A recent study, based on the data from the Swedish alcoholic beverages industry, shows that even in a very developed market like Sweden, gaining access to smaller retail formats increases sales at a much higher rate than when selling in large stores. The reasoning is that although small retail formats may provide only a small pie due to limited store size and smaller assortments, manufacturers can reach a larger market share exactly due to these very same reasons. Linking this to our research in the megacities of developing markets, this relationship obviously holds for nanostores, the small mom-and-pop neighborhood stores that flock the megacities of this world. Nanostores, which carry only a few brands of a product category due to limited cash and shelf space, allow a winner-takes-almost-all strategy.

However, serving the nanostore channel is costly. With tens of thousands of stores to be reached in a single megacity, the mere distribution costs can be very high. While many incumbent players serve stores directly, multinational manufacturers entering in these markets often adopt a strategy where wholesalers are used. The latter is driven by the lower operational cost and the lower headcount to such manufacturers when using this channel. Obviously, this goes at the expense of a lower market growth rate since wholesalers have less of an incentive to develop demand for a specific product; they are driven by their entire product portfolio. For example, as we have learnt from the data of a CPG company delivering in the city of Bogota, the wholesale channel is 9% more profitable per unit sold than the direct channel, while the direct channel grows the market 11% faster than the wholesale channel.

In chapter 4 of the PhD dissertation (now available online) of my student Jiwen Ge, we study this trade-off. Under which conditions should manufacturers prefer one channel over the other?

There are two simple metrics that drive this choice. The first metric is the gross margin (that we denote below by the symbol M), essentially measuring the additional profit margin contribution of selling one additional unit, taking into account the price (typically higher in a nanostore sale than when selling to a wholesaler) and the distribution costs per unit (typically higher in the direct channel). The initial thought would be to pick the channel where the gross margin is highest. For new entrants into the market, where the cost of setting up direct distribution to tens or hundreds of thousands of nanostores is high, this usually would imply selecting the wholesale channel.

However, this does not take into account the effects of better replenishment and faster sales growth in the direct channel. Hence, the gross margin effect needs to be adjusted for the anticipated sales growth differences. For that, we introduce the second metric of growth adjusted profitability (that we denote by the symbol P), which is the gross margin M divided by the anticipated sales growth rate.

Comparing the two channels, then three potential strategies emerge: going direct, using wholesale, or first going direct and eventually switching to wholesale. In the latter strategy, first the direct channel is used to introduce the product and to grow the market, and subsequently the wholesale channel is used to take advantage of its lower cost once the product has been established. The combination of the gross margin and growth adjusted profitability metrics defines whether one strategy is better than the other.

Using the above-mentioned metrics, the tables below show what to do for different lengths of decision making horizons. Note that M(D) denotes the gross margin of the direct channel, M(W) the gross margin of the wholesale channel, P(D) the growth-adjusted profitability of the direct channel and P(W) the growth adjusted profitability of the wholesale channel.

An interesting trait that impacts the decision significantly is the decision making horizon. In some companies, a return on investment (reflected for instance in the Net Present Value of a project) needs to be made in a short time. For instance, a company requires returns to be positive over a one of two-year decision making horizon. These companies will find it hard to start with a direct channel strategy, since the benefit of higher sales may not be realized within the decision making horizon, and the initial loss may be too large. In many case, this implies that these companies will not win in the market through using the direct channel. Entering into the nanostore channel directly requires longer breath, and a decision making horizon is typically a bit longer, which allows manufacturers to enter the market using the direct channel and then switch to the wholesale channel to take advantage of its cost efficiency. If the horizon is long enough, and the gross margin high enough, a direct strategy should be used without ever switching to wholesale.

Of course, our findings are based on stylized models, and details may differ in different markets and for specific ratios, but based on these insights, it will be possible for any neighborhood of any city to define the ratios mentioned above, and to make the trade-off whether to go direct or make use of the wholesale channel.

This blogpost has been published earlier on LinkedIn