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EP245 Lecture 4



Today, we're going to be talking about distribution channels. How does your product get from your company to your customer? You're all familiar with the business model canvas. We've already talked about value propositions and we've talked about customer segments in the last two lectures, but today we're going to talk about channels. So let's take a look at our business model canvas. Channels is just one of the nine boxes in the canvas and it's a series of hypothesis of how does our product get from our company to our customer. Now, when companies first started, there were essentially manufacturing concerns and they hired agents, outsiders to be their sales channel, and the first types of companies we had made physical products and therefore, had physical channels--salespeople, stores, etc., but with the emergence of the web, we now have web and mobile channels. And so a choice for us is picking the right distribution channel. We're going to talk about physical versus web mobile channels.

Distribution Channels Overview

So one of the best ways to understand channels is to think about how business first started. We first started distributing and making physical products--cars, food, utilities, etc. and we distributed them through direct sales force--that is people you shook hands with, look in the eye and met. And it wasn't until the mid-20th century when we actually started selling virtual products-- things that didn't quite exist physically like insurance, stocks and bonds, enterprise softwares, shrinkwrap software start to be distributed through physical channels but they didn't exist in the real world. But it wasn't until the mid-1990s with the emergence of the Internet that we were able to distribute physical products through a virtual channel. Think of Amazon or Zappos or Netflix--even consumer electronics sold through the web. And what's happened in the beginning of the 21st century is we now have products that don't exist at all--Facebook, Twitter, Google--they're all bits, and they're also distributed via the web. This virtual virtual distribution channel allows for easier customerization, optimization, and allows you to change both product and channel almost on the fly. Through the rest of this lecture, we're going to show you which channels might be optimum for your startup and allow you to chose which one to pick.

Your Product

Thinking about the 2 x 2 matrix on the last slide, a real question for you is-- how does your product get to the customer? I think the real questions start with what type of product do I have. Do I have a product made out of bits that is--is it virtual or is my product a physical product. Now, I think that's a simple choice you need to make right now. Is your product physical or is it bits. The next thing you need to ask is what's going to be my distribution channel. Is it going to be direct--that is am I going to either offer it on a website AOL or have direct sales people that work for me, or is it to be indirect. That is, am I going to put it on a third party website like an Amazon or a web aggregator, or physically, am I going to use system integrators or VARs or some other indirect channel like a retail store. Just select what you think will work for your product, and so later on in the lecture, we'll analyze the potential choices for you to pick for your product.

Your Product Solution

But the good news is there really is no answer. As we get further on in the series of videos, we'll get to see how you end up choosing which is right for your company.

Web Distribution

If you remember in our last slide, one of the choices was whether you were using physical or virtual distribution channels. Let's take a look at virtual channels, which are not only the web but also might include iPhone apps or the Cloud as well. The first choice might be dedicated e-commerce. That is you might have a website that belongs to you and that is one choice. Another choice is that you might have an app that runs on a mobile device, and mobile devices like Android or Apple and others and Microsoft require you to use their platform app store and so that might be a choice. Another choice is to use two-step distribution that is there might be other distributors who have major web presences like Amazon, Wal-Mart, other local and regional stores. And you might actually sell your virtual products through theirs or physical products. You might use an aggregator. An aggregator is somebody who takes a vertical market approach. Insurance, shoes, etc. Some examples are, for insurance, Lending Tree or Zappos. Another might be social commerce. Social commerce sites for distribution might include Facebook, Twitter, etc. Zynga, which is a video game company, uses predominantly Facebook as its platform. And then finally flash sales. Examples include Groupon and Living Social. Now, the first instinct of almost any startup founder is when you understand all the choices for distribution channels is to say yes. And the question is, yes to what? You can't afford to pick multiple channels on day one. Most successful startups pick one of these and then may eventually expand into others. So the question for you is what's going to be your first distribution channel on the web, Cloud, or for mobile devices?

Physical Distribution

Maybe your product requires a physical distribution channel. Let's take a look at all the choices that you might have when you start a company. The first one is you might be an OEM. OEM stands for original equipment manufacturer. You might have a component. Let's say a graphics chip that goes inside of someone else's laptop. So you might be a graphics supplier to Apple or Hewlett-Packard. But it's Apple's and HP's name and their brand that shows up on the outside of the box. And so while you're making money, it is their marketing and brand. So for a system integrator, you might be selling to a company. Let's say you're Cisco. But you're selling to somebody who's building an entire telephone switching network and this system integrator would take your component, your switches and routers, and actually build out a system that includes devices from other companies and they add some value-added software and additional hardware and create an entire system for an end user. A value-added reseller might take a computer system and other pre-packaged softwares from other third-party vendors and maybe some utilities of their own and sell a turnkey solution to an end user and so they build less complex systems with less value added than system integrators but they could be great partners. In a physical channel, a direct sales force are sales people that work for you directly and typically sell directly to the end user. Now if you're delivering a physical product, one of the alternate channels that you might want to consider is the web or online sales as well. So for some industries, distributors play a pivotal role in the distribution of the product. They provide wholesale and warehousing. They provide distribution and accounting, bill collection, etc. And distributors might sell to dealers. Most dealers are just simply storefronts. Some of them might actually add some service or support but they're essentially an extension of the distribution channel, and they talk to the end users. So dealers might not have a physical storefront for end-user customers, but retailers are all about main street and talking to your customers. Another form of retailer are mass merchants. So instead of just small storefronts, they aggregate tens or hundreds of thousands of products under one roof. Retailers and mass merchants often, though not always, get their products supplied through distributors.

Distribution Complexity

Here are four examples of distribution channels--system integrator, dealer, web, direct sales. I want you to start thinking about which channel can handle the most complexity and which channel can handle the least. Enter the numbers 1 through 4.

Distribution Complexity Solution

So we just discussed the number of distribution channels available to a startup and we talked about picking one but what's really interesting is the solution complexity that each channel can handle. That is system integrators are designed to handle complex systems. And so therefore on the x-axis, we see increasing complexity of what each channel can actually have. And what's the sales and marketing complexity of each sale on the y-axis? So for example, system integrators are great for putting in defense systems or telecom systems that require hundreds or thousands of moving parts and software and hardware. Where on the other extreme, the complexity of selling toner over the web.  Incredibly simple. Simply, consumers already know what they want and the channel just simply is there to fulfill end-user demand. And the marketing complexity, would simply just say toner for you printer. So when we look at a sales channel, we talk about what's called value-added. How much value is the channel adding? And as we go up this curve, we're seeing higher value added at each step. Web: Telesales, almost no value added. Retail maybe adds a little support. VARs, a lot of integration and support. Direct sales, that's direct connection to your factory. System integrators, not only supporting, servicing, and integrating your products but potentially tens of others. So each portion of this channel is adding higher and higher value. Now what's interesting is this higher value added comes with a cost. Typically, higher volume systems are at the low end. So you might be selling hundreds or hundreds of thousands of cases of toners, but you might be doing ten large system integrations a year. So more examples, retail channel might carry PCs. VARs might do video editing systems that are turnkey. For direct sales though, this is the anomaly. Remember, these are the salespeople who work for you directly. One of the interesting things that you'll be considering later is how much you're paying your salespeople and how many dollars they need to be bringing in every year to justify their existence and bringing a profit to their company. So this ends up to be an interesting calculation. Your direct sales people can actually be the one talking to the consumers directly or they could be the ones selling to system integrators, VARs, retail, and web and telesales people and so this is a math problem we'll think about in the coming discussions.

Product Channel Fit

So let's take a look and see how much you've learned about product channel fit. If you remember we talked about system integrators, having your own direct sales force, the role of value added resellers, retail, and web or teller sales, and let's see which products do you think would fit bet under each channel. So select one product for each channel.

Product Channel Fit Solution

So for teller sales, I thought the best answer was toner. Now, for retail, I thought the best answer was PC's. For VARs, turnkey video editing systems. And for direct sales, insurance has been sold that way for the last 100 years. And for system integrators, putting together a telecommunications network is their expertise.

Direct Channel Fit

So let's take a look at the channel economics. In other words, how are we going to make money? So let's take a look at a direct sales example. You have a sales force and you're selling directly to the end consumer. So let's assume that the list price of your product is $100. So one of the first questions in thinking about how to come up with this $100 list price is to understand how much did it actually cost me to manufacture a product. Now, in the web, it might be the cost my engineers. But in a physical product, it might be the costed bill of materials coming out of my factory. And so let's assume for the sake of discussion that that was $33, $33 to build my product. Next, let's take a look at the cost of my R&D, that is my engineering; the cost of my direct sales people, maybe commissions or direct sales compensation; and then general and administration costs, what it cost me to have leases and lunches and free snacks, and that might be another $20. And so right now it's $53 just to keep the lights on in my building. Now something we should consider is that no end-user pays was priced. So let's assume that this area represents a discount from the list price, let's say 10%. That means your revenue to your company would not be $100 but $90. So wait a minute, you're getting $90 but you spent a total of $53 building the product and keeping the lights on and that leaves right in the middle how much profit you have. In this case, it would be $37. So, you're selling costs were embedded here, this was the commission or direct sales costs or whatever you were paying your direct sales people and you made $37 selling directly.

Indirect Channel Economics

So now that we will update channel economics for direct sales, let's go take a look at what the channel economics would look like if we were selling through an indirect channel, resellers. So as you could see, we still have the same cost of goods to manufacture the product as before, $33. Now, what's kind of interesting is if we will look at the R&D, selling costs, and general administration cost, our R&D might be the same and keeping the lights on the building might be the same, but our selling costs are lower because we're selling through resellers. We still needed a direct sales person but this time instead of them talking to every possible end user, they are actually talking to a few number of resellers. So let's say instead of $20, our SG&A, sales, general, and admin costs plus R&D this time is $15 rather than 20, and that the total of getting the product out the door is now $48. Just like before, our list price is $100 and in the store the end user expects maybe a 10% discount and so the revenue to the sales channel this time, not to us, is $90. But this time, we have resellers and the resellers don't work for us. They're the ones actually selling the product, and they take the difference between $90 and let's say $70, which they're going to pay us. And do their profit is $20 for carrying, stocking, and reselling our product. And our profit is just $22 this time because we're selling through someone else. But remember, our costs were lower. So one of the tradeoffs in using what's called an indirect channel is that your selling costs are lower but you're giving a big chunk of your profit to other people not part of your company.

OEM Channel Economics

So let's take a look at channel economics, but this time assume you are in original equipment manufacture and your product becomes some other customer's cost of goods. So let's assume this diagram on the top is a laptop computer sold for a computer reseller channel. And let's say this laptop sells for $3000 and like any other channel, the end user assumes they get a discount. The reseller is taking a profit but gee that reseller was actually buying these laptops from a master distributor. Now remember, back here the manufacturer of the laptop had their cost of goods sometimes abbreviated COGS, which include manufacturing costs, components, etc. And finally, they had their sales costs, their R&D costs, and their general and administrative costs. And finally, after all that, they make a profit. So where do you fit? This is just a laptop manufacturer. Assume this is Apple or HP. But in this case, you were a graphics chips supplier to Apple or HP. And you were just one single component on their motherboard. Well, if you really think about it, you were fitting in here in their costs of goods. And now your cost of goods; your sales, general, and administrative costs; your profit; and now your reseller costs. Now, in some cases, you might've been selling directly your parts in to HP or Apple and you would not have reseller costs but you would have more direct sales costs. Remember, this stands for sales, general, and administrative costs and so your profit is miniscule compared to what the laptop manufacturer is making but you might be selling millions of single chips and so that profit is multiplied by that high volume when you OEM a product.

Channel Profit Fit

For this quiz to check your understanding of the channel diagrams, match the appropriate channel diagram to the corresponding channel and put the appropriate number in the correct box.

Channel Profit Fit Solution

So direct sales was #2, OEM was #1, distributors was #4, and resellers was #3. Good job.

JerseySquare Channels

So let's take a look at our Jersey Square team and see what they've done with channels. By the time they've gotten to this part in the canvas, they've actually recognized that besides working on channels they actually have two distinct customer segments, sport jersey owners and single-game attendees. And just if you remember, by the time you understand you have multiple segments, that means you need multiple value propositions and multiple revenue streams. And you might also have multiple channels in customer relationships but at least at this point and they're thinking the only thing that matches the channels are the value prop and revenue streams. And so let's see what they've learned about the channels. In getting out of the building, they understood that both segments, the sports jersey owners and the single-game attendees, really liked the idea of going to their website and actually being able to buy or rent a jersey. But their hypothesis that stadium shop owners and vendors would be a channel and/or a partner early on turned out to be incorrect. In talking to those two channels, they discovered that they viewed Jersey Square as a potential competitor and they also understood the sales cycle of selling to them as a channel but it was going to be a lot longer than they had to start up their company. And so they kind of put this off the list for now and they might get back to this later. They also started looking at direct mail and realized that direct mail was nothing more than a potential customer acquisition activity rather than a channel itself so that just left them with a direct website and potentially ticket websites and remember your goal as a start up is not to make the longest list of potential channels but in fact to narrow down what is it you're going to be focusing on in your early days.

Optional Reading

So for next week, I'd like all of you and each one of your teams to come up with your own channel diagram. What's a channel diagram. Let me give you a couple of examples. Here's one for book publishing with the revenue, net and gross to the company shown. Here's how the book publishing economics work. Here's the delivery system. Here's another example for medical devices, how it works for farm channels, what the service provider model looks like, what part is product and service in the dental product channel. Another example of a licensing revenue model, another example for medical devices for channel strategies and cost. Another dental example for distributors, and an online rental channel example. Each one of these are different--there is no right way, but diagraming it out makes you answer each one of the questions implicit in the how does our product get from us to our ultimate end user and how do we make money a step at a time. These samples will be online, see the link below. See you next week.