Communications of the ACM

Communications of the ACM

E-Commerce and the Undulating Distribution Channel

By John M. Gallaugher
Communications of the ACM, July 2002, Vol. 45 No. 7, Pages 89-95
10.1145/514236.514240
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The hype surrounding e-commerce can be both relentless and confusing. Of particular concern to managers is the effect of online commerce on a firm's distribution channels. Distribution channels have been viewed as a strategic asset and channel design has been recognized as a key to successful competition [1]. However, many managers are perplexed when it comes to understanding the impact of online commerce on existing channels, determining where opportunities lie, and recognizing the threats that exist. A subset of issues related to the collapsing, shifting, and extending of distribution channels is examined here, including a series of examples illustrating the forces behind the current channel dynamism.

Pioneering theory in e-commerce relied on classical economics [5] to illustrate incentives for the collapse of distribution channels, shortening the link between buyer and supplier [3]. This concept is referred to as disintermediation, or an elimination of one or more organizations from the distribution channel.¹ The rise of overnight delivery services and the ubiquity of the Internet have created increased opportunities for firms that originate products and services to sell directly to consumers. Many firms embraced the siren song of disintermediation, expecting customers to flock to lower-cost competitive products provided directly from suppliers. However, several pioneers achieved dismal results stemming from a lack of understanding of the implications of removing key elements of the distribution channel.

Intermediaries offer multiple benefits including brand, distribution, coverage, management of product complexity, and selection at the point of purchase [1, 7]. While disintermediation can create savings if the aggregate cost of intermediaries is eliminated, such efforts can also create value gaps by removing critical value from the distribution channel. If the value added by the new channel does not equal or exceed the value added by the previous channel, then a value gap will exist. Value gaps in critical competitive resources can doom an effort to failure.

As an example, consider early efforts by Miami-based Sunburst Farms. Sunburst, a flower growing and importing cooperative, was one of the first firms to take flower orders over the Web. By using FedEx for next-day delivery of high-quality, fresh flowers, FlowerNet eliminated both the local floral shop and order-taking flower networks such as FTD. The advantage of this disintermediation was reflected in early pricing, with FlowerNet offering a dozen long-stemmed roses at roughly half the cost of more traditional competitors. It would seem that fresher flowers at a cheaper price would offer a compelling value proposition. However, despite being a low-cost, early player, FlowerNet failed while better-known rivals prospered. Competitors FTD.com and 1800Flowers have both posted profits, with the latter expecting half of 2002 sales to come from the Web.

By disintermediating floral networks and local retailers, FlowerNet eliminated the strongest brands in the eyes of consumers. Brands were initially thought to be less significant online, particularly in commodity markets where easy comparison would focus attention on price [6]. However, brands offer three critical benefits to online enterprises: brands lower search costs, proxy quality, and inspire trust. Without brand awareness, FlowerNet's customers did not even know the firm existed, let alone whether or not the firm offered a quality product or could be trusted with credit card information.

Failure to recognize the valued role intermediaries can play in consumer education and managing product complexity was at the heart of the lackluster performance of the direct-sale WebSaver annuity offered by Liberty Financial Companies. Annuities are typically sold through agents who take an average 4%–8% in commission fees. By selling annuities over the Internet, Liberty hoped to reduce distribution and selling expenses to roughly 1%. The results yielded an attractive product—the firm's annuity offered rates some 100 basis points above many rivals, and as a bits-based product, overhead could stay low since there was no physical inventory. During the time of rollout, online brokerages were growing dramatically, demonstrating that consumers were willing to purchase financial instruments online. Since the WebSaver was a new product, Liberty recognized the importance of creating product awareness and building brand. The firm advertised the WebSaver on some of the Internet's most popular sites, and the product received positive press coverage. However, first-year sales efforts were disappointingly low with less than 20 products sold.

Figure 1. Value gaps and expense savings.

What Liberty failed to realize is the value added by the agent was critical and this value had not been captured by the other ends of a collapsed distribution channel. While customers proved willing to trade stocks and mutual funds on their own, annuities represent a much more complex instrument. Before most consumers purchase an annuity, they need to be educated about the product and convinced of its value, but the shift to the online channel provided no such provision.

Firms may fail to realize a value gap exists in a new channel because, while it is easy to quantify the savings from removing a channel partner, the benefits of less tangible yet critical assets may be overlooked. A value-focused audit comparing the benefits of elements in the old and new channels could have allowed managers to detect value gaps prior to deploying these failed efforts.

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Shifting the Channel: Channel Pressure

E-commerce presents opportunities to expand or shift elements of existing channels from the physical marketplace to the virtual marketspace [10]. However, the bargaining power of buyers and suppliers is a critical force shaping industry competitiveness [9] and the presence of such power will remain vital in determining a firm's ability to exploit online markets. In particular, those manufacturers that have dominated traditional retail sales may be undermined by their earlier success. Their reliance on traditional outlets makes them susceptible to retailer pressure to curb online experimentation and limit deep discounting online (see Figure 2). Maintaining both channels also presents barriers to execution that are created if attempts to straddle multiple markets limit operational optimization.

Figure 3. Auctions of last resort and first choice.

In particular, those manufacturers that have dominated through traditional retail sales partners may be undermined by their earlier success. In the first quarter of 1999, Compaq was forced to halt sales to deep-discount online retailers in response to pressure from its traditional (and much larger) retail base. Ironically, one of the vendors that Compaq halted sales to was shopping.com, a deep-discounter that was at the time owned by Compaq. While Compaq has since largely controlled online deep discounting and has even taken steps to offer products directly to consumers, at the end of 2001 the firm was still reliant on partners for the majority of its business. As a publicly traded firm wedded to an old channel, Compaq could not afford to alienate vital resellers that had many substitute suppliers to turn to. This committed the firm to a slower transition away from partner vending, allowing its market share to be eroded as the direct-to-consumer segment grew. For contrast, consider that in 1995, direct-to-consumer leader Dell was ranked sixth, seventh, and fifth in desktop, notebook, and workstation markets, but had secured the first position in all three markets by 2001. While Web sales are not essential for the direct-to-consumer model, they play a significant role. By 2001, Dell was doing so much business online that if Dell.com were a standalone company it would rank in the Fortune 100.

Channel pressure from strong retailers such as Home Depot and Macy's has also caused firms such as Stanley Tools and Levi's to halt direct-to-consumer sales, rendering worthless each firm's substantial investment in their respective Web sales efforts. Many suppliers now certify Web merchants in part to ensure that margins among online retailers are comparable with offline counterparts. Similarly, Amazon.com has suffered at the hands of non-compliant suppliers as it has attempted to expand into consumer electronics. Many leading electronics manufacturers have initially refused to authorize and supply the Web retailer for fear of retaliation from large brick-and-mortar chains, forcing Amazon to take costly steps to secure popular items from other retailers. As these examples illustrate, formulating e-commerce plans without considering the channel partner dynamic can result in financial loss, reputation damage, and weaker partner relationships.

Innovation and Channel Pressure. Christensen [4] has pointed out a persistent pattern of failure among sector-leading firms related to a lack of awareness of opportunities in new markets. This blindness is created by a near-exclusive focus on existing customers, coupled with a dismissal of low-profit but developing areas of business. However, channel pressure can also constrict dominant firms even if it is recognized that alternate channels present significant opportunities for growth. This situation limits experimentation, and when coupled with advances in technology, creates an environment ripe for disruptive players to strike at vulnerable, developing markets.

Developments in digital audio represent one area in the midst of such disruptions. The MP3 format allows audio to be compressed at up to a 12:1 ratio and support for the format by major operating system manufacturers has secured hundreds of millions of users worldwide. For a time, "MP3" had even displaced "sex" as the most-searched-for term on the Internet.

Figure 4. Channel-extending intermediaries.

The explosive growth of the MP3 format has prompted the development of portable, flash memory-based MP3 players. These specialized devices exhibit many qualities that make them more attractive than portable CD or tape players. First-generation players stored approximately one hour of digital music, ran on a single AA battery and, unlike CDs and tapes, do not skip when jostled. These devices also benefit from Moore's Law, gaining more capacity at a lower cost over time. It's worth noting that the first such devices on the market were not offered by industry giant Sony, but by upstarts including computer peripheral maker Diamond Multimedia. Diamond (now part of SonicBlue) sold over 200,000 portable MP3 players in the first 10 months after introduction.

Sony's hesitancy lay not in a lack of technical expertise or a blindness to the growing acceptance of a new music standard, but rather in an internal pressure created from the firm's business lines. Sony is vertically integrated, providing both consumer electronics hardware and—as a record label—content. The digital distribution of MP3 files represented a channel that Sony Music did not wish to support due to piracy concerns and the potential adverse impact on recording sales. The Redbook file standard that compact discs are based on is over 20 years old, has a huge installed base, and offers no copy protection, enabling the widespread illegal distribution of music over the Internet. SonicBlue (like many other firms offering MP3 hardware) does not suffer similar pressures and so has been free to establish early leadership in this new, developing market. The market for portable MP3 players has grown steadily and now includes MP3 format CD players. Total sales topped 2.4 million units in 2000, yet CNET reported that as of early 2002, none of the most popular portable MP3 players were provided by Sony. SonicBlue held three of the top five spots and has licensed products to firms such as Nike, for use in the latter's MP3 player. While Sony has begun to respond to the seemingly unstoppable migration to new music formats, its early inaction has initially ceded standard-setting, partnerships, and market share leadership to others.

The constraint experienced by Compaq and Sony is typical of firms wedded to traditional channels that are undergoing a slow, but significant migration to new channels. The disruptions faced by these firms differ from those cited by Christensen because the ineffectiveness of response lies not in an inability to see the oncoming environmental change, but rather in the extent to which these firms are shackled to existing business models.

Shift to Auction Markets: Optimal Channel vs. Channel of Last Resort. The Internet's ability to bring together geographically diverse buyers and sellers has led to a rise in leveraging auction markets as distribution channels. However, the relative scarcity of items offered has a significant impact on motivating auction participants as well as in creating competitive advantage for the auction operator. These issues are illustrated by contrasting liquidation auctions with market efficiency auctions.

Auctions such as those offered by Priceline are run as liquidation services that sell excess commodity inventory at below-market rates. The majority of Priceline's revenues come from travel—a service that is low in scarcity and high in substitutes. Liquidation markets exist because suppliers experience operations inefficiencies in areas such as production, forecasting, and distribution. When such circumstances are present, the supplier's long-term priority is to remove margin-deteriorating inefficiencies. As such, growth in liquidation auctions will be limited as suppliers move first to lower any surplus using techniques such as ERP, supply chain, and yield management. When faced with the prospect of giving up customer contact and a percentage of revenue to a third party, suppliers may also be motivated to sell excess inventory through their own e-commerce efforts.² For these reasons, suppliers may always view third-party liquidation services as markets of last resort.

For providers of rare products or services with exclusive or limited access, auction models present a compelling alternative to traditional channels. Indeed, these markets may be viewed by both suppliers and buyers as markets of first choice. Suppliers of rare goods seek large markets because more buyers will bid prices higher. Similarly, buyers seeking rare goods first visit the largest market to maximize their likelihood of finding the item sought. This cycle creates the demand-side economies of scale of network effects.

The success of eBay provides a stunning example of the strength of these benefits. While revenues at Priceline fell 5% in 2001, eBay grew 74%, even though it is the largest player in its field. The consistently profitable firm holds roughly 80% of the U.S. online auction market for consumer goods, despite the fact that strong brands such as Yahoo and Amazon have offered competing services with lower fees. EBay has maintained its network advantage via an online rating system for evaluating auction participants. The rating system has helped lower the risk premium associated with doing business on eBay and has created switching costs, strengthened over time, in that participants who leave must re-create their reputation anew at another service. The success of eBay's market efficiency auctions for collectibles has created a critical mass of consumers that has allowed the firm to leverage this client base to expand into other markets. Many items now found on eBay are not at all scarce. By early 2002, eBay boasted 38 million buyers and was the leading Internet destination not only for collectibles, but also for autos and auto parts, computers, and photo equipment. Suppliers seeking to tap into the firm's customer base include IBM (eBay's largest seller) and even Priceline. This has allowed the firm to expand beyond market efficiency auctions and into fixed-price purchases, payment services, advertising, and liquidation auctions.

Firms hoping to create market efficiency auctions as alternatives to existing market mechanisms must consider whether the new system can match and exceed the aggregate benefits of the traditional way of doing business. At first glance, the market for initial public offerings (IPOs) in the U.S. would seem a likely candidate for market efficiency auctions. In this case, the firm going public is the supplier and the investors in the firm's stock are the buyers. In the traditional system, investment banks that take a firm public charge fees (typically 7%) and regularly underprice the issue to ensure a sellout, both of which reduce the amount of capital that a firm raises in an IPO.

In a hot market for IPOs (regardless of its rationality), the gap between the offer price and the price the market is willing to pay for a new issue can grow quite large. The accompanying table, "Market Inefficiencies for U.S. IPOs," demonstrates this gap.³ This market inefficiency is of great concern to newly public firms because it translates into financing raised at a price below what the market is willing to pay. Thus, firms have less cash to meet the demands of a market that values them at significantly higher premiums above the IPO. On the buy side, small investors are locked out of shares at the offer price. Initial shares are offered to institutional investors (such as pension and mutual fund managers) and large clients who regularly flip shares during the run-up to gain a fast profit.

OpenIPO was introduced by the firm W.R. Hambrecht to correct the inefficiency of the current system. Hambrecht's OpenIPO charges only 4% underwriting fees while using a modified Vickrey auction to set the price of a new issue.⁴ The goal is to provide all investors equal opportunity at obtaining IPO shares, and companies with a better way to raise more cash while creating a more stable investor base.

Unfortunately, clients have not flocked to OpenIPO. The system has handled approximately half a dozen IPOs between 1999 and 2001. Hambrecht's limited appeal is related in part to value gaps that exist between the traditional method of going public and OpenIPO. There is concern that auctions price issues based on hype rather than the due diligence offered by traditional investment banks. OpenIPO has also been criticized for lacking the solid and diverse customer base needed to accurately set the offer price at market equilibrium. In at least two issues handled through OpenIPO, Peet's Coffee and Tea, and Andover.net, share prices still jumped more than twofold when hitting the market immediately after the IPO. The relatively smaller issues handled through OpenIPO tend to attract less analyst coverage, yet coverage is critical for creating the awareness necessary to provide continued liquidity for the stock. Firms that are taken public by highly regarded Wall Street firms also benefit from a prestige factor and a first-day price run-up may be seen as a marketing event that further raises awareness of a firm. As in disintermediation, the shift to auctions is appealing only if new efforts can capture and exceed the value offered by traditional channels. Without clear moves to bridge the value gap, the appeal of OpenIPO may be limited.

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Lengthening the Channel: Channel-Extending Intermediaries

While e-commerce has been thought of as a catalyst for the collapsing and shifting of channels, a new category of firm is using technology to lengthen distribution channels. These channel-extending intermediaries (CEIs) insert themselves between existing elements, aggregating buyers and suppliers into new markets and leveraging opportunities to add value that address weaknesses in traditional systems. Buyers see incentives to join CEI networks when, for example, traditional alternatives offer high customer search and switching costs, or low customer satisfaction [2, 11].

As an example of CEIs, consider mutual fund supermarkets [3]. Launched in 1992, Schwab's OneSource leveraged technology to establish the first consumer marketplace for no-load mutual funds. With OneSource, Schwab moved from a firm that offered no actively managed funds to one that today makes available thousands of funds from hundreds of firms. The addition of a Web front-end allowed Schwab customers to rapidly sift through a myriad of choices, narrowing in on key criteria such as performance. Switching costs between fund families have been virtually eliminated, as assets can be instantly shifted among fund companies as if users were buying or selling stock.

Supplier participants in markets created by channel-extending intermediaries typically engage in a margin for volume exchange—trading a portion of their revenues for access to the CEI's customer base. In the case of mutual fund networks, supplier fund companies offer the fund network a percentage of their management fee. However, this "Devil's Bargain" may also hurt suppliers by further commoditizing supplier products, weakening supplier brand, shifting the switching cost asset to the CEI, and displacing the supplier as the primary interface with the customer. This last item may be particularly important, as customer contact is vital in creating a defensible data asset and is important for experimentation.

CEIs and Supplier Motivation. Why would suppliers be motivated to participate in a CEI if they are likely to see competition increase while their competitive assets are eroded? Indeed, this is the question many firms asked when rejecting overtures from third-party business-to-business exchanges. Third-party B2B exchanges were a venture capital darling in 1999, but the vast majority of these exchanges have collapsed due to an inability to create enough participation to generate a liquid market.

Online markets for new autos present another example of the difficulty in balancing value delivery and buyer-supplier motivation when developing a CEI. Customers have flocked to the Internet for car shopping advice, with over 60% of U.S. auto buyers surfing the Web for information prior to visiting a dealer. However, many car sales CEIs that match car buyers with low-cost, no-haggle dealer quotes have struggled. Online shopping presents a value gap in that a dealer remains critical to obtaining a trade-in assessment of a car. Search costs are not saved if a customer feels it necessary to verify a trade-in estimate by visiting additional dealers. Many auto sites have also sought to provide access to financing, creating channel pressure with dealers that are reluctant to lose high-margin finance business to Web partners. Finally, auto sites suffer from a free-rider problem in that customers can get a quote online and use this to shop outside the network.

Schwab's success in attracting a critical mass of suppliers to OneSource is the result of a number of factors. As the largest discount brokerage firm, Schwab offered fund firms access to a substantial customer base. The mutual fund industry is also highly fragmented, thus limiting the concentration of supplier power. Also, the uncertainty of returns within a fund category promotes a tolerance of comparison among rival funds. However, as the examples here illustrate, the favorable characteristics that allowed Schwab to build the extremely successful OneSource may be difficult for many would-be CEIs to replicate.

Threats to Channel-Extending Intermediaries. Not only can it be difficult to craft a successful CEI, but ubiquity of the Internet and the relentlessly falling price of computing make it easier for new entrants to threaten established channel-extending intermediaries. Credible threats to CEIs can arise from suppliers forward-integrating or from firms that can leverage existing distribution channels to access customers. Fidelity Investments has created a rival fund network by moving forward in the value chain, opening up its customer base to competing funds that are willing to share their management fees. Auto manufacturers have also moved forward to launch sites that compete with online auto-sales networks. In many cases, forward-moving suppliers can leverage a significant pool of assets including established market presence, strong brands, access to capital, more comprehensive inventory knowledge, and loyal customer bases. The Internet has also created virtual distribution channels at customer aggregation points and these assets may be extremely valuable to firms that control them. For example, Microsoft has leveraged the firm's various properties—MSN, interactive TV services, and the Internet Explorer browser—in promoting its CarPoint dealer network and other e-commerce properties.

Although rival networks can be easily launched, early movers gain a tremendous advantage as market makers. While research has challenged the notion of the first-mover advantage under certain conditions [12], for CEIs the first-mover advantage is critical in establishing a dominant network. The viability of a new market is largely based upon network effects. In the case of CEIs, more customers attract more suppliers and more suppliers attract more customers. This positive feedback loop can be extremely difficult for new entrants to surmount. Early movers also benefit from establishing brands, pioneering standards, creating switching costs, and locking in suppliers with exclusive contracts [8]. Although large suppliers (for example, Fidelity) and those controlling customer access routes (for example, Microsoft) may be able to create sustainable alternative markets, early movers with large market share such as Schwab and Auto-by-Tel have continued to maintain their lead positions based in part on the increasing returns of their large networks. For example, six years after the deployment of OneSource and despite having its model copied by many competitors, Schwab's fund network remained over three times larger than its nearest rival. And despite the weaknesses of auto sales CEIs, Web pioneer Auto-By-Tel is nearly twice as large as rival CarPoint and even managed an operating profit in 2001. The threat to CEIs posed by forward integration and firms with distribution channels is legitimate and should be taken seriously, however, given the benefit of network externalities, a substantial early market share lead may be particularly difficult to displace.

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Conclusion

The extent of the collapse of distribution channels brought about by the advent of the Internet appears to have been overestimated. Instead we are faced with an undulating distribution channel that can contract, shift into cyberspace, or expand depending on the complex interaction of industry players, value delivery, product offerings and characteristics, and market power. An understanding of the interplay of these disparate forces is vital for those seeking to determine how e-commerce will affect a firm and its industry.

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The Digital Library is published by the Association for Computing Machinery. Copyright © 2002 ACM, Inc.

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