Channel Conflict on the Internet 1 Overview The final projects submitted by the 15.810 classes in Spring 2000 and Fall 2000 investigated the problems that firms have faced when introducing an Internet channel. A complete description of the project instructions is attached as an Appendix. The reports identified three types of problems: The Internet threatens the relationship with the existing channel The Internet provides competition for existing channels, thereby threatening the income and in some cases the continued presence of these traditional channels. The Internet leads to coordination problems The introduction of an additional channel increases the need for communication due to more decision-makers and greater dispersion of information. The Internet destroys traditional segmentation criteria Firms use multiple distribution channels to target different segments with separate marketing offerings. However, the advantage of targeting customers through different channels is undermined if customers have access to both channels. In this summary I summarize the different solutions that were implemented to address these problems. Because the appropriate solution varies with the market and firm context, I also include a series of questions to identify when each solution is appropriate. Note that few of the problems and solutions are specific to the Internet. 2 The Internet threatens the relationship with the existing channel Participants in traditional channels often perceive the introduction of an Internet channel as a source of competition. This results in two closely related complaints. The first focuses on the returns the traditional channel earns on its historical investments in a brand. The second complaint focuses on the returns the traditional channel earns on its more immediate investments in promotion and service. 2.1 Threatened returns on historic investments Many channel participants observed that they had contributed to the development of a manufacturer's brand, and that they expected to share in the rewards from this development. The introduction of an Internet channel disrupted this partnership and prevented them from earning returns on their historical investments. This problem was well-illustrated in an interview with Allstate Corporation. Allstate is one of America's largest insurance companies, with more than 15,600 agents catering to more than 14 million households. Allstate has been slow to implement plans to sell its insurance products over the Internet precisely because it has been concerned about its agents' reactions. A Senior Vice President at Allstate reported that, "Allstate agents have created a tremendous brand image over the last 50 years and would likely have looked askance if we bypassed them and went directly to customers." Customers' interaction with the company has primarily been through the agents. Because it is difficult for customers to know whether an insurance company is adequately reserved (capitalized), the historic investments by Allstate agents in community relationships have contributed crucially to the Allstate brand. The company has been concerned that the sale of insurance over the Internet detracts from this relationship-based approach. Should these agents become dissatisfied with the evolution of Allstate's distribution channels, they could potentially jeopardize the quality of the brand. Channel members are particularly threatened when the Internet offers advantages over traditional distribution methods. For example, the Internet can be an efficient vehicle for providing information to customers, making personal interaction with customers unnecessary. This reduces the value of customer relationships developed by travel agents, real estate agents, investment brokers and insurance agents. The strength and exclusivity of these client relationships have in the past enabled agents and brokers to share in the wealth created by the transactions they facilitate. Although the client relationships may survive, their importance diminishes if clients can access information and complete their transactions over the Internet. For example, while it was always possible for consumers to book tickets by calling airlines directly, only travel agents provided a convenient way to compare fares. Internet travel agencies such as Expedia.com now provide easy access to such information, and even airlines make competitive fare information available. Consequently, as of 2000, 9 million households are reported to have booked travel on the Internet. The return on historic investments is also threatened by the Internet's unrestricted geographic reach, which enables it to overcome local geographic exclusivities that have yielded regional monopolies in traditional channels. This has particularly affected automobile dealers. Traditionally dealers' geographic dispersion and consumers' comparatively high travel costs limited how many dealers each customer visited. Car dealers' regional monopolies are now threatened by car dealers such as Thom Toyota on Route 1 in Norwood, MA. Internet leads generate nearly 12% of Thom's sizeable business. The average customer comes from 45 miles away, a much larger radius than customers who purchase through the traditional channel. The loss of geographic exclusivity is also a problem at Avon. Avon is perhaps best known for its reliance on a direct sales force of "Avon Ladies," channel that has been in place for more than 115 years. This sales force closes the sales and then distributes products to customers. In an effort to reach out to more consumers, as well as to accelerate growth, Avon started selling products on the Internet in 1997. As a result, location no longer guarantees exclusivity for Avon Ladies. 2.2 Threatened returns on current investments The second major complaint from members of the traditional channel focuses on returns to more immediate investments in promotion and service. Several managers cited examples of customers to whom they had provided advice and pre-sales service, leaving their stores and purchasing at a lower price over the Internet. Almacenes Paris, a leading Department Store company in Chile, illustrates the problem. The company launched its online initiative Almacenesparis.com in September 1999, and has enjoyed considerable success. Online prices are 7-9% lower than those in physical stores. Therefore, many customers go to the stores to see products and get help from sales people, while buying the products on Almacenesparis.com. Not surprisingly, this creates conflicts with traditional commission-compensated sales personnel. Staples, the office supply giant, provides another example. Staples has established Internet kiosks in retail locations to give consumers access to Staples.com. Store managers felt that Staples.com free-rides on the stores because the revenues accrue only to the Internet division. Conflict with the traditional channel does not require that the traditional and Internet channels actually compete. Conflict occurs even in markets in which the channels serve different segments or where no transactions are conducted over the Internet. The traditional channel's competitive position may be damaged simply by the efficiency with which the Internet informs customers about competing prices and the availability of alternative retailers. The automobile industry offers an example. Automobile manufacturers have developed sophisticated Internet sites to provide customers with price and product information and to inform customers about the location of authorized dealers. Even though customers cannot purchase directly from manufacturers' Internet sites, dealers have long disliked the availability of model, option, and price information on manufacturer's websites. Some traditional dealers reported that they can extract higher margins from consumers that are uninformed about both competing dealers and alternative product options. 2.3 Adverse outcomes Perhaps the most dramatic responses from the traditional channel is to threaten not to distribute products that are also available on the Internet. The Ryobi Group, manufacturers of "Craftsman" power tools, was among those that received a "cautionary" letter from Home Depot, which sells a large volume of Ryobi's products. In this letter Home Depot warned that if Ryobi undercut Home Depot's prices through an Internet channel, they might be dropped as a supplier. Similarly, a Vice President of Sales at Warner Bros. Records reported that one of the leading CD retailers, Tower Records, threatened to stop carrying the products of those labels that were selling directly to consumers over the Internet. Other retailers have demanded increased payments to promote albums if their labels were selling directly to consumers on the Internet. An alternative response from the traditional channel is to withhold information about customer preferences, customer identities and inventory levels. Access to this information is important if firms are to optimize manufacturing and marketing decisions and coordinate activities between their channels. Kodak's foray into digital imaging illustrates this problem. In addition to providing tools to retailers for digital image processing, Kodak offers similar services directly to consumers. Kodak's services range from "Picture Maker" kiosks for digital editing, reprints and enlargements (19,000 worldwide), to Digital Lab Systems for scanning and printing, and to Print@Kodak for uploading, storing and sharing pictures online. Kodak's dual role as supplier to retailers and direct seller to end-consumers makes retailers reluctant to share data about consumer behavior and preferences that can be gathered when processing digital images. At present, retailers are claiming ownership of this information because they are afraid that Kodak's use of this information will enable it to bypass its retailers and market directly to consumers. This not only hurts Kodak's ability to cross-sell, but also leads to channel inefficiencies because marketing and product policies are not optimized. The traditional channel may also respond by reducing efforts to promote products that are available on the Internet. If compensation schemes consider only the performance of a single channel, channel participants tend to focus on activities that benefit their channel alone, often to the detriment of other channels. The traditional channel may refuse to answer customers' questions related to Internet operations, or refuse to accept product returns and warranty claims. Participants in the traditional channel argue that performing these services amounts to additional work, with no increase in compensation. West Group is the legal publishing division of Thomson Corporation. It has a wholly owned field sales force, which sells legal materials on an auto-renewal subscription basis, so that a single sale by a rep has substantial lifetime value. A new Westgroup.com Internet store accounts for a small, but growing portion of new sales. As the Internet has grown, the conflict between the field reps and the Internet has become more evident. The "Sticker Incident" has come to symbolize the problem. An outside consultant who traveled with a West Group Field Sales Rep reported the incident as follows: as the Rep gave collateral to his customers, he attached a sticker with his contact information directly over the West Group Web address, explaining, "I wouldn't recommend using the Internet and I'll tell you why. First of all, if you call me, I'll make sure nothing goes wrong with your order. Second, you know I need the commission to put food on the table." Other traditional retailers and distributors have responded to the threat of competition from the Internet by developing their own Internet channels including for example Tower Records, Macy's, and CompUSA. Ironically, many of these firms find themselves having to resolve channel conflict issues within their own firms. Employees of the traditional channels often express the same concerns as external channel participants. They fear that the value of the relationship they have with customers will be undermined and are concerned that they will not be compensated for efforts that increase sales in the Internet channel. They respond in similar ways, refusing to promote products that are sold on the Internet, and favoring customers who purchase through the traditional channel when providing post-sales customer service. Several firms have experienced resignations by some of their most-valued employees. An example is BBO, a Venezuelan based financial services firm, with activities in asset management, brokerage, project and corporate finance and derivatives for the Andean Region. In mid-1999, BBO started offering fixed income trading services through the Internet. The process is as follows: an order comes in, the desk head assigns the operation to a trader based on the activity level of the desk at the time. Because the traders add little value to the transaction, their commission for this type of transaction is significantly lower than that of standard operations. Following an increase in the promotional expenditure on the Internet channel, two of the most important traders resigned, ostensibly over concerns that their clients would migrate towards the online channel and deprive them of commissions. 2.4 Underlying issues The undermining of historic investments can be characterized as a hold-up problem. Investments were made without anticipating that the Internet would change each party's reliance on the relationship. Some manufacturers are now in a position to pursue alternative distribution options, without compensating downstream channel members for their prior investments. If the Internet is an effective distribution alternative, then there is little that traditional retailers can do to preserve the current relationship. A threat to terminate the relationship is unlikely to deter manufacturers given the availability of an alternative distribution channel. As long as investments are not specific to the relationship with the manufacturer then the historic investments may have value elsewhere. For example, the relationship between a customer and an investment broker may not be tied to the brokerage firm that employs the broker. As a result, investment brokers may be able to convince clients to shift to a new brokerage firm if their original firm holds them up. However, when the investments are specific, so that their value is limited to the original relationship, then the traditional channel is left in a very weak bargaining position. Insurance agents who have invested in the Allstate brand have few options available to preserve their investments in the brand should they choose to represent another insurance company. The outcome is not just lost income for the traditional channel. Perhaps just as important is the reluctance of these channel partners to make future investments. The hold-up problem arising from long-term investments can be distinguished from the problems that arise with investments designed to yield immediate payoffs, such as pre-sales service. These short-term investments are less susceptible to hold-up threats because even though the frequency of investment may be high the level of exposure is small. If a manufacturer's actions undermine the returns earned on current transactions, then the channel can simply withhold its investment in future transactions. Rather than hold-up, short-term investments are subject to free-rider problems. When customers receive pre- sales service from a traditional retailer and then leave the store to purchase at a lower price through the Internet channel, the Internet channel is free-riding on the efforts of the traditional channel. A version of the free-rider problem has also historically arisen between retailers. Competition between traditional retailers may lead to customers receiving pre-sales service at one store and then purchasing from a second store; in this example the second store free-rides on the efforts of the first store. The Internet has introduced the problem between a retailer and the manufacturer itself. The outcome is not just lost income for the traditional channel, but also under-investment in pre-sales service. 2.5 Solutions Manufacturers have pursued a variety of strategies to address these hold-up and free-rider problems. We can categorize these strategies under three headings: 1. No longer rely on investments from the traditional channel. 2. Create opportunities for the traditional channel to benefit from the Internet. 3. Mitigate the threat to the traditional channel. The selection of an appropriate strategy depends upon the answers to the following questions. Is the threat real? Although there were many examples of strong reactions by channel members, systematic evidence that the Internet channel was damaging the traditional channel's business was rare. In many cases, the trigger for conflict is one or more specific examples of a traditional channel customer purchasing via the Internet. Some manufacturers have been able to allay the concerns of their traditional channel by claiming that these examples are isolated. In support of this claim they argue that the Internet provides access to new customer segments and so does not cannibalize from existing customers. For example, the Boston Globe argued that the availability of an online version enables the newspaper to access readers who historically did not read the printed version. Even where there is evidence of a credible threat to the traditional channel, other firms have pointed to the entry of competitors and claimed that ignoring the Internet will not protect the traditional channel. Automobile manufacturers would find it difficult to prevent product information from becoming available to customers online, even if the information were removed from their own web sites. Similarly, if the music industry chose not to distribute over the Internet through its own licensed sites, it is likely that distribution would continue to be available through a range of unlicensed sites. How important will the traditional channel be in the long term? In some industries the segment of customers who purchase from the Internet channel is relatively small and will remain small in the foreseeable future. In markets where a significant segment of customers will continue to prefer the traditional channel, firms may find it preferable to limit the growth of the Internet channel, perhaps by restricting the pricing and product options available to this channel. There were many examples of firms who responded to evidence of conflict simply by withdrawing from the Internet channel. Rather than close their Internet sites, firms generally maintain an Internet presence but require that customers complete their purchases either through the Internet sites of their traditional retailers (Levis) or through the traditional channel. For example, it is extremely costly for dealers to maintain an inventory of Kawasaki parts. The Internet appears to be a more efficient distribution channel. However, Kawasaki dealers opposed the Internet as they feared this would damage their customer relationships. Kawasaki's response was to put its entire parts catalog online but not to allow ordering. Customers are able to enter the model and VIN of their product and look up the parts they need for their motorcycle or Jet Ski. They can see drawings and part numbers, but for purchases, customers are required to go to a dealer. Where the Internet is expected to become the dominant form of distribution, manufacturers tend be much more aggressive in developing this channel, despite the risks this poses to relationships with traditional channel members. Consistent with this prescription, major recording labels have continued with plans for the direct distribution of their songs, despite protests from major retailers such as Tower Records. Airlines have been similarly unaccommodating. To evaluate the long-term importance of the traditional channel, manufacturers should consider whether the Internet has inherent efficiency advantages in satisfying customer needs. Examples of these advantages include: (a) purchasing need not coincide with traditional retail hours or sales force schedules, (b) customers may obtain their own product and service information, and (c) the Internet may provide an effective delivery vehicle for products that do not involve a physical product or service. However, even in the presence of these advantages, many customers continue to prefer traditional channels despite the availability of an Internet channel. For example, in the insurance and finance industries customers are often reluctant to report confidential information over the Internet. Problems also arise when customers must choose from a range of product or service options. Customers who lack expertise value the advice provided by sales representatives. Firms have discovered that often it is difficult to provide this advice over the Internet in a manner that is both comprehensive and sufficiently customized to individual customers. How important will the traditional channel be in the short term? Even in markets where the Internet will eventually become the dominant distribution channel, manufacturers must consider how to maintain the cooperation of the traditional channel in the short term. An important segment of consumers will continue to be served by the traditional channel while the transition of customers to the Internet is underway. To evaluate the importance of the traditional channel in the short term, manufacturers should ask themselves whether customers are more loyal to the retailer or to the manufacturer. How many customers will visit another retailer if they do not see their favored brand on the shelf? If customers have more loyalty to the store than to the brand, then the manufacturer cannot afford to lose the cooperation of the retailer. The Home Depot example illustrates the problem. While manufacturers may hope to transition eventually all customers to an Internet channel, the consequences of being dropped by Home Depot would be devastating in the short-term. Are there actions available to the manufacturer to protect the traditional channel? Firms have a range of options available to protect the traditional channel. For example Hallmark, which wanted to develop a strong Internet presence while maintaining the on-going support of its network of privately owned retailers, developed an online strategy to increase demand for Hallmark branded products at its traditional retail stores. To increase demand at its Gold Crown Stores, Hallmark provides online information about collectibles such as artists, release dates, and availability. In addition, Hallmark.com promotes the "Gold Crown Card" (frequent buyer awards program) that may only be used in Gold Crown stores. According to one retailer, who owns three stores in Colorado, two in New Mexico, and two in Arizona, Gold Crown Card sales are a significant source of revenue for Gold Crown Stores. Revising the method of compensating the traditional channel can provide new incentives for the traditional channel to support the Internet channel. For example, several firms now compensate their traditional channel for all sales, even if the transaction occurs over the Internet. However, effective incentives are generally contingent on the accurate measurement of the traditional channel's effort, which for several reasons are often difficult to obtain. First, measurements of the traditional channel's performance may be inaccurate if activities in one channel affect performance in another channel. Measures of sales, product returns, warranty claims and service activities are all distorted if there is a flow of customers between channels. Second, accurate measurement may also require a large investment in information technology. Finally, incentive schemes that compensate the traditional channel for Internet channel sales can lead to the traditional channel receiving compensation without performing any work. For example, Staples decided to allow sales people at retail locations to place orders for large products and furniture with the Internet division. This allowed Staples to stop maintaining large warehousing space at each location without creating channel conflict. Each retailer store earned profit on each sale without bearing any of the inventory, handling, or distribution costs. In other cases firms have been able to protect their traditional channel by charging consumers separately for the service and the product. For example, in the financial services industry, the price of providing investment advice was historically bundled with the price of a securities trade. The development of discount brokerage services on the Internet provided an opportunity for customers to avoid paying for investment advice by consulting with full service firms and then completing trades through discount brokerages. Full service firms such as Merrill Lynch have responded by changing their pricing policies so that customers now pay a fee for investment advice, based upon the percentage of assets managed rather than upon the number of trades executed. 3 The Internet leads to coordination problems Many of the tasks and decisions involved in managing a distribution channel require coordination. For example, advertising is more effective if sales people are trained and if inventory is available to respond to customer enquiries. Similarly, decisions regarding inventory levels and manufacturing schedules often depend upon sales in each channel. There were many examples in which the Internet made coordination harder, leading to frictions and conflict within and across firms. These obstacles to coordination lead to several adverse outcomes. 3.1 Adverse outcomes Firms report greater difficulty scheduling, manufacturing, and planning inventories. For example, the availability both of Internet and bricks and mortar bookstores has made it more difficult for publishers and retailers to manage inventories. WordsWorth is an across-the-board book discounter in Cambridge, Massachusetts. Founded in 1976, WordsWorth has used the Internet and its predecessors since the early 1980s when it set up a storefront on the CompuServe mall, selling books to the then-tiny online audience. In 1993, WordsWorth started an Internet channel. However, according to the general manager and webmaster of WordsWorth.com, this introduced new problems:"Our biggest challenge is stocking. Since both the physical and web stores share stock and we keep separate databases for legacy and security reasons, we have to make sure that our website allows for this." Best Buy provides another example. The company gives consumers the option of picking up merchandize that was ordered online, in a local Best Buy store. Because the inventory at Best Buy stores was managed locally and because communication between the online retailer site and stores was poor, the company initially experienced inventory shortages in retail stores. Firms also experience problems coordinating sales leads. Leads are not passed between channels, either because the channels compete or because there are no incentives to help the other channel. Even when there are incentives to share leads, communication difficulties resulted in some customers receiving contacts from multiple channels, while other customers receive no attention. IBM and Bose reported that customers are often confused about whether to purchase from the direct or indirect channel. In the automobile industry, coordination difficulties have led to slow response times on referrals. Manufacturer sites refer customers to dealers to obtain quotes for follow-up sales. However, according to Consumer Reports, as of 1999, 65% of customers receive no response from dealers within two days of the customer request. Problems also arise when orders are received via one channel, but are fulfilled in another channel. April Cornell provides one such example. April Cornell carries a product line of silk-screened patterns and operates in over 70 bricks and mortar retail stores in up-scale shopping districts of major metropolitan areas in North America. The company's order fulfillment for its Internet site, Aprilcornell.com, relies on its retail stores. An online order is forwarded from the corporate office to the closest (to the customer) retail store that has the item in stock. The store then ships the order and charges the customer's credit card. However, once the order is given to the store, the corporate office has no information regarding the status of the order, putting at risk the company's attempts to maintain service quality. In another fulfillment example, Amtrak started selling tickets on its website in February 1997. In an effort to integrate ticketing across all channels, Amtrak's consumer web site connects with the same "Arrow" reservation system that other Amtrak ticket channels use. However, because this system handles all Amtrak ticketing, it cannot offer Internet-only date- specific or route-specific deals. Consequently, the system cannot automatically check whether a sale price submitted from the web site is accurate, requiring an Amtrak reservation agent to confirm manually the price before "Arrow" allows the transaction to proceed. This lack of automation severely limits Amtrak's Internet-specific marketing options. At Bose Corporation the introduction of an Internet channel led to inconsistent marketing messages. Bose's Internet group was established as a separate business unit responsible for the website, including design, content and Internet communication. The corporate communications group and the Internet group did not have established processes for exchanging ideas or discussing strategies, resulting in different messages being distributed through the various channels. 3.2 Underlying issues The interviews identified three underlying issues that hinder coordination when introducing an Internet channel. First, there is an increase in the amount of communication required. Firms generally use a combination of approaches to coordinate activities. Some decisions are made centrally, while other decisions are decentralized by delegating authority to the separate channels. Centralized decision-making requires communication up and down from the central decision-maker to the channels, while decentralized decisions require communication between channels. Developing an Internet channel introduces additional decision-makers and increases the dispersion of information. As a result, coordination requires more communication, both between channels and with a central decision-maker. These issues tend to be exacerbated when firms outsource their Internet operations, so that communication must cross firm boundaries. Second, the technical and operational challenges associated with the Internet are often different from the challenges that arise in other channels. As a result, specialized IT systems, languages and cultures have developed to support each channel. This introduces a classic trade-off between specialization and coordination. While development of specialized languages and technologies makes it easier to solve problems specific to each channel, lack of standardization makes it harder to achieve coordination between channels. A good example of IT differences is Citibank's effort to coordinate its PC banking with its call center operations. Initially, Citibank's software for Home Banking was independent from the information technology (IT) system used in branches: any transaction made through a different channel would produce a confirmation number internal to the channel. When customers called customer service they referred to the transaction number that the software generated. However, that number had no meaning for other Citibank systems. Similarly, online traders at Nomura Securities initially were unable to provide the same information to customers as to offline traders due to differences in their information systems. Examples of language differences between channels often relate to technical production issues. Promotions Unlimited Corporation (PUC) is the largest supplier of promotional/seasonal items (Halloween, 'Back to School' products, party decorations) to independent retailers in the United States. In November 1999, PUC launched an online division, Goliath Falls (GFI), to extend its marketing reach and address the underlying needs of retailers beyond procurement. Managers at PUC and GFI reported that coordination is hindered by language differences between channels: while personnel in both channels use the same terms as they relate to the supply chain and products (SKU, cycle time), they speak very different languages with respect to internal operating procedures. For example, GFI focused on server crashes, website usability, cognitive engineering, and click-through rates; terms which PUC executives did not understand. A related problem can be found at the Boston Globe, where sales personnel for the print version sell lines and millimeters, while the online versions sells page views. These language differences were offered as one explanation for poor coordination of online and offline sales efforts. Language and culture differences also extend to communications with customers. Bose and Gillette reported that the global availability of their Internet sites created problems because they had not translated the content into the languages of their international customers. This contrasts with the firms' traditional channels, where customers and channel participants interact using the local language and customs. Third, conflict with the traditional channel can introduce its own channel problems. Recall that a common response for the traditional channel is to withhold information about customer preferences, customer identities, and inventory levels. This makes it harder for manufacturers to undertake product development and optimize pricing, promotion and other marketing decisions. Since 1995, Allaire Corporation, a leading provider of web application development software, has used its flagship product Cold Fusion Web Application Server to rapidly build, deploy and manage web applications. In addition to its direct sales channel, Allaire has developed indirect channel partnerships with resellers, OEMs, system integrators, and other VARs. Now, almost 60% of Allaire's sales are from indirect channels. Because indirect partners have no incentive to pass customer information to Allaire, the company lacks knowledge of customer profiles, feedback, and usage, and cannot contact its users to share information about upgrades, patches, and security alerts. This hinders Allaire's product development activities and demand forecasts. Bath Store International (BSI, name disguised for reasons of confidentiality), a global retailer of upscale personal care products, provides a similar example. BSI relies strongly on franchise stores that comprise approximately 40% of its U.S. retail stores. The company has recently founded Bath Store Digital (BSD) to enable consumers to buy BSI products online. Since BSD is functioning as the online store not just for its company owned store but also for BSI's franchisees, BSD is trying to build a database about the franchisees' customers. However, franchise stores have little motivation to work with BSD, as they fear that BSD will cannibalize part of their business by accessing consumers directly. This creates inefficiencies because each channel has incomplete information about customers and their demand for BSI's products. Similar examples can by found at Nomura Securities and BBO Brokerage, where traders and sales people stopped providing information about customer preferences following the introduction of online trading. 3.3 Solutions Solutions to the coordination problems described in this section fall into two categories: 1. Implement mechanisms that overcome barriers to communication. 1. Restructure to reduce the number of decision-makers and/or the dispersion of information The selection of an appropriate strategy depends upon the answers to the following questions. What additional information is required to improve decision-making? A solution to most coordination problems can be found by providing better information to decision-makers. However, the changes required to achieve this depend upon the organization. In some firms, coordination can be improved by centralizing more decisions, while in other organizations, less centralized decision-making is called for. More centralized decision-making can facilitate coordination by reducing the number of decision-makers. Bose Corporation's Manager of Electronic Media speculated that moving the Internet group back under the corporate communications group would solve the inconsistencies in marketing messages between the Internet and traditional channel. Allaire provides another example of a firm benefiting from a more centralized structure. Allaire created an account management position that oversees both the direct and indirect sales operations for a particular region. This improves the coordination of sales activities across channels because the distribution of leads and allocation of effort is determined by a single authority. In contrast, decentralizing decision-making ensures that decision-makers are closer to the customer, inventory, product or manufacturing information required to make the correct decision. The advantages of a more decentralized structure are well- illustrated by the decisions both of J. Crew and of Nordstrom to allow their Internet and traditional channels to maintain separate inventories and manage their own fulfillment. While this solution sacrifices firm-wide synergies, it overcomes the need for cross-channel coordination. Resolving the trade-off between centralization and de-centralization depends on the type of information required to improve decision-making. If the current coordination problems arise because decision-makers are unsure about the decisions of other decision-makers, then a more centralized structure is required. Alternatively, a less centralized structure will help if decision- makers lack more functional information, such as customer, inventory, product or manufacturing details. Will overall performance incentives lead to free-riding? Incentive conflicts were a common source of coordination failures. Several firms have been able to overcome these problems by redesigning their incentive systems. Merrill Lynch now pays its brokers based on the total assets they manage, rather than on the number of trades they facilitate. As a result brokers have less incentive to discourage clients from using Merrill's Internet trading service, as these trades no longer cannibalize their own commissions. In other cases firms have rewarded participants in both channels for any sales, irrespective of the channel in which the transactions occur„ This encourages channel participants to increase overall performance by communicating relevant information accurately. Unfortunately, incentives based on overall performance often result in the firm compensating all channels for transactions that only one channel contributed to. It may also lead to free-riding, under which employees in one channel rely on the efforts of another channel. Free-riding is more of a concern where the actions of the different channels are substitutes rather than complements. There is also evidence that free-riding is more likely if employees in the separate channels have little regular interaction. Regular interaction allows participants in the different channels to monitor and sanction each other. How valuable is specialization? Rather than develop specialized languages and technologies to solve problems specific to each channel, several firms have relied on increased standardization to simplify communication between Internet and traditional channels. For example, Amtrak described plans to reconfigure the "Arrow" system to allow it to confirm the appropriate final pricing for fares regardless of which channel produced the sale. With this system in place, Amtrak will be able to pursue Internet-specific promotions, increasing the attractiveness of the channel to potential consumers. Similarly, to solve the problem of misdirected customer calls relating to Home Banking transaction numbers, Citibank eliminated the confirmation number and gave consumers the option to receive a printed record similar to that for an ATM transaction. In these examples the gains from standardization did not require either firm to forgo the benefits of specialization. Instead, the firms identified examples of specialization that hindered coordination and offered few inherent benefits. Can process changes reduce the need for communication? The interviews revealed several opportunities to improve coordination by reducing the need for communication. Several firms were able to overcome coordination difficulties by rotating employees between channels. This yields three advantages. First, communication is often easier, because employees share a common language. Second, there is less need for communication because employees share common expectations about the nature and timing of tasks. And third, employees are less likely to make decisions that help their channel at the expense of the other channel, if they are likely to transfer to the other channel soon. Examples include Staples, which now encourages employees to transfer internally between the online and traditional channels. Of course job rotation is typically only available as a solution when the traditional and Internet channels are owned by the same firm. Other examples include firms that developed alternative sources of information to overcome incentive conflicts or other barriers to communication. Allaire, the web server software company, uses the Internet to contact customers who purchase through its traditional channels. Consumers are invited to register products online and participate in special development communities on Allaire's password restricted website. The registration process allows Allaire to build a current customer list, even if its resellers refuse to share customer information. 4 The Internet destroys traditional segmentation criteria The use of multiple distribution channels is an important mechanism for targeting separate segments with different marketing offerings. A clothing retailer such as Banana Republic accesses many of its customers through its retail stores, while accessing other customers through its Internet catalog. The use of these two channels enables Banana Republic to satisfy customers who prefer to try on clothing before purchasing and to satisfy customers who do not have time to visit a retail store. Price and product offerings are varied across the channels in response to differences in the preferences of the separate segments. The benefits of using the Internet as a segmentation mechanism are undermined if customers use more than one channel. When customers are exposed to multiple channels, the attempt to differentiate will fail. This is not the only cost of maintaining more than one channel. Inconsistencies in product and price offerings tend to result in customer confusion and dissatisfaction. The ease with which customers can access information on the Internet makes these issues particularly relevant. Information often is publicly available and customers accessing Internet sites are generally anonymous. 4.1 Adverse outcomes It is helpful to distinguish two scenarios in which problems arise. To illustrate the first scenario, consider a firm that has a traditional retail store and has also recently introduced an Internet channel. The need to maintain consistency between its Internet and traditional channels may prevent the firm from designing one set of product and price offerings for customer segments that purchase over the Internet and different offerings for customers that purchase through the traditional store. J.Crew, a company that started in 1983 as a catalog-clothing retailer and opened its first store in 1989, exemplifies the problem. When it started selling online in 1996, J.Crew offered promotions and discounts on its Internet site before offering them in catalogs and retail stores. This led to confusion among customers who used more than one channel. Consumers who purchased in a retail outlet and later noticed that they could purchase the same item online for a lower price felt "cheated." Examples are not limited to the consumer market. Many firms selling in the business market have experiencing similar problems. For example, Office Depot, the largest supplier of office products and services in North America, reported that many of its business customers complained when it charged different prices on the Internet from those it charged in its stores. The problems are also not limited to inconsistencies in pricing strategies. Other sources of customer dissatisfaction and confusion include discrepancies in return policies (Barnes and Noble, Staples), product selection (CVS, Toys R Us), lead times (Standard and Poor's), and packaging (Toys R Us). Barnes and Noble's online division bn.com initially did not allow consumers to return books at Barnes and Noble's retail locations. Customers naturally assumed that the two firms were actually one company and were confused by inconsistencies in the return policies. A similar problem occurred with Toys R Us's Internet site (Toys.com). Since Toys.com relied on Amazon.com's fulfillment operation, consumers received goods in Amazon packaging, leading to confusion about the origin of the merchandise. At Standard and Poor's, a Lexington, Massachusetts based economic research firm, the different lead times between CD-ROM and the Internet channel confused customers who perceived inconsistencies among reports. In the words of one of their clients:"In October 1998, I picked up a CD-ROM, and printed out reports from it. The Russia text had been written in April. There was no mention at all of the devaluation of the Ruble. Absolutely ridiculous." The second scenario involves firms that target different customer segments in their traditional channels. Consider a firm that maintains two retail stores, one in Region A and the other in Region B. Prior to the introduction of an Internet channel the firm may charge different prices and offer different products in the two stores as long as customers in the two regions do not overlap. In an Internet channel, customer anonymity often makes it difficult to vary prices and products offered to customers in different regions. In this case, maintaining consistency between the Internet and traditional channels requires that the firm abandon its earlier strategy and instead offer the same prices and product assortments at its two retail stores. For this reason, the introduction of the Internet can make it more difficult to discriminate in traditional channels. Xerox provides a good example. Xerox's internally managed direct sales force organizes accounts by geographic territories and accounts for 80% of Xerox's revenues. The Xerox Internet site provided complete pricing information, however, this hindered the direct sales force's ability to vary prices between clients, reducing overall profit margins. Other firms that have had trouble maintaining domestic regional pricing policies include Staples, Verizon and CVS. The global reach of the Internet has led to related problems for firms that sell products internationally. Intellution Inc. produces software designed to integrate the automatic operations of industrial processes and machinery. Before the introduction of its website, international customers did not know that US customers were paying less. After unveiling the web site, international customers were able to see what prices US customers were offered. Bose faced a similar problem. 4.2 Underlying issues At the core of these problems lie two issues. First, consumers do not always consider third degree price discrimination a legitimate business practice. While they are used to paying different prices for identical goods in some industries (airlines, for example), they find it "unfair" in many others. Firms that attempt to charge multiple prices may attract considerable negative reaction. Recently, Amazon.com was widely criticized for charging different customers different prices for the same items. Not surprisingly, this problem is most common amongst firms that identify the association between their Internet and traditional channels using a common brand name. Customers are more likely to expect consistency between the channels if the same firm owns both channels. The second problem is that third degree price discrimination is only effective if firms can associate individual customers with specific segments. When firms implement regional pricing policies, they segment customers on the basis of the retail outlet the customer uses. The Internet makes geography largely unobservable and so firms may no longer associate a customer with a specific location. 4.3 Solutions Firms adopted a mixture of the following four solutions: 1. Abandon attempts to discriminate. 2. Limit customers' access to price and product information. 3. Increase product differentiation to make it harder to compare prices. 4. Use alternative discrimination mechanisms. The choice of a solution depends upon the answers to the following questions: Is a response necessary? Although many firms were concerned about customer reactions, none of the firms reported that they had systematically investigated how customers react when they observe a product or price inconsistency. Nor were any firms planning a systematic investigation of this issue. This is surprising given the actions taken by several firms in anticipation of adverse customer reactions. How much is gained by targeting separate segments with different offerings? Several firms had abandoned attempts to price discriminate and now maintain the same prices across their retail store, catalog and Internet channels. Examples include IBM, which reported plans for a uniform channel pricing policy, and Siemens, which implemented a consistent price policy for large corporate clients. Office Depot also reacted to customer complaints by creating a standardized pricing structure across its channels. In particular, Office Depot's business customers received a special Pro-Card Procurement Card that allowed them to obtain supplies from a retail store at a contracted Internet rate. Other examples include Toys R Us, which now keeps its online prices consistent with its store prices, and Verizon, which has adopted a nationwide flat pricing strategy. To support their claims that prices are consistent between channels, several firms promote a price matching policy. J. Crew matches any promotion price from its catalog or Internet site if a customer can bring in proof of the promotion. Similarly, Nordstrom offers to match a lower price if a customer notices a price discrepancy between channels. Firms have also retreated from offering different products and maintaining different policies between channels. Siemens has standardized its warranties between channels, while Staples has changed its policy and now ensures that products and return policies are consistent. Although abandoning the practice of offering different products and prices to different customer segments may resolve customer confusion or dissatisfaction, this response comes at a cost. The firms would have preferred to target different segments with different offerings. Maintaining the same offering is less profitable because it prevents the firms from tailoring their offerings to the preferences of the separate segments. The magnitude of this opportunity cost depends on the extent to which the preferences of the different segments vary. The greater the difference, the more costly it is to abandon a differentiated marketing mix. Can consumers learn price and product information from third parties? Some firms have simply withdrawn product and price information from the Internet channel. For example, Xerox has limited purchases through the Internet and now directs customers to its traditional channel. Similarly, Horizon, a manufacturer of window coverings, has tried to mitigate the impact of the Internet on its pricing policies by only allowing online retailers to sell lower-priced, commodity-type products. However, this strategy only works if product and pricing information is not available from third parties. Edmunds.com, and Kelley's Blue Book provide such detailed pricing information that any attempt by car manufacturers to restrict access to product and price information would have little effect. An alternative solution is to vary brands, model numbers, and product specifications. The resulting loss of price and product transparency makes it difficult for customers to compare this information, even in the presence of third party information sources. Examples include Standard & Poor's, which anticipates that its DRI division's new "e-data" product will help to resolve consistency questions by making it more difficult to compare prices between channels. Similarly, Ryobi a manufacturer of power tools, has created a proliferation of model numbers to service different customer segments. Can consumers be asked to identify themselves by name or location? Some firms have tried to preserve the benefits of segmentation by limiting access to information on their Internet sites in an attempt to minimize the overlap between segments. A common approach in the retail market is to require that customers enter their zip code before receiving price or inventory information. In the business market, several firms reported that they had developed corporate extranets that allow them to vary the information provided to specific accounts. Sylvania created MySylvania, a password protected, invite-only extranet site that is customized to trigger customer-specific pricing and ordering information when customers log in. Other examples include Dell, Xerox, and the corporate computer dealer NECX. Does the Internet provide new segmentation criteria? While the Internet destroys some segmentation criteria it can also become the source of new ones. The Internet allows firms to segment consumers by their history. These strategies are only possible if consumers cannot easily acquire a different "personality," as Amazon.com's consumers did after they noticed that they were being charged higher prices than consumers who had just registered with Amazon.com. 5 Conclusions A useful question that is not addressed directly in the preceding discussion is whether there are any firms for which none of these problems arise? There were three scenarios in which firms developed Internet channels without experiencing any of these problems. The first scenario involves firms that do not have a strong position in the traditional channel prior to developing their Internet channel. This includes new entrants who focus solely on the Internet market. The absence of a traditional channel overcomes the channel conflict problems that arise with a traditional channel. These firms do not need to maintain consistency in prices, products or services across multiple channels and face few coordination difficulties due to the dispersion of information or decision-makers across channels. Measuring and compensating effort is also easier in this setting, without the need to measure externalities across different channels. Carrier Corporation provides an insightful example of this scenario. Carrier manufactures residential and commercial air conditioning equipment. Although the company had a strong presence in many commercial and international markets, its market share in the US residential market is relatively small. Most large retail chains did not sell its products and the absence of a complete line of residential products also resulted in low penetration amongst independent dealers. In contrast, Carrier has had considerable success selling residential air conditioners direct to customers over the Internet. This success is at least in part due to the absence of competition - Carrier was the only manufacturer selling direct over the Internet. Traditional retailers, who have well- established relationships with other manufacturers, prevented the competing manufacturers from developing their own Internet channels. The second scenario involves firms that developed an Internet channel only to service niche markets that were poorly served by the traditional channel. Examples include Gibson Guitars, and The Gap. Gibson discontinued sales of its core guitar products on its Internet site in response to an adverse reaction from its traditional guitar retailers and distributors. However, it received little adverse reaction to sales of accessories on its site. Guitar accessories are typically low margin products with many different variants, making it difficult for retailers to maintain a complete inventory. An Internet channel is ideally suited to selling small volume items with many different variants. Consolidating national demand for each variant through a single warehouse is more efficient than maintaining complete inventories in dispersed locations. The Gap offers a similar example, with the Internet better-suited to selling unusual color and size variants for which there are relatively low volumes. Note that these examples could be interpreted as an application of the first scenario - the lack of problems can be explained at least in part by the absence of a well-established traditional channel for these niche products. The third scenario involves firms that used the Internet to complement rather than substitute for the traditional channel. These include firms that do not sell on the Internet, but instead use the Internet to facilitate procurement, inventory management and logistics for the traditional channel. These firms, together with their partners in the traditional channel, enjoy the coordination benefits of improved communication, without the problems associated with competition between the channels. In many respects, this scenario describes extensions to the traditional channel, rather than the introduction of a new channel. Because transactions do not occur on the Internet, there are no externalities affecting measurement and compensation, nor is any information provided to customers about prices or the availability of alternatives. 6 Appendix: Final Exercise Instructions The Internet provides a new distribution channel. However, use of this channel introduces the potential for conflict between the Internet and other traditional distribution channels. Firms have responded to this conflict in different ways. For example, Home Depot at one stage sent a letter to each of its manufacturers warning that they would no longer sell products that were also available on the Internet. This exercise requires that your group interview one or more companies that have experienced conflict between the Internet and traditional distribution channels. You may choose to interview a manufacturer whose products are distributed both on the Internet and through traditional distribution channels. Alternatively, you may interview firms participating in the Internet or the traditional channels as a distributor or retailer. Please submit a four-page report that addresses the following questions: Identify up to five examples of conflict that have arisen as a result of the development of an Internet channel. For each example complete the following tasks: 1. On the following page I have listed different categories of coordination, incentive and resource issues. Categorize each issue under one or more of these headings. 2. Summarize the conflict in one sentence. 3. Summarize how the firms have attempted to resolve or respond to the conflict in one sentence. 4. Elaborate on the nature of the conflict and the response to it. 5. Is this conflict specific to the Internet or have examples of similar conflict arisen with traditional channels. If the conflict is specific to the Internet explain why. If similar examples have arisen with traditional channels explain how firms have resolved or responded in these traditional channels.