarity versus Specificity: The Effects of Thin Markets
The key to asset specificity is that a resource, tangible or intangible, not only creates substantial
value (making it an important asset) but that this asset loses value if redeployed to a different
usage or user. These assets are customized, making them highly unusual. In contrast, some assets
are rare (in short supply), but are not specific. For example, the conjunction of selling ability and
technical knowledge that makes a good salesperson for semiconductors is uncommon, while
demand for their services is enormous: These salespeople are rare. Hence, they are expensive. A
semiconductor manufacturer may be tempted to reduce selling costs by employing salespeople
directly rather than going through a manufacturers’ representative. Unless the manufacturer’s
products are unlike other semiconductors or its methods are highly unusual, this strategy will not
work. The manufacturer will discover that in lieu of paying high commissions to the
manufacturers’ representative, it is meeting a high payroll. Indeed, the manufacturer’s costs will
actually increase, as it is giving up the rep’s economies.
Another case of rarity (not due to specificity) results from industry consolidation. Consolidations
among manufacturers due to mergers and acquisitions command headlines, but consolidation is
also a substantial phenomenon downstream. For example, wholesale distribution was the second
most active industry for mergers and acquisitions in the United States in 1997. Consolidation
(the concentration of market share in the hands of a few players) prunes markets so much that
they become thin. The effect is that suppliers cannot find resellers or agents, and downstream
channel members cannot find suppliers. In fear of having little real choice, organizations
scramble to form alliances with those players they estimate will be left standing as a level of an
industry consolidates. Since alliances often serve to exclude other parties, this thins the market
even further. To foreclose the prospect of dealing with a monopolist, many firms integrate
backward or forward as consolidation occurs. However, this is no panacea if the integrating firm
does not have a competitive competence level in performing these functions.
Turning the Lens Around: Should the Channel Member Integrate Backward?
For purposes of exposition, the principles here have been presented from the standpoint of the
manufacturer looking downstream. However, the principles are perfectly general and can be
applied to the downstream channel member contemplating backward integration into production.
Several of the issues already discussed have been presented in this fashion, for if the
manufacturer is at risk of being held up by the channel member who owns a unique asset, the
channel member is also at risk of being held up by the manufacturer. The manufacturer that is
willing to abandon the channel member inflicts a loss on that party, who is left with an asset that
is suddenly worthless. This prospect tempts the channel member to integrate backward, just as it
tempts the manufacturer to integrate forward.
The symmetry of this situation is often overlooked. Many readers will find it more “natural” to
consider the prospect of a manufacturer integrating forward than the prospect of, say, a
distributor integrating backward. Backward integration, however, is not at all unusual. Indeed, it
is often invited by manufacturers themselves, who welcome the infusion of capital and know-
how, particularly market knowledge.
How, then, should a downstream channel member consider the issue? It should consider it in the
same fashion as we have already discussed for forward integration. In general, vertical
integration is a poor idea. In making an exception, the key issue is this: Does the ongoing
transaction involve specificities in assets that are of great value?
These may be in any form: know-how, relationships, the creation of brand equity, dedicated
capacity, site, and physical facilities. Where these specificities are of value, a contracting hazard
exists. The higher the value of these company-specific capabilities, the more it is worthwhile to
provide protection, first in the form of relational contracting and eventually in the form of
vertical integration (backward).
Activity 7.4
A theme that appears in advertisements for stores owned by manufacturers is, “Buy factory
direct at our store. You’ll save money. We can offer you low prices because we cut out the
middleman.” Evaluate this argument. Is it valid? Would you expect a factory store to offer
lower prices? Why or why not? Are there other differences you would expect to find
between a manufacturer-owned store and an independent retailer?
Commentary: the issue could be seen in terms of the level of service needed by the buyer
from the retailer.
7.4 Vertical integration to cope with environmental uncertainty
An uncertain environment is one that is difficult to forecast. This may be because the
environment is very dynamic (fast changing) or very complex (therefore, difficult to grasp). Such
volatile environments pose special challenges. Should the manufacturer integrate forward to
meet them?
This is a controversial issue, and the evidence is mixed. One school of thought holds that a
manufacturer needs to take control in order to cope with this environment. The manufacturer can
use its control to learn more about the environment and to carry out a coherent strategy for
dealing with it. Accordingly, it is argued that uncertainty demands integration. The opposing
school of thought likens managing under uncertainty to betting on the winner of a race among
many comparable horses: One bet is as good as another, and most bets will lose anyway. From
this viewpoint, the firm is urged not to bet until the race is far enough along that it can improve
the odds by guessing who is winning (or at least avoiding those who are losing). Accordingly,
the manufacturer is advised not to commit to any distribution system, including its own system,
unless and until the uncertainty is reduced to a level that makes it easier to ascertain the best way
to distribute in the environment. This means outsourcing. The argument is that uncertainty
demands distributing through third parties, changing third parties as the situation demands
(committing to no one).
Proponents of vertical integration retort that it is defeatist to wait until the race is well along to
place a bet: By integrating, the firm can alter the course of the race. Critics respond that it is
arrogant of the manufacturer to imagine that it possesses such wisdom. Better to switch from one
third party to another and finally settle on the best option (the best third party, or one’s own
means of going to market) when the best option actually can be ascertained.
The proponents retort that the best option may be closed by the time the manufacturer is ready to
pursue it. A key feature of this argument concerns how easy it will be to change the marketing
channel as the environment changes. Proponents of vertical integration often underestimate the
difficulty of making real organizational change happen once in-house distribution is in place.
Both sides of the debate have valid arguments. How to incorporate them into one approach? A
useful frame to resolve this issue is to complicate it slightly. One begins by asking whether the
distribution involves (or will involve) substantial company-specific capabilities. If not, the firm
can easily change third parties.
This flexibility is of great value in volatile environments. Absent significant specificity,
uncertainty favors outsourcing.
But if specificities are substantial, flexibility is already lost. The firm will become locked into its
third parties, and there can be no changing one’s bet. Then the manufacturer faces the worst of
all worlds: small-numbers bargaining in an environment that requires constant adaptation. The
result will be endless bargaining, high levels of opportunism, and high transaction costs. In the
presence of significant specificity, uncertainty favors vertical integration forward.
There is, of course, a third argument: In the presence of significant specificities, do not go into
the business at all. To justify the overhead of vertically integrating, the business must be very
promising, and yet by nature the uncertainty makes it difficult to tell how promising the business
really is. This conundrum can be solved by avoiding the business altogether. Perhaps the most
common approach to distributing in uncertain environments when specificities are high is not to
enter the market at all. Because those activities that firms decide not to pursue are difficult to
observe, it is not known how often such business activities are never undertaken. Yet, non-
market-entry, while difficult to notice, is always present—and is frequently attributed to other
factors.
For example, multinational business activity occurs at very low levels in sub- Saharan Africa,
even though there are rich potential markets in a region of more than 700 million people. This
often is attributed to high political risk and lack of economic development; however,
multinationals operate in other risky, underdeveloped markets, many of which were largely
ignored only a decade earlier. Why continue to overlook Africa? One explanation is that (a)
many African markets are little known and potentially highly volatile and (b) the lack of
distribution infrastructure implies that much of what the manufacturer does to distribute will be
idiosyncratic in that market. The combination of uncertainty and specificity, as opposed to
uncertainty alone, may help explain low investment in Africa (of course, many other factors
contribute to the phenomenon as well). In contrast, some politically risky Asian countries have
better distribution infrastructures, permitting multinationals to find qualified third parties already
operating in the market. With specificity removed, uncertainty can be handled by outsourcing,
encouraging more market entry.
It is noteworthy that market entry by some firms encourages more entry and that it does so by
reducing specificity. Once a number of multinational corporations (MNCs) have entered a
market, they create a pool of local personnel who know the procedures of MNCs. This makes it
easier to find third parties that qualified to work in a manner that is nonstandard in the market but
standard in MNCs. India, for example, has seen growth in the number of qualified joint-venture
partners and distributors as a cumulative result of decades of multinational investment. This
process is now underway in China.
Summary
Who should do the work of distribution, in whole or in part? Should the same party do
manufacturing and distribution? Should two parties split the work? If so, how? Splitting the work
means sharing the costs (resources, risk, responsibility) and the benefits (or lack of them).
Vertical integration in distribution is not an all-or-nothing decision but can pertain to the decision
of whether to make or buy any individual channel flow or set of flows. Thus, a manufacturer can
totally vertically integrate just a subset of channel functions but still use independent
intermediaries to perform other functions. It is common that both vertical integration and
decentralization (outsourcing to a third party) characterize the channel system.
The fundamental idea behind this analysis is that any player should respect the fact that the work
of any other player requires competencies. Therefore, no party should merely assume that it can
take over another party’s functions and perform them better and/or more cheaply. In short,
arrogance has no place in a vertical integration decision, which should be undertaken with
respect for the competence of another type of organization.
Being committed to a system (such as outsourcing) is not the same thing as being committed to a
given member of the system. Vertical integration is too often used as a way to go around
unsatisfactory results from or relationships with another organization. If this is the rationale, the
firm should first ask whether the current relationship can be made to work better (using the
techniques in this book, for example), or whether another third party would be more effective.
Vertical integration is a drastic step that invariably raises overhead and that often fails to reduce
direct costs or increase revenue. The step should not be undertaken lightly.
Many readers will be surprised at the assertion that markets for distribution services are
frequently efficient. This does not mean that a firm cannot do better by vertically integrating, but
it does mean that to get better results the firm must be prepared to make a very substantial
commitment and often to operate in a manner that is unusual for its industry or market. For
vertical integration to improve on outsourcing, the firm must take large risks and make
substantial commitments.
It is never possible to estimate transaction costs, production costs, and return on investment
precisely under any scenario, vertically integrated or otherwise; however, the framework
presented here allows the decision maker to forecast the direction in which these costs will go
and to arrive at a rough approximation of which system works best in the longer term.
This chapter presents the decision path in steps, beginning with the assumption that outsourcing
distribution is superior because it profits from six advantages of the outsider: motivation,
specialization, survival of the fittest, economies of scale, coverage, and independence. Step 2
involves questioning this assumption under these circumstances: company-specific capabilities
(especially when combined with environmental uncertainty), and thin markets (rare, rather than
idiosyncratic).
Some readers find themselves uncomfortable with opportunism, one of the fundamental ideas
underlying this analysis. They find self-interest seeking in a deceitful or dishonest manner to be
negative, discouraging, and perhaps unrepresentative of human nature (or perhaps representative
of the worst of human nature). However, it is important not to personalize the discussion.
Opportunistic behavior is a characteristic of organizations interacting with each other in
conducting business. This is not to say that it is the nature of two people interacting with each
other in their private lives. Further, to focus on opportunism does not mean that all organizations
are opportunistic at all times. It is merely to say that some organizations are opportunistic in
some circumstances, and it is difficult to forecast in advance which will be opportunistic. The
make-or-buy decision rests on pragmatically anticipating and forestalling opportunism.
An important reason to undertake vertical integration is to gain market research or to create an
option to be evaluated in the future. Thus, in some circumstances it is justified to integrate
distribution, not to do a better job of distributing but to do a better job of learning or to hold open
a door to a future investment. Integration forward or backward is often a means of improving
overall performance, not improving the performance per sale.
The vertical integration decision is fundamental, for it drives the firm’s capabilities for the long
term and is difficult to reverse. “Owning it all” is a solution of last resort to the problems of
distributing effectively and efficiently.
Part one: Multiple choice questions
1. Which of these businesses are usually 100% integrated?
a. Restaurants
b. Wholesale department stores
c. Oil companies
d. None
2. Which part of the chain is the "supply side"?
a. Producer and refiner

b. Distributor and retailer
c. None
3. When a firm engages in activities that bring it closer to its customers, the firm has
a. Provided a source of additional revenues to the firm
b. Entered into a strategic alliance.
c. Engaged in backward integration.
d. Decided to forward integrate.
4. When a firm is unfairly exploited in an economic exchange, then
a. Opportunism exists
b. It should increase its transaction specific investments.
c. The firm should engage in both backward and forward integration
d. The firm needs to enter into long-term contracts with suppliers
e. None
5. In opportunism-based explanations of vertical integration, decisions are based on
a. Opportunism exists
b. It should increase its transaction specific investments.
c. The firm should engage in both backward and forward integration
d. The firm needs to enter into long-term contracts with suppliers
e. None
6. When a firm resolves uncertainty faster than its competitors and begins to reap the
advantages of vertical integration, the firm can achieve
a. Decreases in costs which lead to an increase in net profits
b. A higher return on resources invested in transaction specific investments
c. Greater resources and capabilities
d. A competitive advantage
Part two: Answer true if the statement is correct and false if the statement is incorrect
7. Vertical integration means buying out a competitor to gain market share.

8. Vertical integration means a merger somewhere up or down in the marketing chain.
9. A home business making costume jewelry and selling on the internet is vertically
integrated.
10. Competing with your established customers is a risk of vertical integration.
Part three: Discussion questions
11. What are the steps required when deciding whether to outsource or not?
12. The cost of exiting a vertically integrated business is less than the cost of exiting a non-
vertically integrated business. Do you agree with this statement?
Chapter 8
Introduction to Marketing Logistics
Introduction
Logistics is the process of planning, implementing and controlling the efficient, cost-effective
flow and storage of raw materials, in-process inventory, finished goods and related information
from the point of origin to point of consumption for the purpose of conforming to customer
requirements. Logistics is mainly classified into inbound and outbound logistics and this chapter
focuses on presenting outbound logistics. Therefore, this chapter introduces the concepts,
historical developments, activities and missions of logistics. Further, the environment of logistics
and its interface with marketing are discussed along with presentations on logistics customer
services.
Learning objectives:
After reading this chapter learners will be able to :
Understand the basic concepts of outbound logistics
Analyze logistics activities and perform logistics operations in a firm

Manage the logistics function through effective coordination of other functional units in
the firm
Manage logistics customer service
Determine logistics costs to manage efficient logistics operation in a firm
8.1 Logistics: An overview
The definition of logistics might vary based on the perspective of the definition:
Operational Definition : For the purpose of this module logistics is defined as follows:
“ Logistics is the process of planning, implementing and controlling the efficient, cost-
effective flow and storage of raw materials, in-process inventory, finished goods and
related information from the point of origin to point of consumption for the purpose of
conforming to customer requirements”.
Historical Development of Logistics
In the 1950s and ‘60s, the military was the only organization using the term logistics. There was
no true concept of logistics in private industry at that time. Instead, departmental silos including
material handling, warehousing, machining, accounting, marketing, and so on, were the norm.
The five phases of logistics development—workplace logistics, facility logistics, corporate
logistics, supply chain logistics, and global logistics are discussed below.
i. Workplace Logistics: Workplace logistics is the flow of material at a single workstation.
The objective of workplace logistics is to streamline the movements of an individual
working at a machine or along an assembly line. The principles and theory of
workplace logistics were developed by the founders of industrial engineering working
in WWII and post-WWII factory operations. A popular name today for workplace
logistics is ergonomics.
ii. Facility Logistics: Facility logistics is the flow of material between workstations within
the four walls of a facility (that is, inter-workstation and intra-facility). The facility
could be a factory, terminal, warehouse, or distribution center. Facility logistics has
been more commonly referred to as material handling. The roots of facility logistics
and material handling are in the mass production and assembly lines that
distinguished the 1950s and 1960s. In those times and even into the late 1970s, many
organizations maintained material-handling departments. Today, the term material
handling has fallen out of favor because of its association with non-value added
activities. In the 1960s, material handling, warehousing, and traffic were grouped
together to become known as physical distribution; procurement, marketing, and
customer service were grouped together to become known as business logistics.
(Even today in many academic institutions, logistics is still divided along these lines;
where logistics is taught in the business school, it is taught as business logistics and in
the engineering schools as physical distribution).
iii. Corporate Logistics: As management structures advanced and information systems

accordingly, the ability to assimilate and synthesize departments (material handling,
warehousing, and so on) into functions (physical distribution and business logistics)
in the 1970s permitted the first application of true logistics within a corporation.
Corporate logistics became a process with the common objective to develop and
maintain a profitable customer service policy while maintaining and reducing total
logistics costs. Corporate logistics is the flow of material and information between the
facilities and processes of a corporation (inter-workstation, inter-facility, and intra-
corporate). For a manufacturer, logistics activities occur between its factories and
warehouses; for a wholesaler, between its distribution centers; and for a retailer,
between its distribution centers and retail stores. Corporate logistics is sometimes
associated with the phrase physical distribution that was popular in the 1970s. In fact,
the Council of Logistics Management (CLM) was called the National Council of
Physical Distribution Management (NCPDM) until 1982.
iv. Supply Chain Logistics: Supply chain logistics is the flow of material, information, and
money between corporations (inter-workstation, inter-facility, inter-corporate, and
intra-chain). There is a lot of confusion surrounding the terms logistics and supply
chain management. The supply chain is the network of facilities (warehouses,
factories, terminals, ports, stores, and homes), vehicles (trucks, trains, planes, and
ocean vessels), and logistics information systems (LIS) connected by an enterprise’s
supplier’s suppliers and its customer’s customers. Logistics is what happens in the
supply chain. Logistics activities (customer response, inventory management, supply,
transportation, and warehousing) connect and activate the objects in the supply chain.
To borrow a sports analogy, logistics is the game played in the supply chain arena. It
is unfortunate that the phrase supply chain management has been so readily and
commonly adopted as a reference to excellence in logistics. First, it is not supply (or
demand) that should dictate the flow of material, information, and money in a
logistics network. Actually, there are some links in the chain and some circumstances
in which supply dictate flow and some in which demand should dictate flow. Second,
if you drew lines connecting all the trading partners in a typical supply chain, what
you would see would not look anything like a chain. You would see something that
looks more like a complex web of links. A chain stretched full is a line. The danger in
the choice of the term chain is that the term oversimplifies the complexities in
logistics management and leads to inflated expectations for what can be achieved by
supply chain management systems. Finally, the term management suggests that a
single party in the chain can truly manage and dictate the operations of the supply
chain. Instead, the best any party can do is to collaboratively plan the operations of
the chain.
v. Global Logistics: Global logistics is the flow of material, information, and money
between countries. Global logistics connects our suppliers’ suppliers with our
customers’ customers internationally. Global logistics flows have increased
dramatically during the last several years due to globalization in the world economy,
expanding use of trading blocs, and global access to Web sites for buying and selling
merchandise. Global logistics is much more complex than domestic logistics, due to
the multiplicity of handoffs, players, languages, documents, currencies, time zones,
and cultures that are inherent to international business.
vi. Next-Generation Logistics: There are many theories as to the next phase of logistics
development. Many logisticians believe that collaborative logistics, logistics models
built with continuous and real-time optimization and communication between all
supply chain partners will be the next phase of evolution. Other camps in the logistics
community believe the next phase of evolution will be virtual logistics or fourth-party
logistics, where all logistics activities and management will be outsourced to third-
party logistics providers who are in turn managed by a master or fourth-party logistics
providers acting kind of like a general contractor.
Activity fragmentation to 1960 Activity Integration 1960 to 2000 2000+
Demand forecasting
Purchasing
Requirements planning
Purchasing/
Production planning Materials
Management
Manufacturing inventory
Warehousing
Logistics
Material handling
Packaging
Finished goods inventory Supply Chain

Physical Supply Chain
Management
Distribution Management
Distribution planning
Order processing
Transportation
Customer service
Strategic planning
Information services
Marketing/sales
Finance
Classification of Logistics
Logistics is classified into two main categories i.e. inbound logistics and out bound logistics.
i. Inbound logistics: focuses on getting all the necessary inputs for the production
process. This will involve the following major tasks: requirement planning,
demand forecasting , purchasing , transportation, warehousing, manufacturing
inventory and materials handling.
ii. Outbound logistics: also known as physical distribution or marketing logistics
focuses on making goods and services available to the customers by maintaining
higher effectiveness and efficiency in order to satisfy customers’ requirements. In
doing so the following tasks will be accomplished: packaging, finished good
inventory, distribution planning, order processing, transportation and customer
service. The focus of this module is on outbound logistics.
8. 2 Logistics Activities
In the definition, logistics is comprised of five interdependent activities: customer response,
inventory planning and management, supply, transportation, and warehousing. Each activity and
its objective are described briefly below:
i. Customer Response: Customer response links logistics externally to the customer base
and internally to sales and marketing. Customer response is optimized when the customer
service policy (CSP) yielding the lowest cost of lost sales, inventory carrying, and
distribution is identified and executed. The logistics of customer response includes the
activities of:
• Developing and maintaining a customer service policy
• Monitoring customer satisfaction
• Order Entry (OE)
• Order Processing (OP), and
• Invoicing and collections
ii. Inventory Planning and Management: The objective of inventory planning and
management (IP&M) is to determine and maintain the lowest inventory levels possible
that will meet the customer service policy requirements stipulated in the customer service
policy.
The logistics of inventory planning and management includes:
• Forecasting
• Order quantity engineering
• Service level optimization
• Replenishment planning
• Inventory deployment
iii. Supply: Supply is the process of building inventory (through manufacturing and/or
procurement) to the targets established in inventory planning. The objective of supply
management is to minimize the total acquisition cost (TAC) while meeting the
availability, response time, and quality requirements stipulated in the customer service
policy and the inventory master plan. The logistics of supply include:
• Developing and maintaining a Supplier Service Policy (SSP)
• Sourcing
• Supplier integration
• Purchase order processing
• Buying and payment
iv. Transportation: Transportation physically links the sources of supply chosen in

sourcing with the customers we have decided to serve chosen as a part of the customer
service policy. We reserve transportation for the fourth spot in the logistics activity list
because the deliver-to points and response time requirements determined in the customer
service policy and the pick-up points determined in the supply plan must be in place
before a transportation scheme can be developed.
The objective of transportation is to link all pick-up and delivery -to points within the
response time requirements of the customer service policy and the limitations of the
transportation infrastructure at the lowest possible cost.
The logistics of transportation includes:
• Network design and optimization
• Shipment management
• Fleet and container management
• Carrier management
• Freight management
v. Warehousing: Warehousing is the last of the five logistics activities because good
planning in the other four activities may eliminate the need for warehousing or may
suggest the warehousing activity be outsourced. In addition, a good warehouse plan
incorporates the needs of all the other logistics activities. Good or bad, the warehouse
ultimately portrays the efficiency or inefficiency of the entire supply chain.
The objective of warehousing is to minimize the cost of labor, space, and equipment in the
warehouse while meeting the cycle time and shipping accuracy requirements of the customer
service policy and the storage capacity requirements of the inventory play. The logistics of
warehousing includes:
• Receiving
• Put away
• Storage
• Order picking
• Shipping
The mission of logistics management
It will be apparent from the previous comments that the mission of logistics management is to
plan and co-ordinate all those activities necessary to achieve desired levels of delivered service
and quality at lowest possible cost. Logistics must therefore be seen as the link between the
marketplace and the operating activity of the business. The scope of logistics spans the
organization, from the management of raw materials through to the delivery of the final product.
The figure on the next page illustrates this total systems concept.
Materials flow
Suppliers Procurement operation Distribution Customers
Requirement information flow
Figure 8.1 : Logistics Management Process
Logistics management, from this total systems viewpoint, is the means where by the needs of
customers are satisfied through the coordination of the materials and information flows that
extend from the market place, through the firm and its operations and beyond that to suppliers.
To achieve this company-wide integration clearly requires a quite different orientation than that
typically encountered in the conventional organization.
For example, for many years marketing and manufacturing have been seen as largely separate
activities within the organization. At best they have coexisted, at worst there has been open
warfare.
Manufacturing priorities and objectives have typically been focused on operating efficiency,
achieved through long production runs, minimized set-ups and change-over and product
standardization. On the other hand marketing has sought to achieve competitive advantage
through variety, high service levels and frequent product changes.
In this scheme of things, logistics is therefore essentially an integrative concept that seeks to
develop a system-wide view of the firm. It is fundamentally a planning concept that seeks to
create a frame work through which the needs of the market place can be translated in to a
manufacturing strategy and plan, which in turn links in to a strategy and plan for procurement.
Ideally there should be a ‘one-plan’ mentality with in the business which seeks to replace the
conventional stand-alone and separate plans of marketing, distribution, production and
procurement. This, quite simply, is the mission of logistics management.
8.3 The supply chain and competitive performance
The supply chain is the network of organizations that are involved, through upstream and
downstream linkages, in the different processes and activities that produce value in the form of
products and services in the hands of the ultimate consumer, thus for example a shirt
manufacturer is a part of a supply chain that extends upstream an downstream through
distributors and retailers to the final consumer. Each of these organizations in the chain are
dependent up on each other by definition and yet paradoxically by tradition do not closely co-
operate with each other.
Supply chain management is not the same as ‘vertical integration’. Vertical integration normally
implies ownership of upstream suppliers and downstream customers. This was once thought to
be a desirable strategy but increasingly organizations are now focusing on their ‘core businesses-
in other words the things they do really well and where they have a differential advantage.
Everything else is ‘out-sourced’-in other words it is procured outside the firm so companies that
perhaps once made their own components now only assemble the finished product, e.g.
automobile manufacture. Other companies may also subcontract the manufacturing as well.
These companies have sometimes been termed ‘virtual’ or’ network’ organizations.
Clearly this trend has many implications for logistics management, not the least being the
challenge of integrating and coordinating the flow of materials from a multitude of suppliers,
often offshore, and similarly managing the distribution of the finished product by way of
multiple intermediaries.
In the past it was often the case that relationships with suppliers and downstream customers
(such as distributors or retailers) were adversarial rather than cooperative. It is still the case to
day that some companies will seek to achieve cost reductions or profit improvement at the
expense of their supply chain partners. Companies such as these do not realize that simply
transferring costs upstream or downstream does not make them any more competitive. The
reason for this is that ultimately all costs will make their way to the final marketplace to be
reflected in the price paid by the end user. The leading-edge companies recognize the fallacy of
this conventional approach and instead seek to make the supply chain as a whole more
competitive through the value it adds and the costs that it reduces overall. They have realized
that the real competition is not company against company but rather supply chain against supply
chain.
It must be recognized that the concept of supply chain management whilst relatively new, is in
fact no more than an extension of the logic of logistics. Logistics management is primarily
concerned with optimizing flows within the organization whilst supply chain management
recognizes that internal integration by itself is not sufficient.
It will be apparent that supply chain management involves a significant change from the
traditional arms-length, even adversarial, relationships that so often typified buyer/supplier
relationships in the past. The focus of supply chain management is on cooperation and trust and
the recognition that properly managed ‘the whole can be greater than the sum of its parts’.
The definition of supply chain management that is adopted in this module is:
“ The management of upstream and downstream relationships with suppliers and

customers to deliver superior customer value at less cost to the supply chain as a whole”
8.4 The changing logistics environment
As the competitive context of business continues to change, bringing with it new complexities
and concerns for management generally, it also has to be recognized that the impact of these
changes on logistics can be considerable. Indeed, of the many strategic issues that confront the
business organization today, perhaps the most challenging are in the area of logistics.
Much of this course will be devoted to addressing these challenges in detail but it is useful at this
stage to highlight what are perhaps the most pressing currently.
These are:
The customer service explosion

Time compression
Globalization of industry
Organizational integration
i. The customer service explosion
So much has been written and talked about service, quality and excellence that there is no
escaping the fact that the customer in today’s marketplace is more demanding, not just of product
quality but also of service.
As more and more markets become in effect ‘commodity’ markets where the customer perceives
little technical difference between competing offers, the need is for the creation of differential
advantage through added value. Increasingly a prime source of this added value is through
customer service.
Customer service may be defined as the consistent provision of time and place utility. In other
words products don’t have value until they are in the hands of the customer at the time and place
required. There are clearly many facets of customer service, ranging from on time delivery
through to after-sales support.
ii. Time compression
One of the most visible features of recent years has been the way in which time has become a
critical issue in management. Product life cycles are shorter than ever, industrial customers and
distributors require just-in-time deliveries, and end users are ever more willing to accept a
substitute product if their first choice is not instantly available.
The issue of logistics lead times is important in such an environment.
The concept of logistics lead time is simple: how long does it take to convert an order into cash?
Whilst management has long recognized the competitive impact of shorter order cycles, this is
only a part of the total process whereby working capital and resources are committed to an order.
From the moment when decisions are taken on the sourcing and procurement of materials and
components through the manufacturing subassembly process to the final distribution and after-
market support, there are a myriad of complex activities that must be managed if customers are
to be gained and retained. This is the true scope of logistics lead-time management.
As we have noted, one of the basic functions of logistics is the provision of ‘availability’.
However, in practice, what is so often the case is that the integration of marketing and
manufacturing planning that is necessary to achieve this competitive requirement is lacking.
Further problems are caused by limited co-ordination of supply decisions with the changing
requirements of the marketplace and the restricted visibility that purchasing and manufacturing
have of final demand, because of extended supply and distribution ‘pipelines’.
To overcome these problems and to establish enduring competitive advantage by ensuring timely
response to volatile demand, a new and fundamentally different approach to the management of
lead times is required.
iii. Globalization of industry
The third of the strategic issues that provide a challenge for logistics management is the trend
towards globalization. A global company is more than a multinational company. In the global
business materials and components are sourced worldwide, manufactured offshore and sold in
many different countries perhaps with local customization. Such is the trend towards
globalization that it is probably safe to forecast that before long most markets will be dominated
by global companies. For global companies the management of the logistics process has become
an issue of central concern.
iv. Organizational integration
In conventional organizations, materials managers manage materials, whilst production

managers manage production, and marketing managers manage marketing. Yet these functions
are components of a system that needs some overall plan or guidance to fit together. Managing
the organization under the traditional model is just like trying to complete a complex jigsaw
puzzle without having the picture on the box cover in front of you.
v. The new rules of competition
In the past the ground rules for marketing success were obvious: strong brands, backed up by
large advertising budgets and aggressive selling. This formula now appears to have lost its
power. Instead, the argument is heard, companies must recognize that increasingly it is through
their capabilities and competencies that they compete.
Essentially, this means that organizations create superior value for customers and consumers by
managing their core processes better than competitors manage theirs. These core processes
encompass such activities as new product development, supplier development, order fulfillment
and customer management. By performing these fundamental activities in more cost-effective
way than competitors it is argued, organizations will gain the advantage in the marketplace.
A major contributing factor influencing the changed competitive environment has been the trend
towards ‘commoditization’ in many markets. A commodity market is characterized by perceived
product equality in the eyes of customers resulting in a high preparedness to substitute one make
of product for another. Research increasingly suggests that consumers are less loyal to specific
brands but instead will have a portfolio of brands within a category from which they make their
choice. In situations such as this, actual product availability becomes a major determinant of
demand. There is evidence that more and more decisions are being taken at the point of purchase
and if there is a gap on the shelf where Brand X should be but Brand Y is there instead, then
there is a strong probability that Brand Y will win the sale.
It is not only consumer markets that the importance of logistics process excellence is apparent. In
business-to-business and industrial markets it seems that product or technical features are of less
importance in winning order than issues such as delivery lead times and flexibility. This is not to
suggest that product or technical features are unimportant-rather it is that they are taken as a
‘given’ by the customer. Quite simply, in to day’s marketplace the order-winning criteria are
more likely to be service-based than product-based.
A parallel development in many markets is the trend towards a consolidation of demand. In

other words customers-as against consumers- are tending to grow in size whilst becoming fewer
in number. The retail grocery industry is a good example in that in most developed countries a
handful of large retailers account for most of the sales in any one country. This tendency to the
concentration of buying power is being accelerated as a result of global competition and the fact
that in most industries there is a worldwide over-capacity. The impact of these trends is that
these more powerful customers are becoming more demanding in terms of their service
requirements from suppliers.
At the same time as the power in the distribution channel continues to shift from supplier to
buyer, there is a trend for customers to reduce their supplier base. In other words they want to do
business with fewer suppliers and often on a longer-term basis. The successful companies in the
coming years will be those that recognize these trends and seek to establish strategies which are
based upon establishing closer relationships with key accounts. Such strategies will focus upon
seeking innovative ways to create more value for these customers. These strategies will be
‘vertical’ rather than ‘horizontal’ in that the organization will seek to do more for fewer
customers rather than looking for more customers to whom to sale the same product.
Such a transition from volume-based growth to value-based growth will require a much greater
focus on managing the core process that we referred to earlier. Whereas the competitive model
of the past relied heavily on product innovation this will have to be increasingly supplemented
by process innovation. The basis for competing in this new era will be:
Competitive advantage = Product excellence x process excellence
Figure 8.2 suggests that for many companies the investment has mainly concentrated on product
excellence and less on process excellence.
This is not to suggest that product innovation should be give less emphasis- far from it- but
rather that more emphasis needs to be placed on developing and managing processes that
delivery greater value for key customers.
We have already commented that product life cycles are getting shorter.
Activity 8.1
Discuss the interface logistics has with the other functions in the organization
Commentary
Consider the organization is a manufacturing firm with the following units:
Purchasing
Finance
Marketing
Production
100
Revised
emphasis
Product excellence (%)
Current
Emphasis
100
Process excellence (%)
Figure 8.2: Investing in process excellence yields greater benefits
What we have witnessed in many markets is the effect of changes in technology and consumer
demand combining to produce more volatile markets where a product can be obsolete almost as
soon as it reaches the market. There are many current examples of shortening life cycles but
perhaps the personal computer symbolizes them all. In this particular case we have seen rapid
developments in technology which have firstly created markets where none existed before and
then almost as quickly have rendered themselves obsolete as the next generation of product is
announced.
Such shortening of life cycles create substantial problems for logistics management. In
particular, shorter life cycles demand shorter lead times-indeed our definition of lead time may
well need to change. Lead times are traditionally defined as the elapsed period from receipt of
customer order to delivery. However, in today’s environment there is a wider perspective that
needs to be taken. The real lead time is the time taken from the drawing board, through
procurement, manufacture and assembly to the end market. This is the concept of strategic lead
time and the management of this time span is the key to success in managing logistics
operations.
There are already situations arising where the life cycle is shorter than the strategic lead time. In
other words the life of a product on the market is less than the time it takes to design, procure,
manufacture and distribute that same product! The implications of this are considerable both for
planning and operations. In a global context the problem is exacerbated by the longer
transportation time involved.
Ultimately, therefore, the means of achieving success in such markets is to accelerate movement
though the supply chain and to make the entire logistics system far more flexible and thus
responsive to these fast-changing markets.
Whilst there are many implications of these pressures for the way we manage logistics there are
three key issues which will be recurring themes throughout the course: responsiveness, reliability
and relationships.
Responsiveness:
In today’s just-in-time world the ability to respond to customers’ requirements in ever-shorter
time-frames has become critical. Not only do customers want shorter lead times, they are also
looking for flexibility and, increasingly, solutions to their problems. In other words the supplier
has to be able to meet the precise needs of customers in less time than ever before. The key
word in this changed environment is agility. Agility implies the ability to move quickly and to
meet customer demand sooner. In a fast-changing marketplace agility is actually more important
than long term strategy in a traditional business planning sense. Because future demand patterns
are uncertain by definition this makes planning more difficult and, in a sense, hazardous.
Reliability
One of the main reasons why any company carries safety stock is because of uncertainty. It may
be uncertainty about future demand or uncertainty about a supplier’s ability to meet a delivery
promise, or about the quality of materials or components.
A key to improving reliability in logistics process is enhanced pipeline visibility. It is often the
case that there is limited visibility of downstream demand at the end of the pipeline. This
problem is exacerbated the further removed from final demand the organization or supply chain
entity is. Thus the manufacturer of synthetic fibers may have little awareness of current
demand for the garments that incorporate those fibers in the material from which they are made.
If a means can be found of opening up the pipeline so that there is clear end-to-end visibility then
reliability of response will inevitably improve.
Relationships
The trend towards customers seeking to reduce their supplier base has already been commented
upon. In many industries the practice of ‘single sourcing’ is widespread. It is suggested that the
benefits of such practices include improved quality, innovation sharing, reduced costs and
integrated scheduling of production and deliveries. Underlying all of this is the idea that
buyer/supplier relationships should be based upon partnership. More and more companies are
discovering the advantages that can be gained by seeking mutually beneficial, long term
relationships with suppliers. Form the suppliers’ point of view such partnerships can prove a
formidable barrier to entry for competitors. The more processes are linked between the supplier
and the customer the more the mutual dependencies and hence the more difficult it is for
competitors to break in.
These three themes of responsiveness, reliability and relationships provide the basis for
successful logistics and supply chain management. They are themes that will be explored later in
this course. As we enter the 21st century the need for a greater focus on the logistics processes
that underpin supply chain effectiveness becomes ever more apparent.
Earlier in this chapter the mission of logistics management was defined simply in terms of
providing the means where by customers’ service requirements are met. In other words the
ultimate purpose of any logistics system is to satisfy customers.
8.5 The marketing and logistics interface
Even though the textbooks describe marketing as the management of the ‘Four P’s’ – product,
price, promotion and place- it is probably true to say that in practice, most of the emphasis has
always been placed on the first three. ‘Place’, which might better be described in the words of
the old cliché: ‘the right product, in the right place at the right time’, was rarely considered part
of mainstream marketing.
There are signs that this view is rapidly changing, however, as the power of customer service as
a potential means of differentiation is increasingly recognized. In more and more markets the
power of the brand has declined and customers are willing to accept substitutes; even technology
differences between products have been removed so that it is harder to maintain competitive
edge through the product itself. In situations like this it is customer service that can provide
distinctive difference between one company’s offer and that of its competitors.
One powerful way of highlighting the impact that customer service and logistics management
can have on marketing effectiveness is out-lined in the figure on the next page. The suggestion
here is that customer service impacts not only on the ultimate end user but also on intermediate
customers such as distributors. Traditionally marketing has focused on the end customer – or
consumer – seeking to promote brand values and to generate a ‘demand pull’ on the marketplace
for the company’s products. More recently we have come to recognize that this by itself is not
sufficient. Because of the swing in power in many marketing channels away from manufacturers
and toward the distributor (e.g. the large concentrated retailers) it is now vital to develop the
strongest possible relations with such intermediaries – in other words to create a customer
franchise as well as a consumer franchise.
Consumer Customer Supply chain Marketing

franchise franchise efficiency effectiveness
X X =
Availability - Partnership Low cost supplier - Market share
Customer retention
- Superior ROI
Figure 8.3: The impact of logistics and customer service on marketing
The impact of both a strong consumer franchise and a customer franchise can be enhanced or
diminished by the efficiency of the suppliers’ logistics system. It is only when all three
components are working optimally that marketing effectiveness is maximized. To stress the inter
dependence of these three components of competitive performance it is suggested that the
relationship is multiplicative. In other words the combined impact depends upon the product of
all three.
How does logistics create customer service?
The 7R’s rule provides a simple description. Logistics create customer service by making
available the right product, at the right time, at the right place, in the right condition, to the right
customer, in the right quantity, and at the right cost. Break down in one of the seven R’s will
result in the interruption of product flow and hence poor customer service.
Service driven logistics systems
Ideally all logistics strategies and systems should be devised in the following sequence;
Identify customers’ service
needs
Define customer service

objectives
Design the logistics system
Figure 8.4 service driven logistics system
It would be appropriate at this point to look briefly at the first two stages of this process:
identifying customers’ service needs and the development of customer service objectives.
Identifying customers’ service needs
It is important to remember that no two customers will ever be exactly the same in terms of their
service requirements. However it will often be the case that customers will fall in to groups or
‘segments’ which are characterized by a broad similarity of service needs. These groupings
might be thought of as ‘service segments’. The logistics planner needs therefore to know just
what the service issues are that differentiate customers. Market research can be of great
assistance in understanding this service segmentation and it is often surprising to see how little
formal research is conducted in this crucial area.
The approach to service segmentation suggested here follows a three-stage process:
i. Identify the key components of customer service as seen by customers themselves.

ii. Establish the relative importance of those service components to customers.
iii. Identify ‘clusters’ of customers according to similarity of service preferences.
i. Identifying the key components of customer
service
The first step in research of this type is to identify the key sources of influence upon the purchase
decision.
For example, if we were selling components to a manufacturer, who will make the decision on
the choice of supplier? This is not always an easy question to answer as in many cases there will
be several people involved. The purchasing manager of the company to which we are selling
may only be acting as an agent for others within the firm. In other cases his influence will be
much greater. Alternatively if we are manufacturing products for sale through retail outlets, is
the decision to stock made centrally by a retail chain or by individual store managers? The
answers can often be supplied by the sales force. The sales representative should know from
experience who are the decision makers.
Given that a clear indication of the source of decision-making power can be gained, the customer
service researcher at least knows who to research. The question remains as to which elements of
the vendor’s total marketing offering have what effect upon the purchase decision.
Ideally once the decision-making unit in a specific market has been identified, an initial, small-
scale research program should be initiated based upon personal interviews with a representative
sample of buyers. The purpose of these interviews is to elicit, in the language of the customers,
firstly the importance they attach to customer service vis-à-vis the other marketing mix elements
such as price, product quality, promotion etc, and secondly, the specific importance they attach
to the individual components of customers service.
The importance of this initial step in measuring customer service is that relevant and meaningful
measures of customer service are generated by the customers themselves. Once these
dimensions are defined we can identify the relative importance of each one and the extent to
which different types of customer are prepared to trade-off one aspect of service for another.
ii. Establishing the relative importance of customer

service components
One of the simplest ways of discovering the importance a customer attaches to each element of
customer service is to take the components generated by means of the process described in step 1
and to ask a representative sample of customers to rank order them from the ‘most important’ to
the ‘least important’. Here the researcher can ask the respondent to allocate a total of 100 points
amongst all the elements listed, according to perceived importance.
iii. Identifying customer service segments

Now that we have determined the importance attached by different respondents to each of the
service attributes previously identified, the final step is to see if any similarities of preference
emerge. If one group of respondents for example has a clearly distinct set of priorities from
another then it would be reasonable to think of them both as different service segments.
2. Defining customer service objectives
The whole purpose of logistic strategy is to provide customers with the level and quality of
service that they require and to do so at less cost to the total supply chain. In developing a
market-driven logistics strategy the aim is to achieve ‘service excellence’ in a consistent and
cost-effective way.
The measure of service is defined as the percentage of occasions on which the customer’s
requirement is met in full.
3. The cost benefit of customer service
All companies have to face a basic fact: there will be significant differences in profitability
between customers. Not only do different customers buy different quantities of different
products, but the cost to service these customers will typically vary considerably.
The 80/20 rule will often be found to hold: that is 80 percent of the profits of the business come
from 20 percent of the customers. Furthermore 80 percent of the total costs to service will be
generated from 20 percent of the customers (but probably not the same 20 percent!). Whilst the
proportion may not be exactly 80/20 it will generally be in that region. (This is the so-called
Pareto Law, named after a 19th century Italian economist.)
The challenge to customer service management therefore is firstly to identify the real
profitability of customers and then secondly to develop strategies for service that will improve
the profitability of all customers.
What has to be recognized is that there are costs as well as benefits in providing customer service
and that therefore the appropriate level and mix of service will need to vary by customer type.
The basic relationship between the level of service and the cost is often depicted as a steeply
rising curve (figure below).
Costs of service
0 service level 100%
Figure8.5 : The costs of Service
This phenomenon is largely due to the high costs of additional inventory required to cover
against unexpectedly high levels of demand.
However if it is possible to find alternative service strategies for servicing customers, say for
example by speeding up the flow of information about customer requirements and by using faster
modes of transport, then the same level of service can be achieved with less inventory-in effect
pushing the curve to the right (figure below). This is the idea of substituting information and
responsiveness for inventory.
Costs of service
0 Service level 100%
Figure8.6: Shifting the costs of service
As far as the absolute level of service is concerned then clearly there must be a finite limit to the
impact that service improvements can have upon customers’ purchasing behavior. In other
words, after some point diminishing returns will set in (see the figure bellow).
Costs of service
0 Service level 100%
Figure 8.7: The returns to service
It is suggested that the service response curve is S-shaped for several reasons. Firstly in most
markets there will be a minimum level of service that is deemed acceptable- this is the ‘service
threshold’. If we do not make it to this point then return to additional service expenditure will be
minimal.
vii. Setting customer service priorities
Whilst it should be the objective of any logistics system to provide all customers with the level
of service they require it must be recognized that because no budget is unlimited there will
inevitably need to be service priorities. In this connection the Pareto, or 80/20 rule, can provide
us with the basis for developing a more cost-effective service strategy. Fundamentally, the
service issue is that since not all our customers are equally profitable nor are our products
equally profitable, should not the highest service be given to key customers and key products?
Since we can assume that money spent on service is a scarce resource then we should look upon
the service decision as a resource allocation issue.
Figure below shows how a typical company might find its profits varying by customer and by
product.
5%
% sales/profits
15%
80
20% 50 100 % products/customers
Figure 8.8: The ‘Pareto’ or 80/20 rule
The curve is traditionally divided into three categories: the top 20 percent of products and
customers by profitability are the ‘A’ category; the next 50 percent or so are labeled ‘B’ and the
final 30 percent are category ‘C’. The precise split between the categories is arbitrary as the
shape of the distribution will vary from business to business and form market to market.
Looking first at differences in product profitability, what use might be made of the A, B, C
categorization? Firstly it can be used as the basis for classic inventory control where by the
highest level of service (as represented by safety stock) is provided for the ‘A’ products, a
slightly lower level for the ‘B’ products and lower still for the ‘C’s’.
Alternatively, and probably to be preferred, we might differentiate the stock holding by holding
the ‘A’ items as close as possible to the customer and the ‘B’ and ‘C’ items further back up the
supply chain.
Perhaps the best way to manage product service levels is to take into account both the profit
contribution and the individual product demand.
We can bring both these measures together in the form of a simple matrix in Figure 7.9. The
matrix can be explained as follows:
(1) (2)
Seek cost Provide high

Volume (by SKU)
reduction availability
Hi
(3) (4)
Lo
Review J.I.T.
delivery
Lo Hi
Profit contribution (by SUK)
Fig 8.9 Managing product service levels
Quadrant 1: Seek cost reductions
Because these products have high volume it would suggest that they are in frequent demand.
However they are also low in profit contribution and the priority should be to reexamine product
and logistics costs to see if there is any scope for enhancing profit.
Quadrant 2: Provide high availability
These products are frequently demanded and they are more profitable. We should offer the
highest level of service on these items by holding them as close to the customer as possible and
with high availability. Because there will be relatively few of these items we can afford to
follow such a strategy.
Quadrant 3: Review
Products in this category should be regularly appraised with a view to deletion from the range.
They do not contribute to profits (or at least only marginally) and they are slow movers form a
sales point of view. Unless they play a strategic role in the product portfolio of the firm then
there is probably a strong case for dropping them.
Quadrant 4: J.I.T. Delivery
Because these products are highly profitable but only sell at a relatively slow rate they are
candidates for J.I.T delivery. In other words they should be kept in some central location, as far
back up the supply chain as possible in order to reduce the total inventory investment, and then
shipped by express transport direct to customers.
viii. Setting service standards
Obviously if service performance is to be controlled then it must be against pre-determined

standards.
Ultimately the only standard to be achieved is 100 percent conformity to customer expectations.
This requires a clear and objective understanding of the customers’ requirements and at the same
time places an obligation upon the supplier to shape those expectations. In other words there
must be a complete match between what the customer expects and what we are willing and able
to provide.
What are the customer service elements for which standard should be set?
Order cycle time

Availability of product
Order cycle consistency
Order condition
Let us examine each of these:
a. Order cycle time

This is the elapsed time from customer order to delivery. Standards should be defined against
customer’s stated requirements.
b. Product availability
This is the most important element of customer service. It is important that the right product, at
the right time and at the right place be available.
c. Order cycle consistency
This refers to variation in the order cycle time or reliability of the order cycle time.
d. Order condition
This refers to damage level at the time of receipt.
8.6 Logistic Costs
Logistic costs account for a significant part of a firms total cost. Logistic it is argued attempts to
provide a higher level of service at the lowest possible cost in order to realize a higher return on
investment for the company. So clearly, careful analysis of these costs needs to be done if
logistics is to serve as a means of gaining competitive advantage.
Total Cost Analysis
The concept of total cost analysis is elusively simple. It states that all costs that are impacted by
logistic system design should be identified and measured by the company. For discussion
Purpose, logistic cost can be grouped in to two categories: Transportation based and Inventory
based.
In a logistic systems design, these two cost categories typically interact; creating the opportunity
for cost-to cost trade-offs. In other words, selected increased expenditures for transportation
services may significantly reduce inventory expenditures. A trade-off is positive if inventory-
associated costs are reduced by a greater amount than transportation cost was increased.
Air-direct versus motor /ware house
An air-direct system of transportation results in lower total cost than the alternative of using field
ware house system. With the use of an air direct system, the cost of transportation is greater but
all costs associated with inventory and warehousing are significantly reduced. This type of cost-
to- cost trade –off is typically the reason why a firm may select to consolidate previously
decentralized inventory into fewer warehouses. Inventory cost declines as a result of substantial
reduction in safety stock when inventory is stocked in fewer locations. Because transportation
dependency is increased, the associated freight cost of the centralized inventory system is greater
than the decentralized logistic structure. However, the balance of the trade off is favorable
because overall, or total, cost is reduced.
While the concept of total cost is simple, it is often difficult to implement in actual practice.
Sub optimization
This is a term that is used to indicate a situation where one department’s objective is optimized
without considering the impact of such action on other departments or functions. For example,
if a firm wants to optimize inventory level ( by carrying the lowest possible inventory level (
low- cost inventory level), then the results could be a higher level of stock out, lost sales, lost
customers, the need to use premium expensive transportation for the purpose of filling orders.
This shows that it is very important to consider what impact a certain decision has to optimize a
logistic activity on other logistic activities. Because if a firm desires to optimize a logistic
activity without considering its impact on other logistic functions, then sub optimization results.
Cost Trade offs
This occurs when a change in the distribution system causes some costs to increase while others
decrease.
Consider the following real company example of Xerox.
Xerox use to ship items from Chicago to California using rail transportation. But a fire accident
on the warehouse in California caused the company to use air freight for emergency shipment to
their customers. Later, when Xerox executives analyzed their cost they discovered that total cost
of using air transportation was lover than the total cost of using rail transportation. This is
because the expenses of running warehouses off-set the higher cost of air transportation. Even
though air transportation was expensive, the faster movement of the product i.e. reduced transit
time obviated the need for operating local warehouses reducing the total costs.
Let us look at the cost of logistic is briefly:
a. Transport cost – This cost is incurred due to the need to bridge geographic
distance. The basic economic consideration affecting transport cost are:
Size of shipment
length of shipment distance
Generally the longer the size of the shipment the lower the cost /weight /distance.
And so an item that weight 10,000 kilo gram will be having a smaller cost / kilo gram
per distance than an item that weights 500 kilo gram.
The impact of shipment size on transport cost is known as quantity discount.
Generally the longer the distance the shipment is transported the lower the cost
/distance transported. The impact of shipment distance on transport cost is called
Tapering Principle.
A logistic system that minimizes transport cost is one that maximizes the distance that longer
shipments are transported while minimizing the distance that smaller shipments are transported.
b. Inventory cost
This is a time based cost. Inventory is an essential asset in a manufacturing firm and in most
types of marketing. Firms desire to reduce the level of inventory that they carry for a variety of
reasons, the reasons include
To reduce the cost and risk of doing business

Generally the cost of carrying an inventory is more than the capital cost of the asset
Total cost analysis
Total cost analysis is based on the reconciliation of the principles of transport and inventory
economics. The minimum for total cost does not appear at the point where either inventory costs
or transport costs are minimum. This is the hall mark of the integrated logistic analysis.
Figure 8.10 Transportation and location economics
Total Transport cost
Its curve is reflecting the size of shipment and length of shipment distance
The minimum for total transport cost occurs at the point where there is a reconciliation of the
tapering principles and quantity discount. In other words the minimum for total transport cost
occurs at the point where there is a maximization of the distance that larger shipments are
transported while the distance that smaller shipment are transported is minimized.
Total Inventory cost
This is having different characteristic to total transport cost. As the number of inventory stocking
locations increase, the inventory costs increase also. But the increase in inventory costs will be at
a decreasing rate. That is, beyond a certain point, as the number of inventory stocking locations
increase inventory cost increases at a decreasing rate.
Total cost curve
The total cost is basically the minimum of the
1. Transport cost and

2. The inventory cost at a particular inventory stocking locations.
As already noted the minimum for the total cost does not occur at the point where both transport
cost and inventory costs are minimum. This shows the inherent need for cost tradeoffs in total
cost analysis
Customer profitability analysis
Is customer A more profitable than customer B? This is an important question that conventional
accounting has difficulty answering.
Customer profitability – in simple terms is net sales (for a particular period) minus cost for the
product (purchased during that period). But, this simple calculation does not show the true
profitability of a customer because there are other costs like sales calls, transportation, and order
processing that need to be considered, in order to see the profitability of a customer
When a firm has many customers it is difficult to do customer profitability analysis for all its
customers. But customer profitability analysis could be made for the representative samples of
the most important customers. The customer profitability analysis will help a company to
allocate limited budget to give more service to the most profitable customer. The analysis can be
a basis for developing strategies to deal with customers.
Protect Cost engineer High
Provide Danger zone

Net Sales
Low Cost of Service
Low High
Figure 8.11: Customer profitability matrix
Provide
Low sales generated by customers which cost low to serve. The firm can find ways of increasing
the volume of the sales it makes to these types of customers without significantly increasing cost.
Danger Zone
These cost high to serve but generate low sales. The firm should decide to drop these types of
customers unless there is a strategic reason in dealing with these customers.
Cost engineer
These generate high sales but cost high to serve. The firm should find ways of reducing the cost
of serving these types of customers. Some possible methods of reducing cots are
- Make deliverers more frequent
- Find a new account in the geographic area to make delivery more economical.
Etc.
Protect
These generate high sales but cost less to serve – these should be protected.
Direct product profitability (DPP)
This is a concept related to the concept of customer profitability analysis. DPP- tries to identify
all the costs that attach themselves to the product as it moves through the distribution channel.
DPP- are essential to the suppliers that want to be considered as low cost suppliers- but this
desire of the suppliers will negatively be influenced by costs that are increased as the offer
moves through the logistic system.
To reduce such costs that negatively affect the product profitability the firm could
-Make deliveries more frequent
- Make direct store deliveries
- Change the case size, etc.
Summary
This chapter has familiarized the student with the tents of competitive strategy and within them
the vectors of strategic direction, productivity and value advantages. The chapter has mentioned
that logistics can be a means of gaining competitive advantage either through value or cost or
both value and cost advantages.
The chapter has mentioned how logistics can enable a firm to gain value advantage by providing
excellent service to customers. Through the discussion of logistic costs an endeavor was made, in
seeing the link between the cost advantage and the logistic costs. Obviously, through reducing
logistic costs and improving the level of service given to customers the chapter has identified
how a firm can have both value and cost advantages, which is the strategic goal of logistics.
Review questions
1. Explain the principles of competitive strategy and the pursuit of differentiation through the
development of productivity and value advantages.
2. explain the concept of value chain and the integrative role of logistics within the
organization
3. Describe the emerging discipline of supply chain management, defining it and explaining
how and why it takes the principles of logistics forward.
4. What is customer service?
5. Explain the concept of Direct Product Profitability.
6. Describe the concept of Customer Profitability Analysis
Self Assessment Questions
1. Which of the following is not true about logistics?

A. Logistics involves storage activities
B. Logistics is all about movement of materials at minimum possible cost
C. Logistics involves strategically managing procurement of materials
D. Logistics aims at maximizing profit, minimizing cost of order fulfillment
E. None of the above
2. One of the following statements is not true?
A. Logistics is the means for satisfying customers through coordinating the materials and
information flows
B. Logistics is an integrative function that attempts to develop a system-wide
perspective of a firm
C. Logistics promotes one- plan mentality, unlike the conventional stand-alone plan of
marketing
D. Logistics is a tool to achieving both productivity/cost advantage and value advantage
E. Logistics mainly focuses distribution activities in separation from procurement and
operation activities
3. Which of the following is a challenge posed against logistics management in its effort to
bring about a competitive advantage
A. A requirement for shorter lead time
B. Globalization of industry
C. Requirement by customers for provision of consistent time and place utility
D. The prevalence of use of JIT/just in time deliveries
E. All of the above
4. In conventional organizations an approach to gap the logistic lead time and the order
fulfillment period has been
A. Reduce the lead time gap

B. Carrying inventory
C. Reducing the logistic lead time
D. All
E. None
5. One of the followings doesn’t belong to the task of outbound logistics
A. Packaging
B. Order processing
C. Production planning
D. Transportation
6. In customer profitability matrix when both of cost of service and net sales are high the
situation is best described by:
A. Cost engineer
B. Protect
C. Provide
D. Danger zone
7. In standardizing customer service the following customer service elements should be given
due consideration, except:
A. Order cycle type
B. Order cycle consistency
C. Product availability
D. Conditions of the product
(1) (2)
High
Volume (by SKU)
Hi
(3) (4)
Low
Lo
Low High
Profit contribution (by SUK)
Answer question number 10 based on the information given in the diagram below
5%
15%
% Sales/profits 80% ‘A’ ‘B’ ‘C’
20% 50% 30%
% customers
8. On the basis of the figure provided above, to serve customers in the A classification
A. The firm needs to maintain inventory downstream in the supply chain
B. The company will have to provide the lowest level of safety stock
C. The level of safety stock maintained will have to be lower for the customers in the A
class than for the customers in the C because the later make up a significant part of the
company’s customers than the former.
D. All
Chapter 9
Transportation and Inventory Management
Introduction
Transportation costs constitute a considerable portion of logistics costs. Savings achieved in

transportation would lead to a remarkable saving in logistics costs. In order to be able to operate
the transportation system effectively and efficiently understanding how the system works and
what the determinant factors are in the system is crucial. This chapter discusses types of
transportation systems, and related costs. It also presents in detail the major transportation
documents.
Additionally, this chapter discusses inventory management. Though all business functions agree
that it is essential to carry inventory, they may be in disagreement as to the amount of inventory
to carry. For example, the production department in order to ensure long production runs and
economies of scale may favor carrying large amount of inventory. Similarly the marketing
department may encourage carrying large amount of inventory in order to enhance a customer
service (i.e. prevent stock out) and in order to offer customers variety.
On the other hand, finance may encourage the firm to reduce the level of inventory it carries in
order to reduce costs and improve return on assets. Integrated logistics may also favor reduction
on the level of inventory a firm carries in order to reduce carrying costs of inventory. In this
chapter you will learn the basic concepts and principle of inventory management.
Learning objectives
After reading this chapter, learners will be able to do the followings:
Make analysis on transport economics
Determine determinants of transportation costs
Make carrier selection decisions
To utilize various transport documents
Efficiently use transportation to maintain lower overall logistics costs
Determine EOQ for efficient utilization of inventory
Make ABC analysis
9.1 Basic Transport Economics & Pricing
Transport economics and pricing are concerned with the factors and characteristics that
determine transport costs and rates. To develop an effective logistics strategy and to successfully
negotiate transport agreements, it is necessary to understand the economics of the industry. A
discussion of transportation economics and pricing required coverage of two topics: The factors
that influence transport economics and the cost structures that influence expense allocation.
9.1.1 Economic Factors
Transport economics is influenced by seven factors. The specific factors are distance, volume,
density, storability, handling, liability, and markets. In general, the above sequence reflects the
relative importance of each factor.
Distance
This is a major influence on transportation cost since it directly contributes to variable cost, such
as labor, fuel, and maintenance. The figure on the next page shows the general relationship and
illustrates two important points.
i. The cost curve does not begin at the origin because there are fixed costs associated
with shipment pickup and delivery regardless of distance.
ii. The cost curve increases at a decreasing rate as a function of distance.
This characteristic is known as the tapering principle, which results from the fact that longer
movements tend to have a higher percentage of intercity rather than urban miles. Intercity miles
are less expensive since more distance is covered with the same fuel and labor expense as a
result of higher speeds and also because frequent intermediate stops typical of urban miles add
additional loading and unloading costs.
Price
Distance
Figure 9.1 : The general relationship between distance and transport cost
Volume
Like many other logistics activities, transportation scale economies exist for most movements.
This relationship, illustrated in the figure next page, the figure indicates that transport cost per
unit of weight decreases as load volume increases. This occurs because the fixed costs of pickup
and delivery as well as administrative costs can be spread over additional volume. The
management implication is that small loads should be consolidated into larger loads to take
advantage of scale economies.
Price per pound
Weight of load
Figure 9.2 : Generalized relationship between weigh and transportation cost/pound.
Density
The third economic factor is product density, which incorporates weight and space
considerations. In terms of weight and space, an individual vehicle is constrained more by space
than by weight. Once a vehicle is full, it is not possible to increase the amount carried even if the
products is light. Since actual vehicle labor and fuel expenses are not dramatically influenced by
weight, higher density products allow relatively fixed transport costs to be spread across
additional weight. As a result, these products are assessed lower transport costs per unit weight.
In general, logistics managers attempt to increase product density so that more can be loaded in a
trailer to better utilize capacity. Increased packaging density allows more units of product to be
loaded into the fixed cube of the vehicle.
Price per pound
Product density
Figure 9.3 : Generalized relationship between density and transportation cost/pound.
Storability
This refers to product dimension and how they affect vehicle (railcar, trailer, or container) space
utilization. Odd sizes and shapes, as well as excessive weight or length, do not stow well and
typically waste space. Although density and storability are similar, it is possible to have
products with the same density that stow very differently. Items with standard rectangular
shapes are much easier to stow than odd-shaped items. For example, while steel blocks and rods
have the same density, rods are more difficult to stow because of their length and shape.
Handling
Special handling equipment may be required for loading or unloading trucks, railcars, or ships.
Furthermore, the manner in which products are physically grouped together (e.g., taped, boxed,
or palletized) for transport and storage also affects handling cost.
Liability
This includes product characteristics that primarily affect risk of damage and the resulting
incidence of claims. Specific product considerations are susceptibility to damage, perishability,
and susceptibility to theft, and susceptibility to spontaneous combustion or explosion. Carriers
must either have insurance to protect against possible claims or accept responsibility for any
damage. Shippers can reduce risk, and ultimately the transportation cost, by improved protective
packaging or by reducing susceptibility to loss or damage.
Activity 9.1
Consider Deluxe Furniture is planning to import rectangular board room tables from China.
The dimension of the table is 8 meters (length), 3 meters ( width ) and 0.80 meters (height)
plus 12 highly chairs. The material is so delicate and needs great care in handling.
Advise the firm on how the dimensions of the table and the material will affect transportation
costs and the ultimate customer price.
Commentary
Discuss in view of the economic factors affecting transportation costs.
9.1.2 Market Factors
Finally, market factors, such as lane volume and balance, influence transportation cost. A
transport lane refers to movements between origin and destination points. Since transportation
vehicles and drivers must return to their origin, either they must find a load to bring back (“back-
haul”) or the vehicle is returned empty (‘deadhead”). When deadhead movements occur, labor,
fuel, and maintenance costs must be charged against the original “front-haul” move. Thus, the
ideal situation is for “balanced” moves where volume is equal in both directions. However, this
is rarely the case because of demand imbalances in manufacturing and consumption locations.
Balance is also influenced by seasonality such as the movement of fruits and vegetables to
coincide with the growing season. Demand directionality and seasonality result in transport rates
that change with direction and season. Logistics system design must take this factor into account
and add back-haul movement where possible.
Cost Structures
The second dimension of transport economics and pricing concerns the criteria used to allocate
cost components. Cost allocation is primarily the carrier’s concern, but since cost structure
influences negotiating ability, the shipper’s perspective is important as well. Transportation
costs are classified into a combination of categories.
Variable Costs
These are those costs that change in a predictable, direct manner in relation to some level of
activity during a time period. Variable costs can be avoided only by not operating the vehicle.
Aside from exceptional circumstances, transport rates must at least cover variable costs. The
variable category includes direct carrier costs associated with movement of each load. These
expenses are generally measured as a cost per mile or per unit of weight. Typical cost
components in this category include labor, fuel, and maintenance.
Fixed Costs
These are those costs that do not change in the short run and must be covered even if the
company is closed down (e.g., during a holiday or a strike). The fixed category includes carrier
costs not directly influenced by shipment volume. For transportation firms, fixed components
include terminals, right-of-way, information systems, and vehicles. In the short term, expenses
associated with fixed assets must be covered by contributions above variable cost on a per
shipment basis. In the long term, the fixed cost burden can be reduced somewhat by the sale of
fixed assets; however, it is often very difficult to sell rights-of-way or technologies. The benefit
of economies of scale is more to modes of transport that are high in fixed costs (like rail,
pipelines). But for modes of transport that are high in variable cost the benefit of economies of
scale will be less, because as volume of activity increases cost increases also.
Joint Costs
These are expenses unavoidably created by the decision to provide a particular service. For
example, when a carrier elects a haul a truckload from point A to point B, Either the joint cost
must be covered by the original shipper from A to B, or a back-haul shipper must be found.
Joint costs have significant impact on transportation charges because carrier quotations must
include implied joint costs based on considerations regarding an appropriate back-haul shipper
and/or back-haul charges against the original shipper.
Common Costs
This category includes carrier costs that are incurred on behalf of all shippers or a segment of
shippers. Common costs, such as terminal or management expenses, are characterized as
overhead. For example if a company incurs repair costs of 5,000 birr while transporting three
different shipments from one origin to another destination because the truck broke down, then
how will this cost be allocated between the three different types of shipments? Is it on the basis
of space utilization or weight of the items? This is an illustration of the challenges that are
involved in the allocation of common costs.
9.1.3 Pricing Strategies
When setting rates to charge shippers, carriers can adopt one or a combination of two strategies.
Although it is possible to employ a single strategy, the combination approach considers trade-
offs between the cost of service incurred by the carrier and the value of service to the shipper.
Cost-of-Service Strategy
This is a “buildup” approach where the carrier establishes a rate based on the cost of providing
the service plus a profit margin. For example, if the cost of providing a transportation service is
Br. 200 and the profit markup is 10 percent, the carrier would charge the shipper Br. 220. The
cost-of-service approach, which represents the base or minimum transportation charge, is a
pricing approach for low-value goods or in highly competitive situations.
Value-of-Service Strategy
This is an alternative strategy that charges a rate based on perceived shipper value rather than the
cost of actually providing the service. For example, a shipper perceives transporting 1,000 Birr
of electronic equipment as more critical or valuable than 1,000 Br. of coal since the equipment is
worth substantially more than the coal. As such, a shipper is probably willing to pay more to
transport it. Carriers tend to utilize value-of-service pricing for high-value goods or when
limited competition exists.
Combination Strategy
This establishes the transport price at some intermediate level between the cost-of-service
minimum and value-of-service maximum. In standard practice, most transportation firms use
such a middle value. Logistics managers must understand the range of prices and alternative
strategies so that they can negotiate appropriately.
9.1.4 Transport Documentation
Several documents are required to perform each transport movement. The three primary types
are bills of lading, freight bills, and shipping manifests.
Bill of Lading
This is the basic document utilized in purchasing transport services. It serves as a receipt and
documents commodities and quantities shipped. For this reason, accurate description and count
are essential. In case of loss, damage, or delay, the bill of lading is the basis for damage claims.
The designated individual or buyer on a bill of lading is the only bona fide recipient of goods. A
carrier is responsible for proper delivery according to instructions contained in the document. In
effect, title is transferred with completion of delivery.
The bill of lading has the following three purposes:
i. It serves as a receipt for goods.
ii. It serves as a contract of carriage and identifies the contracting parties and prescribes
the terms and conditions of the agreement.
iii. It serves as documentary evidence of title.
In addition to the uniform bill of lading, other commonly used types are order-notified and
government. It is important to select the correct bill of lading for a specific shipment.
An order-notified or negotiable bill of lading
This is a credit instrument. It provides that delivery not be made unless the original bill of lading
is surrendered to the carrier. The usual procedure is for the seller to send the order-notified bill
of lading to a third party, usually a bank or credit institution. Upon customer payment for the
product, the credit institution releases the bill of lading. The buyer then presents it to the
common carrier, which in turn releases the goods. This facilitates international transport where
payment for goods is a major consideration.
Government bills of lading
This may be used when the product is owned by the government.
Freight Bill
This represents a carrier’s method of charging for transportation services performed. It is

developed using information contained in the bill of lading. The freight bill may be either
prepaid or collect. A prepaid bill means that transport cost must be paid prior to performance,
whereas a collect shipment shifts payment responsibility to the consignee.
Shipping Manifest
This lists individual stops or consignees when multiple shipments are placed on a single vehicle.
Each shipment requires a bill of lading. The manifest lists the stop, bill of lading, weight, and
case count for each shipment. The objective of the manifest is to provide a single document that
defines the contents of the total load without requiring a review of individual bills of lading. For
single-stop shipments, the manifest is the same as the bill of lading.
Carrier selection
The 3 strategic decisions that managers must make in transportation are:
i. What mode of transportation will the firm use?

ii. What carries in each mode will the firm use?
iii. Will the firm operate its own fleet or hire outside carries for transportation
services?
Possible answers for the above questions are provided below:
ix. What mode of transportation to use?

There are five modes of transportation; each mode of transport has its own advantage and
disadvantage.
The following are factors that affect the choice of mode of transport: Nature of the goods, access
to carries, price, and transit time
E. Nature of the goods
Sand is a bulky and low value product and because of this it is not appropriate to transport it
using air carriers because the low value of the product will not cover the high cost of
transportation, on the other extreme diamond should not be transported using trucks because the
product is highly susceptible to loss or theft and it is a high unit value product.
So at first glance, without the need to make any analysis we can on the basis of the nature of the
product determine the appropriate mode of transportation .
F. Access to carries
Consider a company that may desire a mode of transport that can transport bulky product at a
lower freight rate. If the company gives speed less consideration, then the mode of transport that
will be selected is water transport. But desiring a particular mode of transport to use and having
access to that mode of transport are two different things. In countries where most of the river
system is not navigable, water transport is not an accessible mode of transportation.
In most cases air, pipeline and rail are not accessible modes of transport compared to motor
transport because they do not provide accessibility to many locations.
G. Price
Generally speaking air transportation is the most costly mode of transport followed by motor,
rail, and water respectively. Pipelines are the least cost mode of transport. Obviously, there is a
positive relationship between price of transport and the speed of the mode of transport. That
means, the higher the cost of transport the higher the speed. But in logistics more important is
not how quickly a vehicle moves (i.e. terminal to terminal speed) but how quickly the goods are
moving (i.e. origin to destination speed). This is because of two reasons:
The vehicle could move quickly from terminal to terminal, but to move the product to
where it is needed (i.e. Point of destination) another mode of transport may be required
because of limited range of operation of the rapidly moving vehicle and hence additional
cost.
For products to be transported using pipelines they have to be in liquid, slurry or gas format, however if the
product is in solid format then this mode can’t be used.
The goods could be delivered to destination terminal (after being transported 700
kilometers/hour) but they may‘ve to wait at the warehouse of the destination terminal
before they are transported to where they are needed and this may result in longer transit
time.
H. Transit time
This is another factor that may have an effect on the selection of the appropriate mode of
transport. Transit time has an effect on the order cycle time’ and companies may desire shorter
transit time in order to enhance customers service and reduce the level of inventory that they
carry. This desire may make firms choose a faster mode of transport. On the other hand firms
may want to use transportation for temporary storage function. In such a case a slower mode of
transport may be selected in order to make the transit time longer.
x. What carries in each mode will the firm use?
Carrier selection will naturally follow mode selection. The following factors can affect carrier
selection:
a. Price
Transport managers on the basis of the assumption that all carriers are expected to provide the
same basic service may use price in order to favor one carrier over another. Other things being
equal the carrier with the lowest freight rate will be selected.
b. Accessibility
This factor that affects carrier selection can be considered by asking a question like – which
carrier best satisfies the characteristics of the mode selected? For example, if motor is selected
then the question asked will be, which carries provides the most flexibility in delivery –
providing accessibility to most points of origins and destinations?
c. Responsiveness
This refers to flexibility of the carrier in meeting special needs of customers. The service a
carrier is obligated to provide to the customer is indicated in the contract entered between the
two parties. So, responsiveness refers to willingness of the carrier in meeting special requests of
customers that are not included in the contract.
d. Claims records
Claims record simply means that some carriers damage goods more often than others. Because
of this a carrier providing service at a lower price may not necessarily be the low cost carrier.
When goods arrive damaged – the receiver experiences poor service, the shipper will have a
dissatisfied customer and the carrier may pay a claim – everybody loses.
e. Reliability
Delivery of goods on time is reliability. This factor in carrier selection is important for
customers who are engaged in Just- in- time (J–I- T) programs. Without reliability,
J–I- T., will not work, regardless of the mode of transport.
xi. Will the firm operate its own fleet or hire outside carries for
transportation service?
There are 3 options when considering this strategic decision include hire outside carriers,
operate own fleet and mixed fleet.
e. Hire outside carriers
This approach to hire outside carriers may sacrifice control over carries operation. The carries
may have larger shipment requirement making them consolidate small shipments into larger
ones. This in turn will make the carries maintain (or hold inventory) resulting in buildup of
inventory at both ends of the transport pipeline. The result is increase in inventory cost. The
above situation of large shipment requirement may encourage carriers to impose flexibility
condition impacting delivery time. This will result in poor service for the customer because
delivery time will not be observed. On the other hand many of the challenges encountered in
operating carries like lane, imbalance, driver turnover, backhaul, etc. the firm will not have to
encounter.
f. Operate own fleet
The advantages of operating own fleet is greater control over carrier operation. While the
disadvantage is that the company will have to face many of the challenges encountered in
managing carries like load balancing, vehicle scheduling, routing, etc.
g. Mixed fleet
This is using both for hire carriers and private carries. Though the advantages of both for hire
carriers and private carries are present, the firm will also encounter the disadvantage of both for
hire and private carries.
Activity 9.2
Yegna Baltina is engaged in production and distribution of ‘Ethiopian traditional

spices’ to local and international market. Currently its international demand is
increasing and to meet this demand it is exporting 20 quintals of its various products to
15 countries every day. Further it distributes 30 quintals of products to its local market
every day. The demand for Yegna products increase during holiday seasons by 30% and
during the ‘kiremt’ season will fall by 15%.
What type of mode of transportation and owners do you suggest to Yegna for local and
international markets
Commentary
Support your suggestion with carrier selection variables
9.2 Inventory Management
9.2.1 Rationale for carrying Inventory
Economies of scale: This may be true for production, if fixed costs are spread over larger
quantity through uninterrupted production runs. For purchasing department if inventory runs. For
purchasing department if inventory is obtained in larger amount then there is a possibility of
obtaining quantity discount.
Protection from uncertainties: Safety stock is maintained as a protection against
uncertainties. To prevent interruption in production as a result of uncertainty in replenishment,
safety stock is kept. In order to prevent stock out as a result of fluctuation in demand, safety
stock in maintained.
Balancing Supply and demand: Some producers build up inventory in advance of seasonal
demand. The producer will continue to make products which it will keep in as inventory. By
producing to stock, production can be kept level throughout the year. This reduces idle plant
capacity and maintains relatively stable work force, keeping costs down. Some products are
seasonal, such as canned fruits. By keeping inventory for these types of products, demand can be
satisfied from the finished goods inventory when these products are no longer available.
9.2.2 Objectives of inventory control
In adequate control of inventory may result in both overstocking and under stocking.
Overstocking will result in unnecessary tying up of capital which could have been used more
productively. Under stocking may result in late deliveries, lost sales, and lost customer. At first a
glance overstocking might be seen as the lesser of the two evils, but it is not so given the high
cost of carrying inventory.
The objective of inventory country control is to
(a) Maximize the level of customer service (i.e. by having the right goods, at the right time, at
the right place and at the right cost
(b) Minimize the cost of providing a certain level of customer service
The two objectives are in opposition i.e. as customer service level is enhanced then the
optimizing of the cost objective is compromised and vice versa.
In practice management may set a certain level of customer service and of the task of the
decision maker is to achieve that level of service at the lowest possible cost. Or management
may set cost levels and the decision maker has to then achieve a higher level of customer service
that is possible given the cost limitations.
Towards this end, the decision maker has to avoid both overstocking and under stocking. The
two fundamental decisions that have to be made are:
(1) When to order? Models like the reorder point model (ROP) can be used in order to determine
the timing of the order.
(2) How much to order? This question which deals with the quantity to order can be answered
using the economic order quantity model (EOQ).
9.2.3 Inventory Management Models
Inventory management models can be classified as either pull or push models. Push models order
goods in advance of customer demand or schedule production in advance of customer demands.
Manufacturers push the finished product through the distribution channel by way of the
intermediaries. There are many push models one of which is the EOQ (economic order quantity)
model.
Pull inventory models are based on making goods when customers demand are known. The
product is pulled through the channel of distribution by the customers order. Just-in-time (J.I.T.)
is the most widely used pull inventory model.
i. Economic order quantity model
This model can be used in order to determine how much to order. The basic economic order
quantity equation is as follows:
2PD
EOQ = CV
Where P= Cost of placing one order in monetary units
D= Annual demand for the product
C= Annual inventory carrying cost expressed as a percentage of the products cost or

value
V= average cost or value of one unit of inventory
Using this equation and the information that is given below let us calculate the EOQ answer:
P= 50 birr D= 7,200 units
C= 20 % V= 100 birr
2PD
EOQ = CV
2(50) (7,200)
EOQ = .2(100)
720000
EOQ = 20
EOQ= 190
The above calculation means that the company each time it orders has to order 190 units.
Deciding when to order is based on the lead time- which is the elapsed time between when the
order is placed and delivery of what is ordered is received. The amount of inventory used during
lead time is the reorder point. When the level of inventory is equal to this amount, an order
should be made.
Using the above information, daily demand of the item is (7,200/360 days) equal to 20 units. If it
takes:
1 day to place the order,
3 days to process and prepare the order, and
4 days to deliver it, then the total lead time is (1+3+4) 8 days.
The reorder point is the amount of inventory used during lead time which is (8 * 20) 160 units.
So when the level of inventory reaches 160 units, a new order for 190 units is placed.
It should be noted that the economic order quantity model operates under a number of
assumptions which may stray from real life. However, the EOQ model is the most widely used
single inventory model. It is simple to use, and it produces exact answers.
Activity 9.4
Consider Kangaaroo PLC is a manufacturer of leather shoes. It is currently examining the

amount / volume of hides and skins it need to order at once in order to keep its carrying
and ordering costs at minimal. Use the following data to determine the economic order
Quantity.
Ordering cost: 2000 birr
Inventory carrying cost as percentage of inventory cost : 15%
Average cost of a unit product : 12,000
Annual demand: 10,000 units
Commentary:
Use EOQ formula given above
9.2.4 Types of inventory costs
Inventory costs are a significant part of a firms total cost and hence they need to be carefully
managed. This starts by identifying the types of inventory costs :
c. Carrying costs
These costs are associated with physically carrying the product. They include capital cost (the
capital cost of the item and the opportunity of using the money for some other purpose),
inventory service cost (which includes costs of insurance), and also, inventory risk costs (which
are costs related to obsolescence, shrinkage, damage,) etc
The carrying costs are variable in nature that is as the amount of inventory procured increases,
carrying costs will also increase and vise versa.
d. ordering costs
These represent those expenses incurred in procuring inventory, in determining product
specifications, selecting suppliers, preparing payments, and reviewing inventory levels. Ordering
costs are of a fixed nature that is regardless of the amount of inventory procured they remain
constant. The greater the amount of the order the lower the ordering coast per unit of
merchandise.
It is better for the company to order once or twice a year than it is to order 10 or 15 times a year
because in the latter case ordering cost would higher
Figure 9.2 EOQ model
The figure above shows that the relationship between inventory carrying cost and ordering cost is
inverse, that means, as inventory carrying cost increases then ordering cost decreases, and vise
versa. This shows that a trade-off exists. So if a firm carries large amount of inventory, then the
number of its orders during that period will then be decreasing which will lower its holding cost.
The firm needs to determine the point where it can optimize both ordering cost and holding cost.
This point is the point where total cost is at minimum and this point is called the economic order
quality (EOQ).
Activity 9.5
The cost of placing an order is $ 100, the carrying cost is 20 percent, daily demand is 400
units (use the lunar year), and the product value is $20. Determine the EOQ, and total cost
at EOQ level if fixed cost is birr 580,000
Commentary
Use EOQ formula
9.2.5 Classifying inventory
The ABC classification is used in order to determine the level of attention to give to products on
the basis of their importance to the company. Because products in a company’s inventory are not
equally important ( in terms of sales, cost ,etc ) the level of attention they receive should not be
the same this is to ensure the greatest pay back.
So when employing the ABC classification, the firm will select a ranking factor (say sales), and
on the basis of sales some products will be in the ‘A’ class- and these products will receive the
greatest attention in terms of having the lowest stock out occurrence.
The other products that are in the ‘B’ class would be exposed to a moderate stock out while the
products in ‘C’ class would be exposed to a higher level of stock out.
i. Warehouse Management
The purpose of warehouse is to store products until they are needed by the customers.
ii. Rationale for warehouses
From the perspective of integrated logistics warehouse are necessary for such reasons as
They enable economies of scale in production from long production runs

The enable marketing to maintain or increase customer service
If forecasts are accurate and production is instant, then there would be no need for warehouses
and inventory. But production times vary and forecasts are wrong, as a result warehouses exit as
a buffer between demand and supply.
iii. The role of warehousing
Transportation consolidation facility
Organizations can transport less than truck load into warehouses and then consolidate smaller
shipments into larger ones and move out large shipments. This enables the firm to reduce the
transportation cost as the total cost of the transport will spread over larger volume, there would
be lower cost per unit of the item transported for the full load.
Stockpiling
Stockpiling is a function of warehouses when they act as a reservoir for production overflow.
Stockpiling can take a variety of forms
i. Seasonal production-level demand

Seasonal production-level demand is common for some products like corn, corn is typically
harvested once a year (i.e. it has seasonal production), while the demand for corn is fairly
uniform through out the year. Warehouses stockpile the corn until customers need it.
ii. Level production-seasonal demand.

Some products have high demand during a particular season, while production is fairly uniform
throughout the year. When these products are no longer needed during a particular season,
production would not be interrupted, but rather production will continue and the output will be
stocked in warehouses until the customers need the products.
9.3 Basic components of a warehouse
People, equipment, and space are the three basic components of a warehouse. Space allows for
the storage of goods and services when these are unequal. Space affects not only warehousing
decisions but the design of logistics systems. If the demand for the warehouse space is greater
than available space or the supply, then the price of storage increases, as firms compete for the
limited space available. This ultimately increases the price of the product.
People are the most critical element of the warehouse. Equipment and space mean nothing
without competent people. Equipment helps in product storage, movement and tracking. So, the
equipment includes material handling devices, docks, information processing system, etc.
i. Functions of a warehouse
The primary functions of a warehouse include movement, storage, and information transfer. In
order to accomplish storage function movement is necessary, and it takes place in 4 distinct
stages.
1. Inbound goods are received from transportation carriers and quality and quantity
check will be made.
2. Transferring the goods from the receiving dock and moving them to specific storage
areas throughout the warehouse.
3. Order selecting the products for filling customer orders including checking, packing,
and transportation into outbound docks.
4. Using some form of transport the goods are shipped outbound to customers.
Storage refers to the physical disposition of the product throughout the facility. Storage can be
temporary or semi-permanent. Temporary storage is storing the product that is necessary for
inventory replenishment. Semi-permanent is when the product is stored because it is in excess of
immediate need. The latter is called safety stock or buffer stock2.
i. Types of warehouses
The primary warehouse decision is to decide the type or combination of warehouse to use. There
are three types of warehouses: private, public, and contract.
ii. Private warehouse
The firm that produces or owns the good has ownership of the private warehouse. High level of
utilization and high volumes justify the use of private warehouses because of economies of scale.
As a result of such economies the firm can maintain high margins or lower prices on the products
2
Safety stock or buffer stock protects the firm against stockout due to fluctuation in demand.
delivered. Private warehouses enable the firm to have greater physical control over the facility as
management would be able to address theft, loss, and damage.
In addition the company can earn extra income from leasing or renting the extra space of the
warehouse. The warehouse is a depreciable asset to the firm and this reduces the net income and
the income tax. But for the company to benefit from owning a warehouse there has to have high
volume and high level of utilization to have economies of scale by spreading the fixed cost of the
facility over many items. The firm needs also to have stable demand and the warehouse needs to
be in a dense market area. Otherwise the firm should consider the possibility of using public or
contract warehouse.
iii. Public warehouse
A public warehouse rents space to individuals or firms needing storage. There are many reasons
why a public warehouse is used:
Leasing lowers the capital cost that is needed to establish a warehouse.

Leasing offers the firm with more flexibility, if the market for the firms product moves to
another area, then the firm will simply rent a facility in that area.
iv. Contract warehouse
A specialized form of public warehousing is a contract warehousing. A contract warehouse often

provides a customized service.
Number of warehouses
How many warehouses are needed in order to effectively serve customers? Theoretically, the
more the number of the warehouse in or near a market area, the higher the level of service
provided by the company, that is because goods can be delivered to the customer faster. But the
benefit of more warehouse and improved customer service must be weighed against the
increased cost of more number of warehouses. Generally, as the number of warehouses increase
in or near a market area, transportation and stock out costs decrease. But inventory and
warehouse costs increase. So the firm needs to determine the optimum balance between the cost
of increased number of warehouses and improved customer service level. Some of the factors
that can be considered to determine the optimum number of warehouses include
The level of customer service required

The number of customers, their location, and buying habits.
The relationship between increased number of warehouse and transport cost in shown in
the figure below.

Total costs
Warehousing cost
Transport costs
Number of regional warehouses
Figure 9.3 : Number of warehouses and logistic costs.
Summary
In this chapter the seven economic factors that affect transport cost were discussed. They are (in
the order of their importance) distance, volume, density, storability, handling, liability, and
markets.
This chapter also discussed the need to carry inventory and the types of inventory costs. Carrying
cost and ordering costs are the two types of costs and they have an inverse relationship, as one
increase the other decreases. The point where these costs intersect is called the economic order
quantity, and it is the point where the total cost of inventory will be at minimum.
The chapter finally has also presented discussion on the reasons for the existence of warehouses,
the function warehouses perform, and the types of warehouses.
Review questions
1. Explain the need for inventory and the types of inventory.

2. Explain the relationship between inventory carrying costs and inventory ordering costs.
3. Describe the primary purpose of a bill of lading
4. What is cost-service pricing? Value-of-service pricing?
5. What factors must a shipper evaluate when selecting a mode or carrier?
Self Assessment Questions
1. Which of the followings is true about economics of scale

1. It is the advantage a firm gets by producing similar items in large quantity
that makes the average fixed cost to go down
2. It related to savings that may come by using the scale in an economic
fashion
3. It is achieved only in long run
4. It is applicable only for manufacturing firms not for service sector
2. At EOQ
1. Carrying cost is higher than ordering cost
2. Both costs are at their minimal point
3. Both costs are equal
4. Ordering costs are rising and are higher than carrying costs
3. Which of the followings is not a warehouse function ?
A. Inbound goods are received from transportation carriers and quality and
quantity check will be made
B. Transferring the goods from the receiving dock and moving them to
specific storage areas throughout the warehouse
C. Order selecting the products for filling customer orders including
checking, packing, and transportation into outbound docks
D. None
4. The difference private and public warehouses include:
1. Private warehouses are owned by the firm but the public warehouse are
under government ownership
2. Public warehouses are available for rent whereas private warehouses are
owned and operated by the firm itself
3. Public warehouses normally favor public institutions however private
warehouses prefer to help private firms
4. B and C
5. The justification for carrying inventory includes:
1. Economies of scale
2. Balancing supply and demand
3. Protection for uncertainties
4. All
Cost
C
Ideal service level
6. In the above graph of EOQ cycle ‘A’ represents
1. Total cost
2. Carrying cost
3. Inventory cost
4. Transportation cost
7. A traditional approach to reduce risks due to forecast error is__________.
A. Reduce lead times
B. Reduce level of inventory
C. Hold safety stock
D. All
E.None
8. The general relationship between transportation costs and density is
A. The higher the density the higher the transportation cost
B. The higher the value of the good is the lower the density
C. The higher the density is the lower the transportation cost
D. Product density has positive relationship with transportation costs
9. How does Storability of a product could affect transportation costs
A. Irregularly shaped products would take large space in the vehicle hence
lead to higher transportation costs
B. Products packed in rectangular or cubic dimension would be charged
lower costs no matter what
C. If products are packed in a container that could be stacked would lead to
higher transportation costs
D. Irregularly shaped containers could not be moved by vehicles
10. In terms of operational flexibility which of the following transportation class is

the least flexible
1. Common carriers
2. Contract carriers
3. Private carriers
4. None
Answers for self assessment questions
Chapter One
1. A
2. D
3. A
4. D
5. C
6. T
7. F
8. T
9. Facilitation of Search, Adjustment of Assortment Discrepancy
10. Contactual efficiency, Specialization and Division of labor
11. The former includes channel participants while the later includes firms which are
not channel members
12. It is managing more than one firm while the other is managing only one firm
Chapter Two
For the activity: They may result in a situation where a channel member cannot carry the
products of other suppliers.
They weaken competition
1. D
2. C
3. E
4. D
5. D
6. F
7. T
8. T
9. Scrambled Merchandising
10. Electronic Data Interchange
11. The socio-cultural environment pervades virtually all aspect of a society.
Marketing patterns (and particularly the structure of marketing channels) are
therefore also influenced by the soci0-cultural environment within which they
exist. Indeed, some channel analysts argue that this is a major force affecting
channel structure.
Chapter three
For the activity: H, H, M, and M
1. C
2. D
3. C
4. A
5. A
6. C
7. D
8. F
9. T
10. T
11. Discuss the issue in terms of service out puts i.e. the more the service outputs the
less the buyer’s cost when getting the offer via intermediaries.
Chapter four
1. E
2. A
3. C
4. C
5. D
6. C
7. D
8. B
9. F
10. T
11. Specialization and economies of scale
12. The distinction between intraorganizational management and interorganizational
management
Chapter Five
1. C
2. B
3. C
4. A
5. A
6. A
7. F
8. T
9. Always-a-share
10. Lost –for- good
Chapter Six
1. C
2. C
3. D
4. D
5. A
6. D
7. B
8. Functional Discounts
9. Seasonal Discounts
10. Cash Discounts
Chapter Seven:
1. C
2. A
3. D
4. A
5. C
6. D
7. F
8. F
9. F
10. T
Chapter Eight
1. D
2. E
3. C
4. D
5. B
6. A
7. A
8. A
9. A
10. A
Chapter Nine
1. A
2. C
3. D
4. B
5. D
6. A
7. C
8. C
9. A
10. A
Bibliography
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Bowersox, D., & Cooper, B. (1992). Strategic Marketing Channel Management: Tata McGraw-
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Coughlan, A., Anderson, E., Stern, L., & El-Ansary, A. (2014). Marketing Channels
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Publishing Company
Dickinson, R., & Hollander, S. (1996). Some Definition Problems in Marketing Channels.
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Hill.
Table of Contents
Contents Page
Module Introduction………………………………………………………………………….…1
Module objective………………………………………………………………………………..1
Chapter 1 Marketing Channels Structure and Functions…………………………………..3
1.1 An overview of marketing channel ……………………………………..……….3
1.2The growing importance of marketing channels…………………………………..6
1.3 Why do marketing channels exist?..........................................................................15
1.4 What is the work of the marketing channel?...........................................................17
1.5 Who belongs to a marketing channel?.....................................................................19
1.6 Evolution of marketing channels…………………………………..………………21
Chapter 2 The Environment of Marketing Channels……………………………….………26
2.1The economic environment………………………………………………………....27
2.2 The competitive environment…………………………………….…………….......29
2.3 Socio-cultural factor………………………………………………………………...32
2.4The technological environment……………………………………………………..32
2.5 The legal environment…………………………………………………….…………34
Chapter 3 Segmentation for Marketing Channel Design: Service Outputs………………..41
3.1 Service outputs……………………………………………………………………42
3.2 Service Outputs as Determinants of Channel Structure…………………………..45
3.3 Marketing costs as a determinant of distribution functions (structures)…………50
3.4 Segmenting the market by service output demands………………………………52
3.5 Meeting service output demands…………………………………………….…...55
Chapter 4 Channel Participants……….…………………………………………………….60
4.1Producers and Manufacturers……………………………………………………….62
4.2 Intermediaries………………………………………………………………………67
4.3What is retailing?........................................................................................................70
4.4 The Retail Level…………………...………………………………………………..71
4.5The problem of Retailing……………...…………………………………...………..74
Chapter 5 Managing Marketing Channels……………..…………………….…………......80
5.1Conflict in the marketing channel…………………………………………..……...80
5.2Causes of conflict………………………………..………………………………….81
5.3Channel Conflict and Channel Efficiency………………….……………………….83
5.4 Resolving Conflict…………………………………...……………………………..86
5.5Channel strategy………………………..……………………………………………87
5..6 Channel Objectives ……………………………...…………...……………………88
5.7 Market Segmentation and Marketing Channel …….………………………………91
5.8 Motivating the channel members……………………………...……………..……94
Chapter 6 Developing the Marketing Channel Design…………..……………………….104
6.1Channel Design………..…………………………………………………………104
Phase 1: Recognizing the Need for a channel Design Decision…………….105
Phase 2: Setting and Coordinating Distribution Objectives…………………106
Phase 3: Specifying the Distribution Tasks………………………………......111
Phase 4: Developing Possible Alternative Channel Structures……………....112
Phase 5: Evaluating the Variables Affecting Channel Structure……………..113
Phase 6: Choosing the “Best” Channel Structure……………………………..122
Phase 7: Selecting the Channel Members………………….………………….122
Chapter 7: Vertical Integration in Distribution ……………………………………..…..127
7.1 Make or Buy: A Critical Determinant of Company Competencies……………..128
7.2 Six Reasons to Outsource Distribution ………………………………………….138
7.3 Six Types of Company-Specific Capabilities in Distribution……………….…..147
7.4 Vertical integration to cope with environmental uncertainty …………………...156
Chapter 8: Introduction to Marketing logistics……….……………………………...…...162
8.1Logistics: An overview……………………………………………………….….163
8.2 Logistics Activities ………………………………………………………….….167
8.3The supply chain and competitive performance………………………..……..….171
8.4 The changing logistics environment………………………………………….......172
8.5 The marketing and logistics interface……….……………………………………180
8.6 Logistic Costs…………………………………………………………...…………190
Chapter 9: Transportation and Inventory Management………………..…………………200
9.1Basic Transport Economics & Pricing………………………………………….......201
9.1.1 Economic Factors …………………………………………..….……... 201
9.1.2 Market Factors…………………………………………………………...204
9.1.3 Pricing Strategies…………………………………………………………206
9.1.4 Transport Documentation…………………………………...………….207

9.2 Inventory Management …………………...………………………………………214
9.2.1 Rationale for Carrying Inventory …………………………………….…..214

9.2.2 Objectives of Inventory Control………………………………………….214
9.2.3 Inventory Management Models ………………………………………….215
9.2.4 Types of Inventory Costs …………………………………………...……219
9.3 Basic components of a warehouse …………………………………...…………….222
Answer to self assessment questions………………………………………………......229

Bibliography
Marketing Channels Management
Prepared By: Tewodros Mesfin and Andenet Worku
Addis Ababa University

College of Business and Economics
School of Commerce
Marketing Management
Graduate Program
(MAMM)
January, 2015

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Introduction to the Module

Marketing channel is a set of practices or activities necessary to transfer the ownership of

The general objectives of the module include the followings:

Marketing Channels Structure and Functions

1. Introduction to the chapter

After reading this chapter, learners will be able to:

1.1 An Overview of Marketing Channel

Definitions of marketing channel

Distribution objectives: The marketing channel exists as a means to achieve distribution

1.2 The growing importance of marketing Channels

i. Greater difficulty in gaining sustainable competitive advantage;

1. Sustainable competitive advantage

A sustainable competitive advantage cannot easily be copied by rivals. However, if the

a. Move to low cost production areas

Promotion strategy: The competitive advantage that is obtained through promotion

Distribution strategy: Place strategy can provide a company with a competitive

vii. Growing power of distributors, especially retailers in marketing channels

ix. The new stress on growth

x. The increasing role of technology

Why do Marketing Channels exist and Change

Facilitation of Search: Marketing channels containing intermediaries arise partly

Adjustment of Assortment Discrepancy: Independent intermediaries in a marketing

a. Routinization of Transactions: Each purchase transaction involves ordering of,

Moreover, routinization leads to standardization of goods and services whose performance

b. Reduction in Number of Contacts (contactual efficiency): Without channel

Figure 1.1: Selling directly to five contact lines

Figure 1.2: Selling directly and selling indirectly

Specialization and division of labor

Commentary: use the formula

1.3 What is the work of the marketing channel?

ii. Product Flows

Suppliers Shippers Manufacturer Dealer Buyers

Suppliers Manufacturer Dealer Buyer

Information flow is flow in both directions.

iv. Information flow

Suppliers Shippers Manufacturer Dealer Buyers

Manufacturer Ad agency Wholesaler retailer consumer

Figure1.4: Flows in marketing Channels

Wholesale intermediaries include merchant wholesalers or distributors, manufacturers’

1.5 Channel structure

2. Channel Design: Segmentation

1.6 Evolution of marketing channels

1.6.1 The Production Era and Distributive Practices

The Institutional Period and Selling Orientation

1.6.2 The Marketing Concept

Commentary: consider the criteria for allocating distribution functions

Self assessment questions

Part one: Multiple choices

1. Which of the following statements is incorrect about the marketing channel?

a. A marketing channel is Intraorganizational management

b. A marketing channel is Interorganizational management

2. Which of the following statement is incorrect?

4. The primary interest of the marketing channel is

Part three: Short answer questions

Part four: Discussion questions

The Environment of Marketing Channels

Introduction to the chapter

1. The economic environment

After reading this chapter, learners will be able to:

Explain some of the major economic forces affecting marketing channels

Explicate the impact of socio-culture on the marketing channel

2.1 The economic environment