Business Techniques in Troubled Times

Distributors are the middle component of a three-tier distribution chain: producer to distributor to retailer. The distributor is the “middleman”. The distributor and the retailer incur their own costs in bringing the product to customers, and both need to recover those costs and earn adequate margins.

In setting their price to distributors , producers must understand both distributor and retailer functions and costs. Producers must also understand the ceiling on their product’s retail price level as dictated by product value and competitive alternatives.

For example, imagine a product priced at $100 retail. Potential pricing for a three-tier distribution model might be:

In this example, the manufacturer’s price to the wholesaler is 59.5% of the retail price. Let’s assume that the manufacturer’s cost includes an allocation of all his overhead, so his 15% markup is pure profit. The total markup by all three players is $48.33, or 92% of the manufacturer’s cost.

To allow “room” for markups by downstream players, the manufacturer must know the likely retail price. This is determined not by retailer whim, but by value to users relative to competition and their prices. See Pricing Technique: “Value in Use”.

Wholesaler markups average 20% and will not exceed 30-40%, according to The Average Profit Margin for Wholesale | Small Business – Chron.com.

For the retailer markup over what he pays the wholesaler, situations vary depending on the size and market power of the players, but a typical retailer markup would be at least 40% for big box retailers and more for boutiques. In this example the difference is 40%: (100 – 71.43 = 28.57) / 71.43 = .40.

Markup Is Not the Same As Margin!

In the example above, the retailer marked up the price 40%, but his margin was 28.57%. For markup, you divide profit by cost. For margin, you divide profit by price. See Pricing, Markup, Margins and Mass Confusion | Brooding on Matters | Travis T.[i]

Channel Margins Tool by Harvard Business School Publishing provides a handy online calculator for markup and margin in a four-tier distribution model.

Channel Functions Create Their Costs

The wholesaler’s price to the retailer determines not only the wholesaler’s markup – it also becomes the base for the retailer’s markup. Competition defines the retail price ceiling, so the retailer’s markup will be that market-determined retail price minus the wholesaler’s price. To understand what markup is fair for both players, you first must understand what value they are adding, and their related costs.

Retailers have higher costs than wholesalers for their facility and for their advertising, promotions, and merchandising, while wholesalers have higher delivery costs.

In general, retailers have higher costs than wholesalers to perform their functions after they have purchased the product. This means retailers need a higher % markup between what they pay to buy the product and what they can sell it for. This markup is mostly used to cover their costs. Only a small percentage remains as a margin for their business.

Alternative: Cut Out the Middleman

At this point one or two players in the chain start to think about vertical integration. For example, the manufacturer considers whether he can deal with retailers himself, to save the wholesaler’s markup.

But here is a “word to the wise”: in doing so, you will have to perform the wholesaler’s functions yourself, so at best you would save the wholesaler’s margin, not the entire markup, most of which goes to covering his costs which you would then incur.

For an example of comparing channel costs, see Understanding the Economics of Your Product Distribution Channels : Money.

Tom Gray helps owners save and grow their companies. He is a management consultant focused on small business and telecom, a Certified Turnaround Professional (CTP), a Certified Business Development Advisor, and a Certified SCORE Mentor. He can be reached at 630-512-0406 or tgray@tom-gray.com. See www.tom-gray.com

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