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    Go Downstream: The New Profit Imperative in Manufacturing - Going Downstream After Manufacturing Profit

     
    1/4/2000
    The 1990s were a great time to be in business — unless, that is, you happened to be a manufacturer. As business value flowed steadily downstream, from producing goods to servicing them, most manufacturers struggled, unable to boost their profits or stock prices. A few manufacturers, though, were thriving. They went beyond the factory gates and began competing in downstream markets — where the money is. In this excerpt from their Harvard Business Review article, Richard Wise and Peter Baumgartner outline some of the challenges and rewards of moving downstream.

    by Richard Wise and Peter Baumgartner

    Rethinking Manufacturing Strategy
    Because manufacturers have an intimate knowledge of their products and markets, they are well positioned to carry out many downstream activities, from providing financing and maintenance to supplying spare parts and consumables. Exploiting the downstream opportunities, though, requires a new way of thinking about strategy.

    Ever since the birth of the modern industrial corporation in the 1920s, manufacturing strategy has been built on three foundations: the vertical integration of supply and production activities to control the cost and maintain the predictability of raw materials and other inputs; disciplined research to create superior products; and a dominant market position to provide economies of scale. With these in place, manufacturers could be assured of a durable cost advantage, steady revenue growth, and substantial scale barriers to competition. The usual reward was double-digit margins and returns on capital.

    But those foundations aren't much help to organizations seeking downstream, service-based advantages. To capture value downstream, manufacturers need to expand their definition of the value chain, shift their focus from operational excellence to customer allegiance, and rethink the meaning of vertical integration.


    Rethinking Vertical Integration
    As value has shifted toward the customer, distribution – once the backwater of strategy – has become the mainstream. It is where much of the profit in many industries can now be found. But distribution lies outside manufacturers' traditional concept of vertical integration as a move upstream into the sources of supply.

    Moving downstream into distribution channels therefore brings a whole new set of challenges. In many industries, the battle for control over distribution is intense. Powerful channel consolidators with national scale, sophisticated operating systems, and a strong desire to control the customer are replacing local mom-and-pop operators. The most visible manifestation of this trend has been the ascendance of retail superstore chains like Home Depot, Circuit City, and Wal-Mart. Their vast scale and purchasing leverage have allowed them to offer broader product selections, lower prices, and better customer service than traditional stores while generating higher margins.

    Although generally good for consumers, these large chains have siphoned profits from manufacturers. They've drawn consumer loyalty away from the manufacturer and toward the store and its house brands, they've levied premiums for shelf space, they've exerted pressure to reduce prices, and they've replaced manufacturers' financing and service businesses with their own.

    Look at what's happened to Whirlpool. Once a dominant player in the appliance value chain, the company today sells one-quarter of its U.S. appliance volume through Sears, most often under Sears's Kenmore brand. Sears has placed intense pressure on Whirlpool to reduce costs and prices and has threatened to switch its purchases to other manufacturers. While Whirlpool once earned considerable profits by offering consumer credit and maintenance contracts for its appliances, these profit-rich activities are now provided by Sears and other retail chains. In fact, they account for a large share of the chains' operating income.

    This power shift is not confined to retailing. The consolidation of wholesalers and the development of "super channels" are under way in pharmaceuticals, office supplies, food, and auto parts. In the computer business, a few large resellers, including Ingram Micro and Tech Data, now control the distribution of 90% of the personal computers sold by IBM, Hewlett-Packard, and Compaq. With that channel control comes enormous power over the customer and the entire value chain. These resellers are now competing head-on with the manufacturers by offering their own cheap clones and establishing their own PC brand names. If the manufacturers attempt to bypass them and sell directly to consumers, the resellers can respond by cutting off the manufacturers' access to a large proportion of buyers.

    New channels, from value-added reselling to telemarketing, have also emerged to threaten manufacturers. The biggest is the Internet, where dozens of new companies like Amazon.com, Autobytel.com, and eBay are becoming electronic intermediaries with powerful advantages: low start-up costs, an ability to provide ample information tailored to individual customers, and the means to allow buyers to customize the shopping experience. By altering the economics of distribution, making comparison shopping easier, and shifting customer allegiance to the intermediary, the Internet puts new pressure on manufacturers and their traditional channels.

    The upshot is clear: successful manufacturers will increasingly be characterized by a hands-on involvement with distribution, a focus on identifying and exploiting new channels, and a willingness to risk channel conflict in the pursuit of competitive advantage. Ford, for example, has recently shaken up the traditional automobile-distribution model by acquiring control of its dealerships in several regional markets. It has also revamped and rebranded retail operations, acquired a leading European autoparts and service chain, and experimented with superstores and other formats. Ford aims to improve the profitability of dealerships and build stronger ties with car buyers across the vehicle life span. Manufacturers that ignore the opportunities for forward integration will see their profits continue to wither, as more and more value flows downstream into distribution channels.

    · · · ·

    Excerpted from the article "Go Downstream: The New Profit Imperative in Manufacturing" in the Harvard Business Review, September/October 1999.

    [ Order the full article ]

    Richard Wise and Peter Baumgartner are vice presidents of Mercer Management Consulting based in Boston and Munich, respectively.

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