Information, power, and control of the distribution channel.

IT is revolutionizing the distribution of consumer packaged goods and enhancing the effectiveness of manufacturer-retailer cooperation. But sophisticated information systems are also altering the balance of power between these groups.

A fundamental change appears to be occurring in how organizations interact with each other. Competitive and antagonistic relationships are giving way as managers begin to realize the strategic and economic potential of increased interorganizational coordination and cooperation. Strategic partnerships are reducing design cycle times, facilitating total quality management, and helping companies "compete in time." Information technology can play an important role in this re-engineering of business relationships. IT reduces the cost of accumulating and sharing information across firm boundaries. For example, just-in-time inventory replenishment is enabled by the electronic sharing of information on production schedules, sales forecasts, inventory levels, and product movement.

The relationship between IT and interfirm coordination is particularly evident in the consumer packaged goods industry. Manufacturers such as Lever Brothers and Procter & Gamble produce and sell branded goods through a complex distribution system of brokers, wholesalers, and retailers. The introduction of electronic checkout scanners in the industry over the past 10 years has led to an information explosion. Detailed information on product flow is now available almost instantaneously. IT applications have emerged to harness this information for improved decision making in merchandising, logistics, personnel management, and marketing. This technology creates significant opportunities for restructuring interfirm relationships in the industry, thus improving total channel efficiency through increased coordination.

However, IT-based improvements in coordination may not equally benefit all parties. Changes in channel relationships that increase coordination may, at the same time, affect each party's bargaining power, or their ability to influence the actions of other channel participants and to share in total industry profits. In extreme cases, one party may discover that coordination actually makes it worse off, even though total channel efficiency is improved substantially.

IT AND CHANNEL COORDINATION

Driven by data from checkout scanners, information technology is improving coordination between manufacturers and retailers, particularly in the following areas. Electronic marketing and in-store promotions. Promotions represent a decision by manufacturers and retailers to influence directly short-term customer behavior. This may involve coupons, temporary price reductions, or special displays. Historically, promotions have been a source of inefficiency in the channel. For example, only 2 percent to 4 percent of coupons distributed by manufacturers through inserts in newspapers are redeemed, and many of these redemptions are by customers who would have purchased the product anyway. Similarly, temporary price reductions on the shelf can attract new customers, but at the cost of lost margins on sales to regular customers.

Information accumulated by checkout scanner systems is beginning to be used to improve the targeting of promotions. At checkout time, for example, Catalina Marketing's Checkout Coupon system issues coupons automatically based on scanned purchases. A customer who purchases Coke may receive a coupon for Pepsi. A customer who buys Pampers may get a coupon for baby food. More accurate targeting of coupons enhances coupon value, which, in turn, encourages redemption.

Some systems are going a step further. By identifying purchases with specific customers, marketers can develop promotional programs based on purchase behavior. Many retailers are experimenting with "frequent shopper programs" that encourage customers to present cards at the checkout that electronically identify them. Customers with high brand loyalty can be identified and either rewarded by their existing brand or targeted for switching by a competing brand. Ultimately, promotions to a customer can evolve over time: A family with a child can be targeted for diapers, formula, baby food, breakfast cereal, or other products, depending on the child's age. Information on the long-term effectiveness of promotional programs is available, allowing programs to be refined continually and adjusted over time. The marketer can enter into a dialogue with individual consumers, building customer loyalty and improving marketing effectiveness.

New payment approaches. IT facilitates new payment approaches to promotions that can improve channel efficiency by changing the incentives guiding each party's decisions. In the past, manufacturers have implemented promotions with retailers through the use of case allowances: reduced prices for cases purchased by the retailer during a promotional period in return for promotional support such as special displays, advertisements, and reduced shelf prices. This payment approach, combined with the manufacturer's inability to monitor product movement once it was delivered to the retailer, led to two practices that are extremely inefficient from an industry standpoint:

* Forward buying. Retailers can stock up on goods at the promotional price to cover sales beyond the promotional period. The effect is a reduction of product cost for the retailer with no promotional benefit for the manufacturer.

* Diverting. Frequently, manufacturers will run a promotion only in selected regions of the country. Retailers can purchase goods at the promotional price in one region and sell them to retailers in another where the promotion is not in effect. Again, this reduces the product cost for the retailers involved--with no promotional benefit for the manufacturer. Moreover, the costs of shipping products between retailers serves no economic purpose for the industry.

The cost of these practices to the industry is considerable. It is estimated that 30 percent to 40 percent of manufacturer promotion allowances to retailers represent pure inefficiencies, and that 50 percent of channel inventories are held for forward buying and diverting. Moreover, these practices exacerbate already dramatic spikes in demand because of promotions. Some manufacturers report that 80 percent of product sales occur on four days over the year--the last day of promotional periods. These spikes lead to higher channel inventories and increased manufacturing and handling costs.

Scanner and electronic marketing systems also provide information that can be used to implement "pay-for-performance" arrangements, where compensation is tied to criteria tracked through IT. Such arrangements aim to reduce dysfunctional behavior--such as forward buying and diverting--and to align retailers' objectives more closely with those of manufacturers. Toward that end, the industry is experimenting with two approaches, "pay for results" and "pay for behavior."

Procter & Gamble has pioneered a marketing fund system based on pay for results called "net down pricing." In this system, periodic promotions through case allowances are eliminated or drastically reduced. Instead, the manufacturer prices the product consistently at an every-day-low-price (EDLP), and retailers receive a set amount of funds for implementing promotions. The level of these marketing funds is determined by sales targets negotiated with the retailer and supported by the analysis of scanner data. These funds are increased or decreased over time, based on retailer performance. The retailer has total discretion over actual tactical promotion decisions, although P&G plays an advisory and coordinating role. Payment is based on how well the retailer makes those decisions.

Under net down pricing, case allowances during limited promotional periods are replaced by lower, constant prices. Thus, there are reduced incentives for forward buying and diverting, with considerable benefits for logistical smoothing. In addition, since tactical decisions are shifted to the retailer, there is less scope to exploit manufacturer competition to drive up the level and cost of promotions. Previously, retailer promotion decisions were made period by period, based on how much manufacturers were willing to pay; essentially, manufacturers bid against each other for weekly sales. This led to higher promotion levels and payments--regardless of whether the promotion was effective for the manufacturer. With P&G no longer bidding on a period-by-period basis, the retailer will only promote when effective (toward store sales and P&G product targets). As a result, the overall promotion levels decrease.

Under the "pay-for-behavior" approach, a manufacturer contracts with the retailer for specific promotional services (e.g., couponing, price, advertisement, or display). The provision of these services can be electronically monitored, enabling the manufacturer to measure the program's effectiveness. This type of program is well-established with third-party marketers offering electronic marketing services. For example, Catalina Marketing sells manufacturers exclusive rights to promote on its Checkout Coupon system for a specific category, geographical region, and time period. The manufacturer pays based on a formula that incorporates coupons issued and redeemed, so the cost of the promotion is strongly linked to performance. "Pay for behavior" has a crucial advantage over pay for results: Manufacturers retain more control over the retailers' tactical promotional decisions. If properly structured, pay for behavior can reduce or eliminate forward buying and diverting.

IT for logistics integration. Information technology facilitates the automation of logistics decision making, providing information as a substitute for inventory and distribution resources. Electronic Data Interchange (EDI) is becoming common in the industry. Standards are emerging to facilitate computerized communication. According to estimates, 700 to 800 firms are now using EDI for purchase orders; about half of them also use EDI for invoices. Many firms are experimenting with extending this to include price and promotion information. The short-term benefit from EDI is administrative savings. One large retailer estimates EDI-generated savings of $800,000 a year.

A few large firms are going further than EDI, seeking to restructure their logistics systems to reduce costs. The premier example of this is the partnership between Wal-Mart and P&G. A foundation of this relationship is shared access to information. P&G receives information on store sales directly from Wal-Mart's scanner systems. Thus, the company can plan production and delivery more efficiently. Wal-Mart is using the experience of its partnership with P&G and other key vendors to improve coordination with all of its suppliers. Currently, its EDI network for pricing, purchasing, order tracking, and payment covers more than 2,000 vendors.

Other manufacturers and retailers also are experimenting with "just-in-time" or "quick-response" approaches, under which manufacturers and retailers typically share information, including demand forecasts and data on product movement and inventory levels. Parties also may facilitate coordination by customizing the distribution channel. Goods may be shipped directly to stores, rather than to warehouses. Shipments may be made directly from the production plant, bypassing the manufacturers' distribution center. The retailer may even pick up a shipment directly from the manufacturer. The distribution approach is adjusted to fit changes in demand.

COORDINATION AND BARGAINING POWER

While IT-based changes in channel relationships can yield significant economic benefits for the channel as a whole, they can also affect the parties' relative bargaining power.

Increased value of the point of purchase. Electronic marketing systems have the potential to increase the value of the point of purchase as a critical resource in bargaining with manufacturers. The point of purchase is evermore valuable both as a channel for promotion delivery and as the accumulation point of information on customer behavior. The potential effectiveness of electronic marketing will reduce the value of substitute promotional channels available to manufacturers, such as newspaper inserts and mass mailings. There will still be substitute delivery channels, such as direct mail, but the effectiveness of these substitutes may depend on purchase information accumulated at the point of purchase. That increases retailers' bargaining power.

Differing outcomes of new payment approaches. While the increase in information from scanners and electronic marketing can pave the way for new approaches to payment for promotions, these approaches may have dramatically different outcomes in terms of the coordination and balance of power. "Pay for performance" improves coordination in the channel, but reduces retailers' ability to profit from buying and diverting. Retailers' ability to obtain compensation for these lost profits is affected by the form of the "pay-for-performance" arrangement.

"Pay-for-results" approaches can reduce both promotion expenditures to retailers and overall retail promotion levels. Retailers not only lose profits from forward buying and diverting, but lose their ability to exploit period-by-period competition among manufacturers for promotions. Reducing the level of price promotions at the retail level may accelerate retailer price competition. Retailer competition increasingly would be driven by operational efficiencies and economies of scale--such a situation would favor Wal-Mart and other large retailers. The bargaining power of smaller retailers and retailers that currently rely heavily on promotions is likely to be eroded under "pay for results." Indeed, there has been considerable resistance to P&G's net down pricing program among these retailers. In some cases, this resistance has forced P&G to back down from its program.

"Pay for behavior" may have different implications for promotions and the balance of power. Retailers may be in a better position to exploit manufacturer competition for promotion support, particularly if electronic marketing improves the effectiveness of promotions. Manufacturers should be willing to pay more for increasingly effective promotions. But increasing effectiveness also increases the cost of not promoting, since the incremental sales from a promotion come primarily from competing products. Manufacturers will be forced to bid each period on the right to retain their customers and sales. Prices on effective promotional services will be bid up higher and higher. In this type of arrangement, retailer bargaining power may not be significantly eroded and may even be strengthened.

Limits to logistics integration. The potential benefits from logistics integration are linked to promotion management. Just-in-time logistics are incompatible with high levels of forward buying and diverting that distort demand patterns and increase channel inventories. Logistics costs are lowest where demand is smooth and predictable. This is underscored by the fact that most quick-response partnerships have been with EDLP merchandisers, such as Wal-Mart and Kmart. Traditional retailers that rely heavily on promotions are in a difficult position. They need logistics efficiencies to survive against the economies of scale of the large EDLP players. At the same time, reducing promotions to achieve operational efficiencies eliminates profits from forward buying and diverting and reduces the advantages of their merchandising. This forces them to compete with the mass merchandisers and discounters, such as Wal-Mart, on terms established by these larger players.

SUMMARY

Across a wide variety of industries, buyers and suppliers continue to seek the benefits of cooperation. Particularly in the consumer packaged goods industry, IT can play an important role in helping firms to realize these benefits. But restructuring business relationships to achieve cooperation can lead to shifts in the balance of power between parties. Failure to anticipate these changes can attenuate benefits and, in some cases, lead to a project's failure.

Eric K. Clemons is associate professor in the decision sciences department at The Wharton School of the University of Pennsylvania.

Michael C. Row is a decision sciences research associate at The Wharton School.