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Changing Channels

You thought reengineering was hard? Try switching to a direct-sales mode.
Kris Frieswick, CFO Magazine
February 1, 1999

Parker Hannifin Corp. is in the advance guard of a sales revolution. The $4.6 billion Cleveland-based maker of industrial and aerospace components sells directly to about half its customer base, and the percentage is growing. Its direct customers get to bypass the network of distributors that operates by purchasing Parker products, tacking on a profit margin and reselling the products to the end users. But while its traditional base of direct customers is large original equipment manufacturers, these days more smaller, non-OEMs ask to buy direct-- and Parker answers the call.

"There's a definite trend to direct sales, and it's being driven by the customer," says CFO Mike Hiemstra, who is also Parker's vice president of finance and administration. In such profound shifts, finance chiefs should always be involved, he notes. "What you are talking about is really cutting out the cost of distribution" and passing the savings on to customers, who are often quite insistent about getting that break.

The path to increased direct selling at Parker, however, is itself less than direct. To avoid angering its distributors, the company last year created a special division called Parker Integrated Partners to manage direct sales to smaller customers. Companies interested in any of Parker's 1,400 product lines call the "PIP" 800 number, order what they want, and receive one consolidated invoice--all of which fits the customer's definition of direct. Then, however, Parker routes the order to a distributor, which fulfills the order and gets a margin on the sale.

"The distributors are happy with this model right now," says Mike Marvin, Parker's vice president of marketing services, "because they are still involved in the process."

Ever since Dell Computer Corp. turned the PC industry on its ear in 1984 by launching its own phenomenally successful approach to reaching its market-- prompting archrival Compaq Computer to follow suit last year-- direct selling has been the hottest retailing trend around. In addition to computers, you can now buy Barbie dolls, steaks, airline tickets, cars, insurance, jeans, and a host of other products directly from the companies that make them. Meanwhile, middlemen look on warily, or partner to keep their hand in as the new distribution processes evolve.

And direct selling has an even greater allure for manufacturers in the vast business-to-business sector, where the U.S. Commerce Department estimates that more than $2.5 trillion of product moved through merchant wholesalers last year. Markups for resellers can be handsome indeed--industrial products average gross margins of 28 percent, one recent survey says--and producers have long wanted some of those margin dollars for themselves.

Disrupting the Distributors
For all manufacturers, though, a major impediment to going direct is the threat of alienating established distributor relationships. Furthermore, makers of various parts for industry rely so heavily on distributors for sales and marketing that they don't even know who is buying their products. And the difficulty filling that role can be just the start of the new direct seller's problem.

Whether in the retail or wholesale environment, "the profitability of a direct model is fundamentally different from the profitability of a distribution model," says Eric Wright, senior vice president of REL Consultancy Group. And the financial impact of a shift can hit hard on the bottom line. "People do this without thinking about the fact that this is going to be a profit sponge. They think that they are all of a sudden going to make all this money by cutting out the middleman, but they often start out losing money," Wright explains. "You have to let the finance team look at this model and analyze what the profit implications are."

One company doing this is Kennametal Inc., a $1.7 billion Latrobe, Pennsylvania, maker of tools, dies, and other metalworking products. The company sells through a variety of channels--it even owns one distribution company--and executives work closely with the marketers to identify and resolve potential problems. "We spend most of our time identifying where the channel conflicts are, and whether the additional channels are worth the loss of sales that could result from that conflict," says David Tilstone, Kennametal's global marketing manager.

Companies that have taken steps toward direct sales recommend cautious analysis first. "If you want to sell direct, you really have to look at the business case," says James M. Schneider, senior vice president of finance at Dell Computer. The questions to ask: Is there value-added in the middleman? and, How ready is your company to take over for distributors? "It has to be a financial decision," he warns. To be successful, manufacturers must save money when taking over for the distributor--without endangering the current revenues being generated through the distribution channel.

"Most manufacturers of industrial products are skittish about cutting off distributors that have friends in the big manufacturing plants," says Daniel Heard, chairman of John H. Carter Co., a New Orleans- based distributor that represents Parker Hannifin, among other industrial products makers. "If one of my manufacturers cut me off to sell direct and didn't give me a big cash settlement to stay out of the business, I would be forced to go to his competitor and move my customers to the new products. Most industrial products manufacturers are very squeamish about the short-term financial impact of such a change."


Until recently, the risks were so great, and the path to conversion so difficult, that few manufacturers tried it. The movement started in the early 1980s, when electronic data interchange (EDI) began hardwiring buyers and sellers through dedicated data lines. This reduced purchasing costs for both the manufacturers and their customers. But EDI was, and is, expensive to implement and hard to configure. And it didn't help manufacturers find customers, according to REL's Wright.

Enter: the Internet
The Internet, however, changed everything, providing an inexpensive, nearly ubiquitous platform that serves as a direct conduit between makers and buyers. This new technology spread like wildfire in the business-to-business environment. Last year, an estimated $17.2 billion of company sales was conducted over the Internet--nearly twice that in consumer markets, according to International Data Corp., a technology research firm in Framingham, Massachusetts. At the same time, reliable inventory, logistics, accounts receivable, and electronic-commerce software programs emerged that allowed manufacturers to start duplicating the distributors' role at a fraction of what it would have cost them to do it a decade ago.

"There are software tools available today, especially immediate-settlement tools, that afford companies the ability to move to direct in a much faster way," says Wright. He predicts cheaper products creating "an exponential growth of companies moving from distribution to direct sales."

Recently, customers seem to be especially aggressive, discounting the value of distributors. Lexmark International Inc. confirms that a handful of customers has asked the company to slice distributors out of its network in recent months--even though the Lexington, Kentucky, printer manufacturer already gives middlemen a limited role. Lexmark sells directly to customers through an in-house sales force, only then handing sales over to a team of distributors that fulfills the order and handles custom configuration, installation, and training. Lexmark views its current system as adding value, so the company hopes to satisfy customers without dropping the limited-distribution approach.

"In many cases, the reseller has a relationship with the end-user, but it's not apparent that there is a lot of value coming from that relationship," says Dee Allott, vice president and general manager of Lexmark's North American business printer division. "That is probably why most of these direct requests are coming in." But the direct requests are increasing, he says, and "we have to respond to that."

Challenges Galore
Lexmark, so close to a complete direct-sales model now, may not have a hard time of it. But many other manufacturers--whether they sell retail or wholesale--could encounter problems in several areas.

* A/R and Collections. When it comes to cash management, the direct channel can be a minefield or a field of dreams, depending on a company's preparation. This means staffing up and upgrading processes and systems in A/R and collections in anticipation of a deluge, experts say. "My experience has been that when you go direct, even if you just put your toe into the river...you're going to be overwhelmed with transactions," says REL's Wright. Administrative costs will likely rise with the direct model, he says, and collections will become a primary focus.

"Distributors pay promptly, but the Fortune 500 [companies don't] pay timely," says Bob Atkins, a vice president at Mercer Management Consulting. "You can put distributors on credit hold so they can't buy product, but end-users don't care if you put them on credit hold. They've already got the product they want." Profitability depends on getting customers to accept instant settlement, such as through EDI or electronic funds transfer, says Wright.

Dell's progress in that area, helping keep its days sales outstanding low, is one reason for its success. "We are relentless in our cash collection," says Dell's Schneider. "Consumer credit-card collection is immediate, and we have pretty favorable terms with our credit-card vendors because of volume. Our accounts receivable are in the high 30s"--well under half that for the computer and office-equipment industries as a whole. "Direct sales allow us to have better cash management."

* Inventory and customization. The distributor's specialty is delivering small quantities of product very quickly to many customers. Their warehouses are often models of efficiency and technological advancement, and distributors usually carry product buffers to help meet customer demand for immediate delivery. Direct sellers need to carry that buffer, too--meaning more assets on the books--unless they excel in making products to order, as Dell has with its computers.

Fortunately for companies that might find the make-to-order business daunting, direct channels tend to help inventories turn faster. For the maintenance, repair, and overhaul portion of Parker Hannifin's business making hoses and fittings--the area that the company runs through its established distributor channel--inventory turnover is about three to four times a year. In its business making OEM hoses and fittings for the automotive business, which Parker provides exclusively through direct sales, customers seek to cut down time and administrative cost in the procurement chain, says Parker CFO Hiemstra. "We turn that inventory 20 times a year."


* Logistics. Getting product to customers is another challenge manufacturers face on their own with direct sales. "Changing to a direct channel requires real overhauls of your logistics capabilities," says Mercer's Atkins. In some cases, "you have to have parts inventory distributed densely all over the U.S." For the would-be direct seller, this advice: Prepare to upgrade your shipping information system, your logistics providers, and probably the size and efficiency of your warehouse.

* Customer support.Do you have the on-board staff and knowledge to answer customer inquiries? Troubleshoot? Make emergency shipments? Your distributors probably do, and you will have to acquire these skills if you want to replace them, notes Atkins. Says Dell's Schneider: "If your customer has an issue with a product, you have to be able to support it. We get immediate feedback from our customers, and we can give immediate feedback to our vendors." Still, even Dell outsources some servicing and repairs.

* Marketing strategies. Sometimes a new product requires a live demonstration, something the local distributor might have done well. And, of course, someone must promote your direct-sales efforts in the first place. So be ready to learn and adjust. "One can never account for customer preference, and the customer may want to buy from that guy you want to disintermediate," says Mary Margaret Gibson, CEO of Channel Strategies Inc., a Palo Alto, California, consultancy.

Further, "the internal sales force can feel threatened by direct sales as much as the distributors," says Peter Kirby of Gemini Consulting, in Cambridge, Massachusetts. Ending distributor relationships can hurt compensation by introducing "salesman-free" purchases on the Internet, and can expose staff weaknesses. When Lexmark set up its direct-sales structure after its spin-off from IBM Corp. in 1991, says Dee Allott, a house-cleaning in the sales department ensued. "Many people we brought over from IBM were too focused on calling on resellers, not end-users," he says.

If a strong-enough business case can be made for direct sales, there are ways to avert mass distributor defections and other potential problems.

Some manufacturers buy their distributors, eliminating the possibility that they will be upset and turn hostile. Parker Hannifin's and Lexmark's strategy, hybrid channels made up of direct and distribution models, may also make sense by giving existing distributors a continuing role, and drawing on their expertise. Other companies ease in by selling only specific products direct.

A downside to hybrid channels is that many manufacturers refuse to underprice their distributors, removing a big cost incentive for direct customers and perhaps even alienating them. "The Internet pricing is not our lowest cost," admits Parker's Hiemstra, who says Web-site prices are kept at or near distributor levels.

And, "it's hard to say you're going to have a Dell model if you've still got 15 or 20 other sales channels," says Gibson, who believes that soon "every major vendor that has brand equity will have a direct Internet or call-center model for some percentage of their sales."

From Dell's perspective, that makes sense. "People used to say a PC was something that people would want to touch and use and it would never sell direct," says Schneider. "But I guess we proved that wrong."

Kris Frieswick is special projects editor at CFO.




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