I want to talk to you now about some of the problems that manufacturers have selling through intermediaries. I'll tell you that I've had a lot of marketing executives come to Darden. And as part of the conversations I have with them, part of that is just me talking to them about what they do on their day to day job. And you would think that maybe a marketing person, like a brand manager, spends a lot of time developing fancy advertisement. Turns out that that's not true. The people I talk to spend a whole lot of time dealing with issues surrounding their channel intermediaries. And, in particular, their channel intermediaries doing things with their prices that is counterproductive for them. So when you sell through an individual that owns a private business, of course they're going to do what's in their best interest, which may not be always what's in your best interest. But a lot of companies face that situation because they simply can't go direct to customers, they need to be on a physical shelf somewhere. And the way to do that is to sell it to an independent business, a distributor or a retailer etc. And then, of course, they get to price the item to consumers. So I want to start this by looking at just a real simple example, but I think it's illustrative of the problem that a lot manufacturers face. So let's look at this, it's LED light bulbs. And this column right here is just sales of LED light bulbs. So you can think about this as Q, how much are sold. And just like any demand function, you see that as we raise the price, the number of LED bulbs goes down. And that's just a little demand schedule sitting there. Now, we're the manufacturer and we're thinking about how to price these LED bulbs. And this particular demand function is between the distributor of the LED bulbs and the number that are sold. So it's not our price per se, the manufacturer's price, it's the distributor's price. But as a manufacturer, we're going to have to sell through this distributor, right? We're going to have to sell it to the distributor and then they will sell it on further to the final consumer. And so we have to decide what price that we are going to charge to the distributor, given this kind of demand information that we see right here. So what else would we need to know in order to do that? Well, one thing we would need to know is our cost, right, how much it costs us to manufacture these things. And then based on that, if we know how much it costs us to manufacture, and we know what the price to the consumer is going to be, we can kind of calculate how much total profit there is available in the channel. And what I mean in the channel, I mean among the different independent businesses that are getting this from the point of production all the way to the end consumer. In this simple example it's just a channel of two members, a manufacturer and a distributor. But if you look at the distributor price of 40 and the manufacturer a cost of 30, what you can deduce from that is, well, there's $10 available there. There's a spread of $10. So if you take that $10 and you multiply it by 250 units sold, that's the total potential profit in the channel, total amount we could possibly get. And if you look down this column, what you'll notice is, all right, where is the total potential profit the greatest? Well it's right here, okay, it's at $60. Cost of $30, that gives you a $30 spread between the two. And if you multiply that by the 111, that's where you getting the $3,330. So now I, as the manufacturer, look at this and have to decide, okay, where am I going to set my price? A natural place to look would be where that the channel profit is maximized. So let's say I look at that, and I say, well, that's a good point. So what I'm going to do is I'm going to charge $45. Now where am I getting that number? That's a number that's halfway between the 60 and 30, that cost number that I just showed, right, $45. So essentially what I'm saying is you, distributor, you take half the profit and I, as the manufacturer, will take half the profit. That seems kind of fair, right, and that's where you get to $45. And that implies these two profit figures. You can check my math on that but the math is right. These two profit figures sitting over there for the distributor and the manufacturer. Now suppose that's what I do. A question becomes, what is the distributor going to do if I charge him or her $45? Well, of course, what I'm hoping is that they charge $60. That's what this all was based on, that we're going to split the profits evenly. But if you look at this more carefully, what you realize is that's not what they're going to do, right? Look down the distributor profit and the distributor price. We might want them to go there, but they're going to make more profit if they come down to 80 or even $90. Look at this profit figures right here, relative to the profit figures at $60. So what's going to happen? They're going to jack up the price to 80 or $90. And when that happens, what's going to happen to our profit? Well we're charging that $45, that margin for us remains the same. But that depresses the overall quantity demand, and our profit goes down, and it goes down by quite a bit. Relative to what it would've been if we'd have just split the profits up here before. And when we charged them $45, they charged $60, but their incentives are just different than ours. What I'm showing you right now does have a name. It's the consequence of something called double marginalization. And it is a common thing that happens in industry all the time. I charge one price and my channel intermediary charges a price that I think it's too high and depresses my own profit, so that's one problem. Now, how do companies try to get around that problem? One of common ways they do that is to established a quantity discount. Now look at this manufacturing pricing schedule right here. What this schedule suggests is that the manufacturer is going to charge high prices per unit, like $94 a unit, $88 per unit, at low levels of demand. But then, once demand gets high enough, say 100, and they can sell 100 of these things to the distributor, they're going to drop the price, in this case, to $48per unit. Now notice, $48is bigger than the $45 they were charging in the previous example I gave you, but it does represent a discount from the larger prices on the smaller quantity. So very common, quantity discount, what does that do? Now look at the distributor's incentives in this situation. Now the distributor is strongly incentivized to sell a higher quantity of the item. They need that in order to get the quantity discount. And in fact, they're going to make more money if they charge $60, okay? And here are their profits, right over here, distributor, you see, that's the highest profit that they have. By charging $60, and pushing more quantity out the door, relative to the previous example where I had a constant price, no matter how many units they bought. In that situation, they had incentive to jack up the price and sell fewer units. So a common way to deal with the problem of double marginalization are companies setting up quantity discount schedules very carefully, to incentivize their channel intermediaries to push out more product. So that's one problem and one solution. The solution itself is not cost-free. Some channel intermediaries will game this. What do I mean by they game it? If I'm buying from you and you offer a quantity discount, what I may do is just buy a whole lot of it at one time. And I still might jack up the price over a longer period of time because I know I can't maybe sell that many of them. I what's called forward buy, I buy a lot more than I need for the current time period and I just stick them in a warehouse somewhere. It's also the case that people that have big warehouses, like bigger retailers or bigger distributors, will buy a whole lot of this stuff at a giant quantity discount, and do what's called diverting. Essentially, they sell it to other distributors or retailers who don't have the warehouse space to hold that kind of merchandise. So they make money by kind of going around the channel, selling to people we would rather they not sell to. Those individuals they're selling to take can't take advantage of the quantity discount. And that's the way they make money. And it is a way that larger, more powerful customers take advantage of small customers, okay? So, that's just a really common thing and it does drive manufacturers crazy. But they still do quantity discounts because of that double marginalization problem that I just mentioned. It can also lead to some confusion about costs, margins, and prices. If I give a quantity discount, is that just a decrease in price or is that a marketing cost that should be borne by the market department? Believe it or not, fights happen in companies about this kind of stuff. And who gets charged, the marketing department or the people that are producing the items within the company is sometimes very contentious. So you have to kind of get organized around that and everybody has to be on the same page.
