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Jul 26 22:49 2007 John Henderson Print This Article

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Pay for PerformanceIn channel pricing,Guest Posting the old status quo just does not work any more. Suppliers that are locked into historical volume-based structures simply do not have the flexibility to respond to the dynamics of the new economy. They allow channel conflict to erode their market position and fail to capitalize on opportunities to motivate channel performance.There are three main "pay for performance" channel pricing strategies--functional discounts, activity-based pricing and results-based programs. Each has a unique purpose to achieve specific objectives. While they are distinct approaches, they are not mutually exclusive. Some suppliers require different pricing strategies for each market segment or even multiple strategies for certain channels. While these strategies add complexity, suppliers that do not invest in highly developed programs will let inefficiencies, ineffectiveness, and conflict erode their profits and market share. Despite use of terms such as "discounts" and "incentives," the actual payment mechanisms used within channel pricing strategies can take many forms. Channel pricing can take the form of discounts, rebates, commissions, net pricing, or non-traditional mechanisms such as value exchanges, fees, services, or goods.FUNCTIONAL DISCOUNTS Functional discounts are emerging as an important option for virtually all suppliers. Historically, distributors, retailers, or other channel partners would perform a fairly consistent "bundle" of functions. The traditional distributor purchased inventory, sold it, supported it, and managed credit with the supplier and with the customer. In the past, distributors performed all of these functions reasonably well. Today, however, new entities in the supply chain perform subsets of these functions far more efficiently than traditional distributors. In many cases, a third-party logistics provider can manage inventory, a rep can provide sales support, a call center can provide technical support, and a credit agency can hold receivables at substantially lower costs than traditional distributors.When suppliers unbundle functions to use the most efficient service providers, they must also unbundle the compensation that they offer to their channel partners. They must only pay channel partners for the functions that they perform. Under a functional discount structure, the supplier breaks its traditional discount into discrete functional components. For example, a manufacturer that formerly offered a 50 percent discount could offer a base discount of 25 percent and additional discounts of 10 percent for logistics, 5 percent for presale support, 5 percent for post-sale support, and 5 percent for credit and transaction processing. While many distributors will continue to earn the full 50 percent, those that only perform a subset of the functions will earn reduced compensation. This type of structure gives the supplier the flexibility to hire a third party to perform any or all of the functions.Functional discounts can alleviate destructive channel conflict. If customers use the sales or support services of a high-support channel, but then purchase from a low-cost channel, the customer takes a "free ride" on the high-support channel. A functional discount levels the playing field by limiting the ability of the low-cost channel to undercut the price. Suppliers considering this approach must determine whether their products require high support. If they do not, there is no reason to protect the high-cost channel.ACTIVITY-BASED PRICING Activity-based pricing is similar to functional discounting except it focuses on motivation rather than on compensation. Activity-based pricing assumes that a channel partner is performing a set of functions such as logistics, order processing, sales, or service. Within the context of these functions, however, channels can perform more or less effectively. Prompt payment discounts are a classic example of suppliers using channel pricing to motivate behavior. With a prompt payment discount, the supplier's goal is to reduce its financing costs. Providing an incentive quickens payment and lowers costs. It is a win-win situation for the supplier and the channel partner.Progressive suppliers are moving beyond prompt payment discounts and are using channel pricing to motivate a wide array of value-added activities. These activities generally fall into two categories--activities that generate demand and those that reduce a supplier's retained costs. In consumer markets, for example, suppliers use promotional allowances to motivate retailers to generate demand through advertising, display, and promotion. In business-to-business markets, suppliers pay to motivate specification work, lead follow-up, promotional frequency, and technical support. From a cost savings standpoint, suppliers use order quantity, EDI, prompt payment, and other cost-to-serve incentives to motivate channels to lower the supplier's sales, order processing, logistics, credit, and other costs.RESULTS-BASED PROGRAMS When designing programs to motivate channel behavior, suppliers must determine whether to pay for activities or results. Results-based programs provide rewards to channels that achieve volume, market share, loyalty, or other targets. Results-based programs are attractive because they align with a supplier's objectives. For example, if a supplier is charged with achieving 15 percent growth, it seems logical to pass that incentive on to the channel and pay more to those partners that attain those results. There are important factors to consider before passing results-based incentives on to channel partners. A key consideration is the impact that the program will have on overall channel compensation. A results-based program can unwittingly result in lower margins for distributors who then stop supporting the product line. Results-based programs, if not structured properly, can increase destructive channel conflict, penalize a supplier's best partners, and reduce supply chain efficiency.Developing Effective Channel Pricing StructuresEach supplier's channel pricing structure must reflect its products, services, customers, channels, and resources. What works for one supplier will not necessarily work for another. Some suppliers may drive business results by using all of the performance-based channel pricing strategies identified above. Others may require a singular approach. In any event, it is critical for suppliers to understand the dynamics behind the market to design a program that delivers results. The following analyses will better position the supplier to understand channel dynamics, make better channel pricing decisions, and develop more effective solutions. OBJECTIVES AND VALUES To design effective channel pricing structures, start with your objectives. The program must reflect the supplier's overall sales and marketing strategy. Is the objective to push new products or services? Reduce transaction costs? Manage channel conflict? Effective design can drive successful business results in these and other areas. Dysfunctional channel compensation programs can thwart sales and marketing efforts or wreak havoc with operations.CUSTOMER SEGMENTATION Identify the activities and functions required to satisfy customer needs. Group customers based on their buying needs, purchase potential, and price sensitivity. This step establishes the activities that the supplier or its channels must perform. It also establishes whether there are customer segments that require unique channel pricing models. CHANNEL CAPABILITIES AND OBJECTIVES Profile existing and alternative channels to determine whether they have the capabilities to satisfy customer requirements. Consider all channel options including direct, distributors, e-commerce, logistics, and other third-party providers. For each channel option, determine whether functions such as sales, credit, logistics, technical support, and order processing can be separated or whether you must hire the channel to perform a bundle of activities.REVENUE OPPORTUNITY Discounts are based on costs as a percentage of revenue. Consequently, it is necessary to identify the supplier's revenue potential through each channel option. Start with the price that the end user pays (street price). This price level sets the amount of revenue that the supplier could generate by selling direct. The supplier's revenue will depend upon channel conflict and power. An evaluation of channel conflict indicates whether partners will abandon the product line as a result of excessive competition. An evaluation of channel power considers whether the supplier will lose sales if it does not sell through the end users' preferred channels.The supplier must evaluate the revenue that its own and competing offerings provide for the channel. Suppliers can pay lower discounts if their product outsells the competition.COMPETITOR OFFERINGS Determine the discounts and other forms of compensation that competitors offer to channel partners. This is a data point for the discounts that the supplier may require. If the supplier has channel power, it will be able to offer lower discounts than competitors. If the supplier has little or no channel power, it will have to offer discounts that are equal to or higher than the competition.COST ANALYSES Three cost analyses provide important information for suppliers to develop optimal channel pricing strategies. 1. Direct costs. Identify costs, as a percentage of revenue at street price, which you would incur by selling to or providing functions directly to end users. You should be willing to offer a discount that is equal to or less than your own costs to serve the end user. If you know, for example, that it could sell direct through its own Web site or sales force for a cost of 20 percent, you should not pay your channel partners a 25 percent discount off of street price.2. Indirect costs. Profile the channels' costs to perform functions required to satisfy end users. If you use distribution channels, the compensation or discount to the channel should not exceed the channel's costs and a reasonable profit. Suppliers can reduce the discounts that they offer to channel partners by understanding the costs that those partners incur when they sell the manufacturer's line. If you know that it costs the channel 20 percent to sell the product, the supplier should not pay the channel a 30 percent discount off of street price.3. Retained costs. Assess your retained costs under each channel option. This assessment will help you determine channel profitability and investment. From a pricing standpoint, this analysis establishes the baseline for pricing incentives such as volume, prompt payment, efficient ordering, and other discounts that lower these retained costs.In the new economy, it is more important than ever before to get channel pricing right. It used to be that channel pricing simply consisted of volume discounts to one or two distribution channels. Today, the situation is far more complex. Many channels compete with each other and have different cost structures and value propositions. They are bigger, more powerful, and global. With e-commerce and advances in logistics, suppliers have new options to unbundle the functions that their distribution channels historically performed.Sometimes, suppliers should develop structures that distinguish themselves from their competition. In other cases, market leaders must drive entire industries to change. Under traditional pricing approaches, suppliers let fear and competition transfer profitability downstream. This profit transfer erodes the industry's ability to invest in new products and services and ultimately harms the customer. To break out of this box, market leaders must introduce rational channel pricing strategies that transfer profits back upstream.These challenges require that suppliers develop new channel pricing structures that provide flexibility to use channels strategically. New approaches pay for functions that channels perform and do not pay for functions that channels do not perform. They motivate partners to generate demand and lower supply chain costs. They pay for performance and results and do not drive inefficiencies. They are rational across channel partners, products, and geographical boundaries. Optimal channel pricing strategies are based on an in-depth understanding of costs, channel power, and conflict. This enables suppliers to respond strategically to partners that demand deeper discounts and to determine when it is best to follow the competition and when it is best to lead.

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About Article Author

John Henderson
John Henderson

John Henderson, President and CEO of Frank Lynn & Associates has more than 26 years of extensive consulting experience in diverse industries.  He developed the firm’s channel economics practice and is a noted author, speaker and management trainer. Frank Lynn & Associates is a global marketing and strategy consulting firm offering Channel marketing consulting services.

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