Over the next five years, industrial distributors will face increased profit pressure even as the manufacturing economy begins to recover. This profit squeeze will be caused by functional unbundling occurring in supply chains throughout the U.S. economy.

Unbundling is the process by which the traditional economics of industrial distribution stop working because customers are given lower cost, higher service alternatives to the sub-components within the traditional model. While industrial distribution will continue to remain a viable industry, distributors will find themselves forced to rethink the ways they make money in the supply chain.

We identified the unbundled supply chain as a key future scenario in our recent Facing the Forces of Change: Future Scenarios for Wholesale Distribution study for the National Assn. of Wholesaler-Distributors. Today, those predictions show signs of moving ahead more rapidly than expected.

This article lays out the dynamics of an unbundled supply chain and explains the key strategies for both large and small industrial distribution companies. The forces behind an unbundled supply chain will also lead to new fee-for-service pricing models, increasing use of functional discount programs, and greater focus on profit optimization.

Industrial distributors exist to solve the problems customers have in sourcing, acquiring, handling and using products. The primary functional activities of industrial distributors fall into three major areas:

Demand Anticipation — Industrial distributors hold inventory that can be delivered quickly to customers based on often unpredictable demand patterns.

Demand Generation — Industrial distributors take responsibility for sales and marketing activities at the local level that are not easily or economically done by a manufacturer. Customers rely on trained inside or outside salespeople to obtain technical and business assistance in product selection and use.

Demand Fulfillment — Industrial distributors handle the physical movement of product from manufacturer to customer. Distributors also provide services associated with product handling, such as in-plant stores or crib management. (See Figure 1, p. 92)

Traditionally, industrial distributors have been a one-stop shop for all of these activities and have been "paid" in the form of gross margin — the difference between the selling price to the customer and the cost of a product to the distributor. Any services are provided "for free" as part of this margin. If all goes well, the total cost of performing these functions is less than total gross margin dollars.

The traditional distribution model is coming under pressure because alternative sources of these supply chain and marketing channel activities are emerging.

Consider demand generation. The Internet gives manufacturers an affordable means to provide information to both distributors and customers. Industrial customers are increasingly looking online for product specifications, warranty and rebate information, technical information, potential suppliers, and standard pricing information.

Industrial manufacturers know that the Internet is a viable source of content, but can be poorly suited to the buying behavior and requirements of their end customers. Few industrial customers are willing to migrate their entire purchasing process to a direct relationship. Instead, manufacturers are communicating more frequently and more intensely with their end-use customers, but using the Internet to integrate traditional channel partners.

These emerging "Coordinated Channels" systems are unbundling elements of demand generation activities from demand anticipation and fulfillment. (See Figure 2) A new crop of technology companies is aggressively marketing these Partner Relationship Management and Channel Commerce systems. A number of industrial manufacturers are experimenting with or have already installed these systems.

Unlike the many now-defunct dot-com start-ups, these technology companies recognize that the Internet provides the greatest benefit by enhancing the channel, not by replacing distributors. The interconnection between trading partners increases the likelihood that a distributor can turn a pre-sale inquiry hitting a manufacturer's Web site into a product sale.

These developments pose interesting challenges for the traditional economic model. As customers begin to educate themselves by relying on the manufacturer for product information, the role of the distributor's sales force as a source of information is reduced for a growing segment of customers.

Another type of unbundling is occurring in the physical movement of goods to customers. Third-party logistics providers, who have traditionally been package-handling enterprises, are moving "inside the box" by offering product-handling services such as warehouse management, order processing, pick/pack/ship, just-in-time parts delivery, and many other "wholesale distribution" functions. Although the inventory legally may still be owned by the manufacturer, all of the assets required to ship products out of the plant — warehouses, trucks and personnel — are off the manufacturer's balance sheet.

As a result, manufacturers are increasingly turning to logistics companies to provide "master distribution" services to the highly fragmented industrial distribution channel. U.S. Census data documents a 30 percent decline in the number of manufacturer-owned sales offices and distribution centers over the past 15 years, even as total shipments grew by almost 50 percent during the same period.

There are three implications of a shift of logistics away from distribution. One, local distributors are able to stock less inventory and rely on the manufacturer — via supply chain logistics companies — to drop-ship to customers on their behalf. Two, manufacturers are reducing or eliminating stocking requirements for their authorized channel partners. Three, manufacturers can more easily serve direct business. These developments also suggest very dramatic growth scenarios for the existing master distributors in the industrial channel.

Traditional distributor economics allow a weaker component of the business to subsidize a stronger one — an inefficient warehouse with an above-average sales force — as long as average profitability remains positive. Unbundling squeezes profits because portions of demand generation and demand fulfillment activities are moved away from the traditional channel. (See Figure 3)

When this transition has occurred in other industries we've studied, customers and manufacturers expect channel margins to drop since the distributor is adding less value. Either overhead shrinks or distributors must find other ways to justify their gross margin. For example, customers that educate themselves using online information provided by a manufacturer will not want to pay for the overhead of your sales force. As the traditional model is slowly unbundled, manufacturers and customers will not pay for services they do not want or need.

Even more threatening is the reality that distributors will be forced to benchmark their activities against the performance of specialists. Few companies in any industry can produce excellence in every one of the many activities they perform.

One likely outcome of these developments will be a shift from mark-up margins on product sales to service fees. A fee-for-service model provides a more direct and accountable means of measuring value and functions in an unbundled channel. Distributors also have the opportunity to finally get paid for the service activities they provide to customers.

Integrated supply laid the groundwork for this evolution by introducing the concept that product price should be unlinked from the procurement and inventory services required to handle the product. Unfortunately, these agreements have floundered because ongoing process improvements have not generated sufficient savings after one-time reductions in product price.

Today, most industrial buyers are still unwilling to pay for services that they used to get "for free" — even if they acknowledge the economic logic behind the concept. Some customers are already denouncing the fee-for-service trend as self-serving behavior by distributors.

Functional discounts will also grow in the industrial channel as manufacturers attempt to manage the fragmenting roles of their traditional channel. In functional discount programs, distributors can be compensated in an unbundled model because payments (discount off list) are tied to the actual activities being performed.

However, there are serious barriers to making these approaches more widespread in the industrial channel. In reality customers, not manufacturers, are best positioned to determine the value their channel provides. Another challenge is that functional discounts are a form of price discrimination and therefore raise legal issues when being implemented.

Understanding your internal cost structure for each activity is vital to success in an unbundled world. Activity-based costing tools allow a distributor to track internal costs and determine the break-even price for its services. Instead of expensive ABC studies, most distributors should rely on stand-alone ABC technology modules that can extract data from existing corporate systems to provide real-time analysis of costs and profits.

It will not be profitable to serve some customers, such as those who place many small orders or the ones who ask for frequent product demos and then purchase through a lower cost outlet. High service customers with low willingness to pay are much less profitable on a fully allocated cost basis.

Distributors who adopt a fee-for-service model stand to benefit in an unbundled channel as their competitors struggle to serve the worst customers. Even so, distributors who force customers to pay for what they use — or even fire unprofitable customers — will find it hard to accept lower sales in exchange for greater profitability.

Keep in mind that a purely customer-based approach to profit optimization will overestimate the gains from firing unprofitable customers. Many distributors rightly fear the potential loss of volume discounts and the reduction in overhead utilization if customers choose to migrate their purchases to competitors rather than pay the true costs of their service requirements.

Naturally, there is no guarantee that our unbundled scenario from Facing the Forces of Change will fully evolve in the industrial channel. However, recent news events, as well as trends from other distribution industries, suggest that unbundling is happening faster and more intensely than many distributors believed. Now is the time for every industrial distributor to play to win instead of playing not to lose.