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VERTICAL MARKETING SYSTEMS BUILDING CHANNELS On average, the most important distribution decision faced by a marketing organisation is whether

it can perform any or all of the distribution functions more effectively and efficiently through the use of intermediaries or through vertical integration. From a producers perspective, a vertical integration decision relates to whether the firm should establish its own sales branches and warehousing facilities or retailing units. Firms elect to vertically integrate for two reasons : The opportunity to achieve cost reduction and opportunity to attain more control over ones environment or channel. Vertical integration also ensures that the supply of raw materials necessary for production is available when needed. The environmental control offers the vertically integrated producer strategic advantages over competitors. In most business settings, however, an organisations costs of marketing through intermediaries do not substantially differ from that which the firm would spend to receive the same services through its own efforts. Considerations in the use of vertical integration The firm must consider the question of channel efficiency, which centres on how well the channel design performs. It needs to look at channel effectiveness, that is, how well the channel design meshes with the firms marketing strategy. Firms vertically integrate because they seek more control over their environments. Vertical Marketing Systems A vertical marketing system (VMS) consists of a producer, wholesaler, and retailer acting together as a unified system. Conventional Marketing Channels versus Vertical Marketing Systems Conventional Marketing Channels Independent Separate, autonomous members Aggressive intra-channel negotiations Sometimes fail to see big picture Vertical Marketing Systems Unified Linked as a single competitive unit One clear leader with legitimate or contractual power Channel-wide perspective

In conventional systems, each channel member is a separate business attempting to maximise its own properties. Because individual members act independently, profits for the channel as a whole are frequently lessened. Manufacturers, wholesalers, and retailers generally deal with one another at an arms length, negotiating aggressively over transaction terms. In VMS, on the other hand, one channel member either owns the others, or has so much legitimate or contractual power that the other firms cooperate. VMSs are managed channel systems, purposefully designed to achieve operating economies and maximum market impact. VMSs originally emerged as a way to control the channel member behaviour and reduce the conflict that arises when channel members independently pursue their own objectives. Ideally, VMS units operate at near-optimal levels and have stable structures and relationships. Members are in

effect pre-programmed or re-programmed to achieve certain channel economies. A firms entry into a VMS is controlled by the system is controlled by the system requirements and market demands. Member loyalty is through contractual agreements or ownership. In vertical marketing systems, entire channel systems are linked together as a single competitive unit, with at least one firm that possesses enough strength relative to other members to organise channel resources. This firm is the channel leader. It maintains channel-wide perspective and prompts other channel members to perform the functions that they do best. This directly contrasts with conventional systems, where independent members often assume that their competitive advantages arise strictly from autonomous actions taken at their channel levels. In conventional channel systems, there is often a failure to see the big picture. Finally, VMSs often provide effective strategic options for organisations struggling in competitive markets. Administered Vertical Marketing Systems Administered vertical marketing systems are similar to conventional channels in that the participating firms are independently aimed and operated. They differ, however, in that the system features highly effective interorganisational management usually emanating from one dominant firm. By virtue of their expertise, brand image, market share, overall reputation, strong consumer demand, and/or ability to grant rewards, some firms command unusual cooperation from others in terms of displays, preferred shelf-space, or promotional and pricing policies. These firms that oversee the VMS are known as administrators. Administered systems are one step removed from conventional marketing channels. Channel managers operating in conventional channels often attempt to create an administered VMS to compete more effectively against more vertically integrated systems. This strategic opinion is far more feasible for larger, more powerful manufacturers or retailers because they have the power necessary to secure cooperation. Regardless of its size, a manufacturer, or wholesaler, or retailer administering a VMS will usually combine usually combine the use of expert and/or market power with reward power. The administrator also must be viewed as dependable, credible and knowledgeable. Smaller channel members can use VMSs giving them viable options for offsetting the advantages inherent in a more integrated system. Administered VMS can be partially or fully administered. In the former situation, only one or a few marketing functions are performed in advance by the lead channel firm. Significant advantages accrue to producers and distributors that operate through administered VMSs. Producers benefit from the ability to develop their sales and profit potential without having to compete in continually changing settings, develop continuity in their promotional function, or develop maximum product exposure among their distributors. Distributors (i.e. wholesalers and retailers) benefit from receiving greater assurances of clearly specified inventory investment requirements, timely availability of merchandise, and preferential treatment from critical suppliers. Contractual VMSs Contractual VMSs consist of independent firms operating at different channel levels that integrate their distribution agendas on a contractual basis. These formal contracts allow each firm to secure greater economies of scale and market impact by working together than either could achieve alone. In particular, such economies often arise in the promotional function.

In a contractual VMS, channel members are better able to manage other members behaviours when they acquire a legal justification to exert power. Carefully drafted agreements formalize and legitimize the roles, obligations, and leaders desire to control resources and costs when the competitive environment is volatile and the firms bargaining is high. Contractual VMSs require little investment in the next level of the distribution chain. Consequently, their use often affords strategic flexibility when firms want to change their product mix or scope of operations. But contracts come with mutual obligations, and obligations can reduce rather than expand options. In contractual VMSs, members are at least moderately committed to the notion of a team and/or an ongoing channel system despite the fact that each member inevitably has somewhat differing goals. The presence of a contract contributes to a formalised organisational structure that also allows the organisations to pursue more general channel goals. Within a contractual VMS, decisions are usually made by the more powerful organisation. Still, each decision is ultimately subject has other members approval. Each organisation is managed autonomously but has generally agreed to a division of labour within the channel. This is because channel members give up autonomy in return for greater economies for scale and overall influence in the market. The manner in which functions are divided among members influences the channels basic design. Two prominent categories of VMS are : Retailer-sponsored cooperative organisations Wholesaler-sponsored volunteer organisations Retailer-sponsored cooperative organisations are established when groups of independent retailers come together and voluntarily agree to pool their buying power. Members of an Rco collectively support a single, democratically operated wholesaling organisation. Retail members often receive rebates at the end of the year based on their cumulative purchases from their cooperative. Rcos play particularly significant roles in the office supplies, drug and hardware industries. In Wholesaler-sponsored volunteer organisations, the impetus for cooperation comes from the wholesale rather than the retail level. Wholesalers establish voluntary organisations comprised of smaller, independent retailers. The wholesalers remains under private ownership. The underlying theme of WVOs is one of mutual cooperation. In WVOs, cooperating retailers acquire a major portion of their goods and services from the same sponsoring wholesaler. By incorporating several independently owned retailers into a voluntary association and standardising buyer practices, a wholesaler can deliver goods and support services with greater efficiency and effectiveness than the retailers acting on their own could achieve. These retailers usually agree to sell advertised products at the same price as do other members. Franchising is another popular form of contractual VMS. Except for the difference in sponsorship, wholesaler and retailer sponsored contractual VMSs operate in much the same fashion. The retail members of each VMs join with the understanding that they will purchase a substantial portion of their merchandise from the wholesaler group. These retailers also typically agree to standardise part of their marketing mix with that of other retailers in the voluntary system. RCOs and WVOs have increased their power relative to that held by manufacturers. Services performed by wholesalers in WVOs Store identification material such as signs or decals

Store location analysis Advertising and promotional programmes Accounting and management information systems analysis and input Training for store management and other key personnel Strategic planning assistance Financial assistance Store operations manuals

Corporate VMSs A corporate vertical marketing system exists whenever a firm owns and operates organisations at the other channel levels. Corporate VMSs also exist whenever a primary marketing function is performed by a single organisation across two or more channel levels. Corporate VMSs are used by organisations operating at any channel level that seek high levels of control over their channel functions. Lead firms in corporate VMSs have the legitimate authority to gain access to detailed information on any aspects of its subunits performance. Organisations that integrate in this fashion have greater performance monitoring capabilities than do firms operating in conventional or other VMS channel systems. Marketers sometimes find it advantageous to pursue forward and backward integration through corporate VMSs. When a manufacturer owns and operates wholesaling and/or retailing units, the VMS is said to be forward-integrated. When retailers or wholesalers operate manufacturing facilities, a backward integrated VMS exists. Corporate VMSs are designed to achieve channel-wide goals and economies that follow from a more efficient division of labour with respect to at least one distribution function. Decision-making in corporate VMSs is not subject to distribution-level approval, as is true of conventional, administered, or contractual systems. Although channel members in each situation should be highly committed to the retailers channel, a retailer that chooses to engage in a backward-integrated VMS should encounter more of the following conditions : The opportunity to engage in centralised strategic planning and implementation The opportunity to, as the recognised authority or power source, dispense centralised directions throughout the channel. More formalised management-subordinate relationships The opportunity to use formalised systems by which channel coordination can be promoted A formalised system through which rewards and punishments can be dispensed In this scenario, our retailer can achieve control over how channel functions are performed across multiple levels of distribution. To arrive at terms of trade relating to prices, warranties, freight or trade allowances in conventional channels, retailers must negotiate across open markets with their firms. If their channel is plagued by environmental uncertainty, opportunism, or bounded rationality, such negotiations usually prove troublesome. No firm operates a complete corporate VMS from raw material to the final user across all distribution functions. A completely vertically integrated retailer would inevitably have diseconomies because each channel activity cannot achieve minimum average cost levels. As firms and markets grow, this waste can be avoided by dividing the separate stages of distribution into

distinct sectors (production, intermediaries, resellers and retailers) comprised of specialised firms. The size, functional capabilities, and numbers of these specialised firms are influenced by the scale economies predominating in the channel level they serve. Firms operating at manufacturing or retailing levels are increasingly teaming up with distribution service firms rather than investing in their own distribution units. Such firms realise they cannot perform the distribution function less expensively than say, FedEx, UPS, or Raodway Express Systems. Comparative Traits across the Three forms of VMS Trait Administered Orientation toward a Members have Common Goal different goals, but informally collaborate for common goals Locus of Authority Strictly at level Provisions for Members are division of labour autonomous but may agree to a division of labour, which may change their structure Commitment to a Low to moderate leadership subsystem Contractual Members have different goals, but some organisation exists lending to common goals. member Primarily at unit level Corporate Units molded into system to achieve common goals At top of the corporate hierarchy System is laid out to facilitate division of labour within entire system.

Members are autonomous but may agree to a division of labour, which may change their structure. Moderate to high High

When should Organisations Vertically Integrate ? Pursuing a vertical integration strategy is more appropriate when : Few organisations that perform specific channel functions efficiently are available in a market or industry, or when the environment in which a firm operates is uncertain. The terms, procedures, and/or products or services are unique or require lots of training to bring outsiders up to speed. Changing to new channel partners would prove extremely costly should existing partners fail to perform as expected. The buying decision is complex or high-involvement, or when required service levels are high. Close coordination between buyer and seller is essential to efficiently perform a channel function, or when transactions are sizeable and frequent. Buyers and/or prospects form strong relationships with salespeople rather than companies or products Channel members can potentially free-ride on the efforts of the others, or when it is difficult to monitor the activities of outsiders The product is in the early stages of its product lifecycle The product in question is closely tied to the firms core business An opportunity exists to gain substantial economies of scale in the performance of channel functions or flows

Benefits and Costs associated with Vertical Integration Benefits Reduce Transaction Costs Ensure Supply Improve coordination Enhance Technological capabilities Elevate entry barriers Secure operating economies (via technological interdependancies, eliminating risk premiums, stable relationships, obtaining capital resources) Secure supply and/or demand Elevate entry and mobility barriers Obtain a more satisfying atmosphere Achieve Product and Price Differentiation Achieve Diversification Costs Costs of overcoming Mobility Barriers Reduced flexibility in exchange partners Higher overall exit barriers Dulled incentives High capital investment requirements Loss of moral involvement

Loss of access to supplier or consumer/marketresearch or know-how Differing managerial requirements across internal distribution levels Communication distortion Internal opportunism Capital requirements Unbalanced throughput Reduced flexibility Loss of specialisation Loss of mobility Bureaucratic numbness to reality

Functional Areas where Synergies in Corporate VMSs have proven hard to obtain Functional Area Channels of Distribution Watch out for While products and markets may appear similar, distribution channels can differ radically. Even when channels are similar, the end-user markets may differ. Pricing practices often differ across units within a corporate VMS. Highly centralised and highly decentralised organisations do not mix easily within VMSs. Across the units that comprise a corporate VMS, agreement on the levels, deployment, and ownership of inventory often prove elusive. Cost allocation techniques are a continual source of strife across unit levels.

Pricing Organisational Integration Inventory Control Allocation of Costs

When should Corporate VMSs be Used? When firms operating in conventional channels have difficulty competing against VMSs, vertically integrated systems may become an attractive option. At other times, a desire to maintain healthy rather than dysfunctional levels of conflict can foster corporate VMSs.

The classic American view of vertical integration is based on ownership. But the ability to fashion successful distribution alliances among firms without any ownership may be a key to success in the future. Japanese firms practice a form of vertical integration that works through ongoing association and minimal ownership. This is known as Soft Vertical Integration. Softly integrated VMSs feature : Several companies providing the supply and distribution network for a single mother firm. High levels of self-sufficiency and autonomy in how these suppliers and distributors perform their assigned tasks Strong interpersonal links that lead to extensive information sharing among the firms. VALUE-ADDING PARTNERSHIPS : BEYOND VERTICAL MARKETING SYSTEMS Vale-adding partnerships (VAPs) involve a set of autonomous companies that work together to manage the flow of materials, goods, and services along an entire value-added chain. VAPs are mechanisms for building positive channel environment relationships by coordinating the performance of channel functions. The term value added chain comes from the field of microeconomics. There it is used to describe what occurs at the various steps a good or service passes through from the raw material stage to consumption by the end-user. Microeconomics has traditionally conceived of interchannel transactions as either arms length transactions (as in a directly managed conventional channel) or distribution hierarchies featuring common ownership (a corporate vertical marketing system). VAPs offer an alternative to those two types of relationships. Usually, these value-driven partnerships first develop between organisations occupying continuous distribution levels in the channel. VAPs operate much like the putting-out system of the industrial revolution. During this era, most production occurred in cottages and was coordinated by a merchant-manufacturer who supplied raw materials and marketed the final product. Over time, the emergence of inexpensive, centralised power sources and efficient manufacturing machinery tipped the balance of competitive power toward larger companies and corporate channel systems. These larger entities were able to approach economies of scale in their output. But now, in the age of low-cost computing and computing and communication, efficiencies may be tipping the balance of power back toward smaller organisations and market-based channel systems. In VAPs, smaller firms each perform one function within a value-added chain and coordinate their activities with the rest of the channel system. VAPs can emerge strictly from computerised linkages between organisations. They can also exist without any technological without any technological hookups at all. Either way, the ultimate success and continuity of VAPs depend largely upon the quality of the relationships between the participating channel managers. Each company in a value-adding partnership should cultivate relationships with a few two to six on each channel level suppliers of critical materials, finished goods, and/or customers. For VAP partners to help one another, they must set up effective ways to share information.. Having too many partners precludes this opportunity. Too many partners means too few repeat transactions and less opportunity for close relationships and other efficiencies to develop. At the same time, partners should avoid becoming overly dependant on too few relationships. A company operating at any distribution level may keep potential may keep potential VAP partners on reserve in case a regular channel partner fails to cooperate. If a partner As costs start creeping out of line, but they know that partner B can partner As costs start creeping out of line, but they know that partner B can easily bail out of the arrangement, they will be more likely to avoid predatory pricing.

Corporate VMS or VAP? The relationship between companies engaged in arms length vertical relationships is usually guarded. The traditional way to prevent gamesmanship in channel relationships is vertical integration. When organisations along the value-added chain operate under one management, the presumption is that they can better coordinate their activities and work toward a common purpose. They work toward economies of scale. In a value-adding partnership, each small company operating focuses on performing just one step or function within the value-added chain. Each unit can focus on improving its performance along this function. Personnel and career paths, plant and equipment, compensation schemes, accounting and inventory systems, managerial styles depend on the nature of the work to be done within the channel. Since each company in a VAP remains free to be different from the others, a diversity that fosters innovation sometimes develops. A relationship orientation naturally follows from the freeflow of information throughout the value-added chain. In spite of the positive differences, VAP also feature many advantages normally associated with corporate vertical marketing systems. Managers in a VAP usually take a genuine interest in the success of other companies in the VAP. The partnership of sharing orientation means they will work toward the common goal of making the VAP competitive. Each member has more command of facts about the market and empathy for the circumstances under which fellow VAP partners operate. Because information is shared throughout the value-added chain, each member knows a lot about the competition. Coordinating ones activities with the activities of ones trading partners becomes easier. VAPs can exploit the advantages flowing from the economies of scale by sharing purchasing services, warehousing, research and development, and of course, information. In short, Vaps combine the opportunity for coordination and scale associated with vertically integrated channel systems, and the flexibility, creativity, and lower overhead associated with administered or contractual channels. Management Issues in VAP relationships Those players who cooperate on the first round of exchange (a natural reaction during the honeymoon stages of a channel relationship) and thereafter do whatever their partner did on the previous move and are more successful. Those who fail to catch on are quickly exploited and eliminated. Robert Axelrods advice is particularly relevant to VAPs : Do not be the first member to play games; stay loyal to the relationship Reciprocate with both cooperation and the lack of it Do not be too greedy Do not be too clever and try to outsmart your partner Improving Relationships through Traditional Vertical Channel Design Another new view of the vertical relationship between manufacturers, resellers, and customers also is emerging. This view takes the administration of marketing channels a step beyond simple considerations of total quality, customer need satisfaction, or even exceeding customer expectations. This new view requires that organisations first think of every product as a service. In other words, each organisation should look at what the product in question does, rather than what it is. Once that perspective is adopted, the task of marketing the product to the next channel level becomes only one of the organisations opportunities to do something extra for its customers. The process that results is known as Bundling, which means that a desirable collection of benefits is spliced together to pursue or sustain a preferred customer relationship. Once an organisation views a product or service, there may be a willingness to contract out channel

functions that it is previously performed. This is known as Unbundling. In the long run the market will surely not take kindly to channel members that try to take advantage of suppliers and resellers. A far more preferable option is to take advantage of win-win channels, wherein suppliers or resellers receive the benefits of long-term channel relationships. Moreover, end-users gain more say over integration processes. In integrated relationships, rather than pitting suppliers (resellers) against one another to achieve the lowest cost, purchasing (distribution) managers work closely with a few select suppliers (resellers) to reduce total cost. Bundling and integrated relationships require companies to analyse more than the manufacturing or distribution costs they usually focus on. Companies that pursue integrated relationships must indeed identify transaction costs that is, everything above the marginal costs associated with making a product or delivering a service. Transaction costs include inventory costs, technical support costs, managerial and labour overhead costs, and just plain waste. They also include the cost of reaching agreements, ensuring that conditions of exchange are fulfilled (i.e. monitoring costs), and of being vulnerable to opportunistic behaviour. Transaction costs occur in every exchange. But excessive transaction costs are most likely to occur from the wrong kind of channel design namely excessive vertical integration. Companies that think of the products they make, buy or sell as services can gain economies along the entire chain of transactions. New products can be conceived when manufacturers think not just about how customers use it.