Quality in Supply Chain Encroachment

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A recent survey by ChannelAdvisor and Retailing Today shows that nearly half of the 347 manufacturers surveyed sell products from their own website, and 59% of them believe that most brands will sell directly to their customers in the future. Direct selling (also known as encroachment) can increase manufacturers’ profits by generating more sales and giving manufacturers a larger share of the margin. If ill managed, however, direct selling can cause substantial damage to supply chain relationships. For example, when Bass Brewers Ltd., the British beer company, launched a home delivery program, its top distributer retaliated by pulling all Bass products off its shelves, forcing Bass Brewers to abandon the direct sales program. When Proctor & Gamble Co. expanded its e-commerce efforts by partnering with Amazon.com, the retailer Target Corp. swiftly retaliated by reducing prime shelf space for P&G products and encouraging suppliers who compete with P&G to offer promotions. Fear of retaliation has become a major barrier for many manufacturers looking to sell directly to their customers.

Our study takes on the challenge of finding out whether retailers are justified in their negative reactions to encroachment. We examine how encroachment affects the manufacturer’s and the retailer’s profits, taking into consideration selling cost asymmetry and quality decisions. We find that under most circumstances, the addition of a direct channel will result in a “win–lose” outcome where the retailer gets the short end of the stick. Moreover, quality differentiation to sell a different product through the direct channel does not solve the problem.   

Our study is the first to consider the quality decision (e.g., durability, craftsmanship, material source) in encroachment. Without considering quality, researchers have shown that encroachment may benefit both the manufacturer and the retailer—a win–win outcome—if the retailer has a lower unit selling cost (due to more experience, better market data, etc.). However, we find that the retailer always loses from encroachment if the manufacturer has enough flexibility in changing quality (i.e., cost of quality, base quality level, or unit cost of producing the base quality level is low). These are settings where the product quality can vary greatly and where the basic product function as well as the associated production cost are low.  This applies to many industries. The apparel industry is a particularly suitable example because the production cost can be extremely low whereas the quality range could be very wide. For instance, the cost of making a polo shirt may be as low as $1 or $2 to over $29. Another example is the consumer electronics industry. The unit production cost of a smartphone has fallen so much that a fully functional one costs just about $43.  Lenovo, which sells smartphones through both retail and online channels, offers phones that vary widely in quality and price (a budget model at less than $100 to a high-end model at about $560).

To address the retailers’ concerns, many firms implement quality differentiation—with each channel serving a different market segment. For example, Eureka Forbes Ltd. sells its premium brand vacuum cleaners directly and its base models through retailers. Kendall-Jackson uses its online channel to sell high-end wines, such as Artisans & Estates, that are usually of higher quality than those available in retail stores. Quality differentiation mitigates channel competition by allowing different channels to target different market segments.

We find that when quality differentiation is implemented, the direct channel always offers the higher quality product. Surprisingly, quality differentiation across channels does not always benefit either the manufacturer or the retailer. For the manufacturer, when the selling cost is high in the direct channel, there is a trade-off between the benefit of market segmentation and the cost of selling more products through a less efficient channel. Therefore, when the difference in selling cost between the two channels is very large, it may be better for the manufacturer to not differentiate and instead sell more products through the more efficient retailer channel. For the retailer, if its selling cost is low and if it sells a lower quality product than the direct channel, then differentiation could actually reduce the retailer’s profit due to a lower margin (from a lower quality product) and serve a smaller segment of the market.

Overall, our study highlights the role of the quality decision in manufacturer encroachment, and shows that encroachment may be more harmful to retailers than researchers previously understood.

Reference

Ha A, Long X, Nasiry J (2015) Quality in supply chain encroachment. Manufacturing Service Operations Management 18(2):280–298. Permalink: http://dx.doi.org/10.1287/msom.2015.0562

Comments

Supply Chain Encroachment is certainly something that would have many a distributor worried, and rightly so. As observed, it creates a dilemma for the manufacture as well. Both want to take advantage of the additional marketing channels available today and end up with an unhappy trade-off.

I wrote an article in Quality Digest to address a similar issue, to find a solution using TRIZ, the Theory of Inventive Problem Solving. The article touches on one possible solution. I would like to hear the authors viewpoint on this.

Here is the link to the article:
http://www.qualitydigest.com/inside/quality-insider-column/structured-innovation-online-marketing.html