Distributors Face Cost Issues Head-On

For all of the services the electronics supply chain can provide, the key emphasis for suppliers and customers remains cost. "Decreasing cost" is still the top priority for all denizens of the electronics industry. Within the past year, surveys from Gartner, UPS, and SCM World all list cost reduction as one of the top three drivers of supply chain innovation.

This has been a unique challenge for electronics distributors, which are considered middlemen in the supply chain. As conventional wisdom goes, every time a product is touched, cost is added. The channel's challenge is how to demonstrate value (rather than expense) while reducing costs internally and externally.

Unlike manufacturers, which can relocate to lower-cost regions, electronics distributors don't manufacture products. Certain aspects of service, such as call centers, can be outsourced to less expensive geographies. But the main function of electronics distributors has been to procure, store, manage, and ship inventory. Much of the cost-management effort centers on the components and computing products that are central to the electronics industry.

Cost begins with the supplier. Manufacturers of chips, connectors, capacitors, resistors, oscillators, and an array of other devices have materials, labor, transportation, and overhead just like any other company. Once all of those things are accounted for, a price for a component is set. The price includes a profit margin for the manufacturer. Once that component moves to distribution, a profit margin has to be available to the distributor. There are two main ways to accomplish this: suppliers take less for themselves, or prices go up to account for distribution's profit.

This detail has been a bone of contention between distributors and suppliers for decades. Suppliers may carry several distributors in the same region, so those distributors can conceivably undercut one another on price. This drives down profit margins for all parties. Suppliers have resisted this by limiting how much distributors can cut prices. Accounting for this is a complex process that ultimately adds cost across the board.

For decades, customers have asked distributors to do a little more to make their lives easier. Manufacturers turn out standard lots of components, and those lots don't always sync with customer needs. Distributors break up those lots into smaller segments to fit customer demand. This very basic task has evolved toward a vast array of value-added services covered in Distributors Secure Role With Extra Services.

As recently as the 1980s, distributors bundled these costs into the per-unit price they charge customers. If a distributor buys a part for $1.00, a profit margin and service cost may bring the cost up to $1.25. As the supply chain got more sophisticated, customers began asking for more services. Breaking down lots, repacking, relabeling, and shipping devices all cost distributors in terms of labor, warehousing, and services. That 25-cent margin rapidly eroded.

Distributors began to implement a practice called activity-based costing, which assigns a value to every service a distributor provides. Cost structures changed from a bundled price to a base price with a menu of value-added services. The $1.00 part, if repackaged, was priced at $1.10. If it was repackaged and relabeled, the price went to $1.15. Services offered by distributors included everything from breaking down volume orders to programming; providing in-house stores at manufacturing sites; software configuration for computer systems; handling consignment inventory; and just-in-time delivery. Leading distributors such as Avnet Inc. and Arrow Electronics Inc. led the charge toward "unbundling" services from component prices by demonstrating to customers the costs associated with each service a distributor provides.

To say this was unpopular with customers would be an understatement. Although in most cases, customers weren't paying more for unbundled services, the menu of costs seemed to jack prices up. The channel moved toward a compromise; much like cable services, customers could choose a basic package, an enhanced package, or a premium package with costs bundled back into the per-unit price.

The impact of the Internet on distribution played a significant role in how the channel priced goods. Customers were able to compare prices directly from suppliers, between distributors, and in the open market. In many respects, this put more power into the customers' hands: Armed with this knowledge, customers could negotiate the best price among these various players. At the same time, this wreaked havoc in the supply chain. Companies could buy and sell more freely within the global market.

Authorized, or franchised, distributors still had to get suppliers' approval to cut prices. Non-authorized distributors, some known as brokers, were under no such restrictions. These companies could charge rock-bottom prices when supply was high, or sell at a premium when supply was low. In my next blog, I will take a look at the evolution of brokers, auction sites, independent distributors, and other sales outlets, and how suppliers and distributors worked to differentiate the authorized channel.