Channel arrangements traditionally consisted of loosely aligned manufacturers, wholesalers, and retailers, all of whom were trying to serve their own ends regardless of what went on elsewhere in the channel structure. In such arrangements, channel control was generally missing. Each member of the channel negotiated aggressively with others and performed a conventionally defined set of marketing functions.

Importance of Channel Control For a variety of reasons, control is a necessary ingredient in running a successful system. Having control is likely to have a positive impact on profits because inefficiencies are caught and corrected in time. This is evidenced by the success of voluntary and cooperative chains, corporate chains, franchise alignments, manufacturers’ dealer organizations, and sales branches and offices. Control also helps to realize cost effectiveness vis-à-vis experience curves. For example, centralized organization of warehousing, data processing, and other facilities provide scale efficiencies. Through a planned perspective of the total system, effort is directed to achieving common goals in an integrated fashion.

Channel Controller The focus of channel control may be on any member of a channel system: the manufacturer, wholesaler, or retailer. Unfortunately, there is no established theory to indicate whether any one of them makes a better channel controller than the others. For example, one appliance retailer in Philadelphia with a 10 percent market share, Silo Incorporated, served as the channel controller there. This firm had no special relationship with any manufacturer, but if a supplier’s line did not do well, Silo immediately contacted the supplier to ask that something be done about it. Wal-Mart (in addition to KMart and Target) can be expected to be the channel controller for a variety of products. Among manufacturers, Kraft ought to be the channel controller for refrigerated goods in supermarkets. Likewise, Procter & Gamble is a channel controller for detergents and related items. Ethan Allen decided to control the distribution channels for its line of Early American furniture by establishing a network of 200 dealer outlets. Sherwin-Williams decided to take over channel control to guide its own destiny because traditional channels were not showing enough aggressiveness. The company established its own chain of 2,000 retail outlets. These examples underscore the importance of someone taking over channel leadership in order to establish control. Conventionally, market leadership and the size of a firm determine its suitability for channel control. Strategically, a firm should attempt to control the channel for a product if it can make a commitment to fulfill its leadership obligations and if such a move is likely to be economically beneficial in the long run for the entire channel system. For example, the thought of winning a contract to supply a mass retailer may lead a company to modify existing channel arrangements. After all, Toys “R” Us accounted for a fifth of the U.S. toy market in 199

6. The Home Depot sold more home improvement products than all hardware stores combined, and the quarter of the underwear purchased by Americans came from Wal-Mart (an estimated 23 percent of the U.S. population shops in Wal-Mart on an average day). Landing an account with one of these mass retailers can double or even triple a supplier’s annual sales. However, rapid revenue growth is not always accompanied by a surge in profits. The strain of coping with high volumes and the service needs of powerful customers can put tremendous pressure on suppliers’ profit margins if they attempt to conduct business as usual. Some manufacturers that supply mass retailers even find that although their sales rise faster than those of other manufacturers, their earnings growth is slower.

Vertical Marketing Systems

Vertical marketing systems may be defined as: professionally managed and centrally programmed networks [that] are preengineered to achieve operating economies and maximum market impact. Stated alternatively, vertical marketing systems are rationalized and capital-intensive networks designed to achieve technological, managerial, and promotional economies through the integration, coordination, and synchronization of marketing flows from points of production to points of ultimate use. The vertical marketing system is an emerging trend in the American economy. It seems to be replacing all conventional marketing channels as the mainstay of distribution. As a matter of fact, according to one estimate, vertical marketing systems in the consumer-goods sector account for about 70 to 80 percent of the available market. In brief, vertical marketing systems (sometimes also referred to as centrally coordinated systems) have emerged as the dominant ingredient in the competitive process and thus play a strategic role in the formulation of distribution strategy. Vertical marketing systems may be classified into three types: corporate, administered, and contractual. Under the corporate vertical marketing system, successive stages of production and distribution are owned by a single entity. This is achieved through forward and backward integration. Sherwin-Williams owns and operates its 2,000 retail outlets in a corporate vertical marketing system (a case of forward integration). Other examples of such systems are Hart, Schaffner, and Marx (operating more than 275 stores), International Harvester, Goodyear, and Sohio. Not only a manufacturer but also a corporate vertical system might be owned and operated by a retailer (a case of backward integration). Sears, like many other large retailers, has financial interests in many of its suppliers’ businesses. For example, about one-third of DeSoto (a furniture and home furnishings manufacturer) stock is owned by Sears.

Finally, W. W. Grainger provides an example of a wholesaler-run vertical marketing system. This firm, an electrical distributor with 1998 sales of $900 million, has nine manufacturing facilities. Another outstanding example of a vertical marketing system is provided by Gallo, the wine company. The [Gallo] brothers own Fairbanks Trucking company, one of the largest intrastate truckers in California. Its 200 semis and 500 trailers are constantly hauling wine out of Modesto and raw materials back in including . . . lime from Gallo’s quarry east of Sacramento. Alone among wine producers, Gallo makes bottles two million a day and its Midcal Aluminum Co. spews out screw tops as fast as the bottles are filled. Most of the country’s 1,300 or so wineries concentrate on production to the neglect of marketing. Gallo, by contrast, participates in every aspect of selling short of whispering in the ear of each imbiber. The company owns its distributors in about a dozen markets and probably would buy many . . . more . . . if the laws in most states did not prohibit doing so. In an administered vertical marketing system, a dominant firm within the channel system, such as the manufacturer, wholesaler, or retailer, coordinates the flow of goods by virtue of its market power. For example, the firm may exert influence to achieve economies in transportation, order processing, warehousing, advertising, or merchandising. As can be expected, it is large organizations like Wal-Mart, Safeway, J.C. Penney, General Motors, Kraft, GE, Procter & Gamble, Lever Brothers, Nabisco, and General Foods that emerge as channel captains to guide their channel networks, while not actually owning them, to achieve economies and efficiencies.

In a contractual vertical marketing system, independent firms within the channel structure integrate their programs on a contractual basis to realize economies and market impact. Primarily, there are three types of contractual vertical marketing systems: wholesaler-sponsored voluntary groups, retailer-sponsored cooperative groups, and franchise systems. Independent Grocers Alliance (IGA) is an example of a wholesaler-sponsored voluntary group. At the initiative of the wholesaler, small grocery stores agree to form a chain to achieve economies with which to compete against corporate chains. The joining members agree to adhere to a variety of contractual terms, such as the use of a common name, to help realize economies on large order. Except for these terms, each store continues to operate independently. A retailer-sponsored cooperative group is essentially the same. Retailers form their own association (cooperative) to compete against corporate chains by undertaking wholesaler functions (and possibly even a limited amount of production); that is, they operate their own wholesale companies to serve member retailers. This type of contractual vertical marketing system is operated primarily, though not exclusively, in the food line. Associated Grocers Co-op and Certified Grocers are examples of retailer-sponsored food cooperative groups. Value-Rite, a group of 2,298 stores, is a drugstore cooperative. A franchise system is an arrangement whereby a firm licenses others to market a product or service using its trade name in a defined geographic area under specified terms and conditions. In 1994, there were more than 2,800 franchisers in the United States, twice as many as in 198

4. Practically any business that can be taught to someone is being franchised. In 1995, sales of goods and services by all franchising companies (manufacturing, wholesaling, and retailing) exceeded $600 billion. Approximately one-third of all U.S. retail sales flow through franchise and company-owned units in franchise chains. In addition to traditional franchising businesses (e.g., fast-food), banks are doing it, as are accountants, dating services, skin care centers, tub and tile refinishers, tutors, funeral homes, bookkeepers, dentists, nurses, bird seed shops, gift wrappers, wedding consultants, cookie bakers, popcorn poppers, beauty shops, baby-sitters, and suppliers of maid service, lawn care, and solar greenhouses. The Commerce Department forecasts that by the year 2000 franchising will account for half of all retail sales. Four different types of franchise systems can be distinguished:

1. The manufacturer-retailer franchise is exemplified by franchised automobile dealers and franchised service stations.

2. The manufacturer-wholesaler franchise is exemplified by Coca-Cola and PepsiCo, who sell the soft drink syrups they manufacture to franchised wholesalers who, in turn, bottle and distribute soft drinks to retailers.

3. The wholesaler-retailer franchise is exemplified by Rexall Drug Stores, Sentry Drug Centers, and CompUSA.

4. The service sponsor-retailer franchise is exemplified by Avis, Hertz, and National in the car rental business; McDonald’s, Chicken Delight, Kentucky Fried Chicken, and Taco Bell in the prepared foods industry; Comfort Inn and Holiday Inn in the lodging and food industry; Midas and AAMCO in the auto repair business; and Kelly Girl and Manpower in the employment service business. Vertical marketing systems help achieve economies that cannot be realized through the use of conventional marketing channels. In strategic terms, vertical marketing systems provide opportunities for building experience, thus allowing even small firms to derive the benefits of market power. If present trends are any indication, by the year 2000 vertical marketing systems should account for almost 90 percent of total retail sales. Considering their growing importance, conventional channels will need to adopt new distribution strategies to compete against vertical marketing systems. For example, they may

1. Develop programs to strengthen customers’ competitive capabilities. This alternative involves manufacturers and wholesalers in such activities as sponsoring centralized accounting and management reporting services, formulating cooperative promotional programs, and cosigning shopping center leases.

2. Enter new markets. For example, building supply distributors have initiated cash-and-carry outlets. Steel warehouses have added glass and plastic product lines to their traditional product lines. Industrial distributors have initiated stockless buying plans and blanket order contracts so that they may compete effectively for customers who buy on a direct basis.

3. Effect economies of operation by developing management information systems. For example, some middlemen in conventional channels have installed the IBM IMPACT program to improve their control over inventory.

4. Determine through research the focus of power in the channel and urge the channel member designated to undertake a reorganization of marketing flows. Despite the growing trend toward vertical integration, it would be naive to consider it an unmixed blessing. Vertical integration has both pluses and minuses more of the latter, according to one empirical study on the subject. For example, vertical integration requires a huge commitment of resources: in mid-1981, Du Pont acquired Conoco in a $7.3 billion transaction. The strategy may not be worthwhile unless the company gains needed insurance as well as cost savings. As a matter of fact, some observers have blamed the U.S. automobile industry’s woes, in part, on excessive vertical integration: “In deciding to integrate backward because of apparent short-term rewards, managers often restrict their ability to strike out in innovative directions in the future.”