CHANNELS OF DISTRIBUTION

The word channel might bring to mind a waterway such
as the English Channel, where ships move people and
cargo. Or it might bring to mind a passageway such as the
Chunnel, the railroad and car tunnel under the English
Channel. Either image implies the presence of paths or
tracks through which goods, services, or ideas flow. This
imagery offers a good starting point for understanding
channels of distribution.
The term marketing channel was first used to describe
trade channels that connected producers of goods with
users of goods. Any movement of products or services
requires an exchange. Whenever something tangible (such
as a computer) or intangible (such as data) is transferred
between individuals or organizations, an exchange has
occurred. Marketing channels, therefore, make exchanges
possible. How do they facilitate exchanges? Perhaps the
key part of any distribution channel is the intermediary.
Channel intermediaries are individuals or organizations
who create value or utility in exchange relationships.
Intermediaries generate form, place, time, and/or ownership
values between producers and users of goods or services.
Marketing channels were traditionally viewed as a
bridge between producers and users. This traditional view,
however, fails to fully explain the intricate network of relationships
that underlie marketing flows in the exchanges
of goods, services, and information. To illustrate, consider
a prescription drug purchase. To get authorization to purchase
the drug, one must visit a physician to obtain a prescription.
Then, one might acquire the drug from one of
several retail sources, including grocery store chains (such
as Kroger), mass discounters (such as Wal-Mart), neighborhood
pharmacies, and even virtual pharmacies (such as
Drugstore.com). Each of these prescription drug outlets is
a marketing channel. Pharmaceutical manufacturers, distributors,
and their suppliers are all equally important
links in these channels of distribution for pharmaceuticals.
Sophisticated computer systems track each pill, capsule,
and tablet from its point of production at a pharmaceutical
manufacturer all the way to its point of sale in
retail outlets worldwide.
To appreciate the complexity of marketing channels,
exchange should be recognized as a dynamic process.
Exchange relationships themselves continually evolve as
new markets and technologies redefine the global marketplace.
Consider, for example, that the World Wide Web’s
arrival created a new distribution channel now accounting
for trillions in electronic exchanges. It may come as a surprise
that the fastest-growing segment of electronic commerce
involves not business-to-consumer, (called B2C in
today’s Web language) but business-to-business (B2B)
channels.
Whether these exchange processes occur between
manufacturers and their suppliers, retailers and consumers,
or in some other buyer-seller relationship, marketing
channels offer an important way to build
competitive advantages in today’s global marketplace.
This is so for two major reasons:
• Distribution strategy lies at the core of all successful
market entry and expansion strategies. The globalization
of manufacturing and marketing requires the
development of exchange relationships to govern the
movement of goods and services. As one sips one’s
preferred coffee blend at the neighborhood Starbucks,
consider that consumers in China, Lebanon,
and Singapore may be sipping that same blend.
Then consider how the finest coffee beans from
Costa Rica or Colombia get to thousands of neighborhood
coffee shops, airports, and grocery stores
around the world.
• New technologies are creating real-time (parallel)
information exchange and reducing cycle times and
inventories. Take as an example Dell Computer,
which produces on-command, customized computers
to satisfy individual customer preferences. At the
same time, Dell is able to align its need for material
inputs (such as chips) with customer demand for its
computers. Dell uses just-in-time production capabilities.
Internet-based organizations compete vigorously
with traditional suppliers, manufacturers,
wholesalers, and retailers. Bricks-and-mortars
(organizations having only a physical location) and
clicks-and-orders (organizations having only a virtual
presence) are in a virtual face-off.
DEFINING MARKETING CHANNELS
The Greek philosopher Heraclitus wrote, “Nothing
endures but change.” Marketing channels are enduring
but flexible systems. They have been compared to ecological
systems. Thinking about distribution channels in this

ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION 109
Channels of Distribution
manner points out the unique, ecological-like connections
that exist among the participants within any marketing
channel. All marketing channels are connected systems of
individuals and organizations that are sufficiently agile to
adapt to changing marketplaces.
This concept of a connected system suggests that
channel exchange relationships are developed to build
lasting bridges between buyers and sellers. Each party then
can create value for itself through the exchange process it
shares with its fellow channel member. So, a channel of
distribution involves an arrangement of exchange relationships
that create value for buyers and sellers through
the acquisition (procurement), consumption (usage), or
elimination (disposal) of goods and services.
EVOLUTION OF CHANNELS
Marketing channels always emerge from the demands of a
marketplace. Nevertheless, markets and their needs are
always changing. It is true, then, that marketing channels
operate in a state of continuous evolution and transformation.
Channels of distribution must constantly adapt in
response to changes in the global marketplace. Remember:
Nothing endures but change.
At the beginning of the nineteenth century, most
goods were still produced on farms. The point of production
had to be close to the point of consumption. But
soon afterward, the Industrial Revolution prompted a
major shift in the American populace from rural communities
to emerging cities. These urban centers produced
markets that needed larger and more diverse bundles of
goods and services. At the same time, burgeoning industrialization
required a larger assortment of production
resources, ranging from raw materials to machinery parts.
The transportation, assembly, and reshipment of these
goods emerged as a critical part of production.
During the 1940s, the U.S. gross national product
grew at an extraordinary rate. After World War II
(1939–1945) ended, inventories of goods began to stockpile
as market demand leveled off. The costs of dormant
inventories—goods not immediately convertible
into cash—rose exponentially. Advancements in production
and distribution methods came to focus on costcontainment,
inventory control and asset management.
Marketers soon shifted from a production to a sales orientation.
Such attitudes as “a good product will sell itself ” or
“we can sell whatever we make” receded. Marketers confronted
the need to expand sales and advertising expenditures
to persuade individual customers to buy their
specific brands. The classic four Ps classification of marketing
mix variables (product, price, promotion, and
place) emerged as a marketing principle. Distribution
issues were relegated to the place domain.
This innovative selling orientation inspired the development
of new intermediaries as manufacturers sought
fresh ways to expand market coverage to an increasingly
mobile population. The selling orientation required that
more intimate access be established to a now more diversified
marketplace. In response, wholesale and retail intermediaries
evolved to reach consumers living in rural areas,
newly emerging suburbs, and densely populated urban
centers.
Pioneering retailers such as John Wanamaker (1838–
1922) in Philadelphia and Marshall Field (1834–1906) in
Chicago quickly sprouted as Goliaths in this brave new
retail world. Small retailers came of age, as well, offering
specialized operations tailored to meet the needs of a
changing marketplace. Retailers and their channels
evolved in lockstep with the movements and needs of the
consumer marketplace. As always, marketing channels
were evolving in response to changing marketplace needs.
The impact of two remarkable innovations taken for
granted today—the car and the interstate highway system—
cannot be ignored. These transforming innovations
simultaneously stimulated and satisfied Americans’ desire
for mobility. Manufacturers suddenly began selling their
wares in previously inaccessible locations. Millions of
Americans fled from the cities to the suburbs in the 1950s
and 1960s. Retailers quickly followed. Yet another channel
phenomenon emerged, this one involving groups of
stores situated together at one site. The suburban shopping
center was born. Its child, the mall, soon followed.
In 1951 the earth moved. That was the year marketers
first embraced the marketing concept. The marketing
concept decrees that customers should be the focal
point of all decisions about marketing mix variables. It
was accepted that organizations should make only what
they could market instead of trying to market whatever
they could make. This new perspective had a phenomenal
impact on channels of distribution. Suppliers, manufacturers,
wholesalers, and retailers were all forced to adopt a
business orientation initiated by the needs and expectations
of each channel member’s customer.
The marketing concept quickly reinforced the importance
of obtaining and then applying customer information
when planning production, distribution, and selling
strategies. A sensitivity to customer needs became firmly
embedded as a guiding principle by which emerging market
requirements would be satisfied. The marketing concept
remained the cornerstone of marketing channel
strategy for some thirty years. It even engendered the popular
1990s business philosophy known as total quality
management. Small wonder, then, that in Japan the English
word customer has become synonymous with the
Japanese phrase for “honored guest.”

110 ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION
Channels of Distribution
The customer focus espoused within the marketing
concept has a broad, intuitive appeal. Yet the marketing
concept implicitly suggests that information should flow
unidirectionally from customers to intermediaries and
from intermediaries to manufacturers. This unnecessarily
restrictive and reactive approach to satisfying customers’
needs has been supplanted by the relationship marketing
concept. As modern communication and information
management technologies emerged, channel members
found they could now establish and maintain interactive
dialogues with customers. Ideas and information began to
be exchanged—bidirectionally—in real time between
buyers and sellers. Channel members learned that success
comes from anticipating the needs of one’s customers
before they do. The earth had moved, again, as the relationship
marketing philosophy was widely adopted.
How important is a customer dialogue? Sophisticated
database and interactive technologies enable channel
members to quickly identify changes in customers’ preferences.
This, in turn, allows manufacturers to modify product
designs nimbly. Relationship marketing allows
manufacturers to mass-customize offerings and to reduce
fixed costs associated with production and distribution.
Retailers and wholesalers make better-informed merchandising
decisions. This is yet another lesson in the costs of
carrying unwanted products. Relationship marketing
yields greater customer satisfaction with the products and
services they acquire and consume. And why not? The
customer’s voice was heard when the offering was being
produced and distributed.
Relationship marketing is driven by two principles
having particular relevance to marketing channel strategy:
• Long-term, ongoing relationships between channel
members are cost-effective. (Attracting new customers
costs over ten times more than retaining
existing customers.)
• The interactive dialogue between providers and
users of goods and services is based on mutual trust.
(The absence of trust imperils all relationships. Its
presence preserves them.)
THE ROLE OF INTERMEDIARIES
This progression from a production to a relationship orientation
allowed many new channel intermediaries to
emerge because they created new customer values. Intermediaries
provide many utilities to customers. The provision
of contractual efficiency, routinization, assortment,
or customer confidence all create value in channels of distribution.
One of the most basic values provided by intermediaries
is the optimization of the number of exchange relationships
needed to complete transactions. Contractual
efficiency describes an aspiration shared among channel
members to move toward the point where the quantity
and quality of exchange relationships is optimized. Without
channel intermediaries, each buyer would have to
interact directly with each seller. This interaction would
be extremely inefficient. Imagine its impact on the total
costs of each exchange.
When only two parties participate in an exchange,
the relationship is a simple dyad. Exchange processes
become far more complicated as the number of channel
members increases. The number of exchange relationships
that can potentially develop within any channel equals:
where n is the number of organizations in a channel.
When n is 2, only one relationship is possible. When n
doubles to 4, up to 25 relationships can unfold. Increase
n to 6, and the number of potential relationships leaps to
301. The number of relationships unfolding within a
channel quickly becomes too large to efficiently manage
when each channel member deals with all other members.
Channel intermediaries are thus necessary to facilitate
contractual efficiency. But as the number of intermediaries
approaches the number of organizations in the channel,
the law of diminishing returns kicks in. At that point,
additional intermediaries add little new value within the
channel.
McKesson Drug Company, the nation’s largest drug
wholesaler, acts as an intermediary between drug manufacturers
and retail pharmacies. About 600 million transactions
would be necessary to satisfy the needs of the
nation’s 50,000 pharmacies if these pharmacies had to
order on a monthly basis from each of the 1,000 U.S.
pharmaceutical drug manufacturers. When this example
is extended to the unreasonable possibility of daily orders
from these pharmacies, the number of transactions
required rises to more than 13 billion. The number of
transactions is nearly impossible to consummate. Nevertheless,
introducing 250 wholesale distributors into the
pharmaceutical channel reduces the number of annual
transactions to about 26 million. This reduction in transactions
is contractual efficiency.
The costs associated with generating purchase orders,
handling invoices, and maintaining inventory are considerable.
Imagine the amount of order processing that
would be necessary to complete millions upon millions of
pharmaceutical transactions. McKesson offers a computer-
networked ordering system for pharmacies that provides
fast, reliable, and cost-effective order processing. The
system processes each order within one hour and routes
the order to the closest distribution system. Retailers are
3n – 2n+1
+ 1
2

ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION 111
Channels of Distribution
relieved of many of the administrative costs associated
with routine orders. Not coincidentally, the system makes
it more likely that McKesson will get their business as a
result of the savings.
Routinization refers to the means by which transaction
processes are standardized to improve the flow of
goods and services through marketing channels. Routinization
has several advantages for all channel participants.
To begin with, as transaction processes become
routine, the expectations of exchange partners become
institutionalized. The need to negotiate on a transactionby-
transaction basis disappears. Routinization permits
channel partners to concentrate more attention on their
own core businesses. Routinization clearly allows channel
participants to strengthen their relationships.
Organizations strive to ensure that all market offerings
they produce are eventually converted into goods and
services consumed by members of their target market. The
process by which this market conversion occurs is called
sorting. In marketing channels, assortment is often
described as the smoothing function. The smoothing
function relates to how raw materials are converted to
increasingly more refined forms until the goods are
acceptable for use by final consumers. The next time you
purchase a soda, consider the role intermediaries played in
converting the original syrup to a conveniently consumed
form. Coca-Cola ships syrup and other materials to bottlers
throughout the world. Independent bottlers carbonate
and add purified water to the syrup. The product is
then packaged and distributed to retailers, and consumers
buy it. That is assortment. That is what channels of distribution
do. Two principal tasks are associated with the
sorting function:
1. Categorizing. At some point in every channel, large
amounts of heterogeneous supplies have to be converted
into smaller homogeneous categories. Returning
to pharmaceutical channels, the number of
drugs available through retail outlets is huge. More
than 10,000 legal drugs exist. In performing the categorization
task, intermediaries first arrange this vast
product portfolio into manageable therapeutic categories.
The items within these categories are then
categorized further to satisfy the specific needs of
individual consumers.
2. Breaking bulk. Producers want to produce in bulk
quantities. Thus, it is necessary for intermediaries to
break homogeneous lots into smaller units. Over 60
percent of the typical retail pharmacy’s capital is tied
to the purchase and resale of inventory. The opportunity
to acquire smaller lots means smaller capital
outflows are necessary at a single time. Consequently,
pharmaceutical distributors continuously break bulk
to satisfy retailers’ lot-size requirements.
The role intermediaries play in building customer
confidence is their most overlooked function. Several
types of risks are associated with exchanges in channels of
distribution, including need uncertainty, market uncertainty,
and transaction uncertainty. Intermediaries create
value by reducing these risks.
Need Uncertainty. The term need uncertainty refers to the
doubts that sellers have regarding whether they actually
understand their customers’ needs. Usually neither sellers
nor buyers understand exactly what is required to reach
optimal levels of productivity. Since intermediaries act like
bridges linking sellers to buyers, they are much closer to
both producers and users than producers and users are to
each other. Since they understand buyers’ and sellers’
needs, intermediaries are well positioned to reduce the
uncertainty of each. They do this by adjusting what is
available with what is needed.
Few organizations within any channel of distribution
are able to accurately state and rank their needs. Instead,
most channel members have needs they perceive only
dimly, while still other firms and persons have needs of
which they are not yet aware. In channels where there is a
lot of need uncertainty, intermediaries generally evolve
into specialists. The number of intermediaries then
increases, while the roles they play become more complex
and focused. The number of intermediaries declines as
need uncertainty decreases.
Market Uncertainty. Market uncertainty depends on the
number of sources available for a product or service. Market
uncertainty is difficult to manage because it often
results from uncontrollable environment factors. One
means by which organizations can reduce their market
uncertainty is by broadening their view of what marketing
channels can and perhaps should do for them. Channels
must be part of the strategic decision framework.
Transaction Uncertainty. Transaction uncertainty relates
to imperfect channel flows between buyers and sellers.
When considering product flows, one typically thinks of
the delivery or distribution function. Intermediaries play
a key role in ensuring that goods flow smoothly through
the channel. The delivery of materials must frequently be
timed to coincide precisely with the use of those goods in
the production processes of other products or services.
Problems arising at any point during these channel flows
can lead to higher transaction uncertainty. Such difficulties
could arise from legal, cultural, or technological
sources. When transaction uncertainty is high, buyers