Driving Growth By Controlling Grey Market Leakage

Piracy is a substantial and growing issue for many companies. The U.S. Chamber of Commerce estimated that in 2006, U.S. based manufacturers lost $250 billion in revenues which led to the loss of more than 750,000 jobs. Piracy, which is pervasive across many industries, can represent a significant share of total market demand for a company's product. Although emerging markets have garnered a lot of the media attention and have a tendency to be the worst offenders; piracy is actually pervasive across all industries and regions.

In addition to the obvious depression of revenues and margins that manufacturers must endure, high levels of piracy can erode overall market viability and channel integrity for both manufacturers and their customers, making it increasingly difficult to service markets/channels and re-invest in new products.

Manufacturers expend a great deal of effort to combat piracy by working with trade associations and governments -- both domestic and foreign -- especially to combat piracy in the form of theft and counterfeit goods. However, few companies have aggressively attacked one of the primary contributors to piracy a key element that is completely within their own sphere of control: Grey Market goods.

Piracy impacts many industries
(% in blue box represents revenue loss as % of legitimate sales)

Grey market product is real product that is leaked into the marketplace where the manufacturer does not receive the full market revenue potential. This form of piracy occurs for multiple reasons, but most often happens as a result of an extended, global value chain that is not well managed. This allows members in an extended partner network to operate in the "grey" and cheat or "go-around" the manufacturer's own policy and pricing guidelines. Extended supply chains often have complex pricing, distribution and control challenges that open the door to arbitrage opportunities that pirates are able to leverage. Our experiences show that there are a number of value chain solutions that are immediate and highly effective measures in addressing Grey market leakage across industries.

Defining Piracy -- 3 Major Contributors

Theft: Real product that is stolen -- includes both inside and outside the four walls of the manufacturer and partners in the supply chain. This is difficult to combat because it can include stolen shipments, theft at gunpoint, organized crime rings, government complacency, etc.

Counterfeit: Includes both high and low quality "knock-off" product -- a form of theft. Counterfeit products may or may not be difficult for the "average" buyer to distinguish from real product.

Grey Market: Real product that is leaked inappropriately into the marketplace where the manufacturer is not paid in full per the terms of the established partner agreement. Grey market product can originate as a result of theft, such as a distributor misreporting damaged or destroyed product that is then sold into the market; it can also include forms such as the unreported sale of goods, the leaking of excess inventory into the market, product that is sold illegally across borders (playing the price arbitrage game) and multiple sales of the same product (where a product can be sold multiple times such as software where the manufacturer receives revenue only for the first reported sale.)

Different techniques are needed to combat the different forms of Piracy. Tightening supply/value chain controls and processes is a critical element in mitigating Grey market leakage.

At the core, grey market leakage results from a lack of management discipline and process structure over the manufacturers' end-to-end value chain. There is a direct correlation between the proliferation of grey market product and the use of highly extended supply chains -- chains that rely on a highly distributed and large number of "extended" strategic partners, to serve final customer needs. Often, legitimate goods are leaked into the market by the partners in the extended value chain for good economic reasons for the partners, but it only helps them.

The fundamental opportunities for a grey marketer are supply/demand balancing for cash flow optimization and the arbitrage between channels, regions and distribution models. There are three major drivers or root causes behind Grey Market Leakage including:

1. Partner Financial Health: Often, a manufacturer may have a number of economically marginal partners who will leak product into the channel inappropriately as a way to ensure their own viability. The following are some observed behaviors -- partners may:

Manipulate stocking levels due to the carrying cost of inventory
Openly stock grey market alongside legitimate product
Misreport inventory and sales
Leak product to compensate for perceived cost issues.
Change order patterns as they compensate for inventory costs:
Be less willing to carry some or all products
Return volumes may increase as Distributors are unwilling to sit on inventory

2. Manufacturer Practices: It is often the manufacturers' own operating practices and policies that provide substantial motivation and incentive for Partners to leak product into the market. We have observed the following behaviors leading to increased grey market product.

Financial Operating Practices

Invoice Accuracy/Tracking: Systems issues resulting in a mismatch between billed and shipped quantities, slowness in dispute resolution and an inability to accurately reconcile disputes can lead to either inaccurate credits and/or Partner dissatisfaction and "incentive" to cheat.
Payment & Credit Terms: Terms often can create or minimize issues associated with distributors' timing of cash flows which directly impacts their available working capital. Payment terms can impact the credit line available to a distributor which can affect the level of inventory that they can order.
Price Protection: Ineffective policies that don't adequately provide Distributors with a credit to offset the impact of a manufacturer's decision to decrease base pricing can often result in an increased amount of Grey Market goods being leaked into the market just prior to a price decrease or product line change.
Return Policies: Distributors might claim product as lost, stolen, defective or miss-shipped as a way around inadequate return allowances or if not allowed to return, leak product into the grey market. Selective returns of defective product and incorrect shipments reduce the danger of grey market goods in the channel.

Marketing/Sales/Transportation Operating Practices

Manufacturers also deal with various marketing and sales issues with their distributors that affect grey market leakage, including promotions, stock balancing and stock rotation. Furthermore, manufacturers can become involved in many dispute resolutions that cover the interim shipment timeframe from them to their distributors or between different parties.

End-To-End Operating Model Assessment

What are the characteristics of the extended network and value chain from end-to-end?
What controls are currently in place across the extended network and delivery chain?
What partners and issues are currently causing the most friction/difficulty?
What regional differences encourage leakage (e.g., pricing inequity?)
What is the extent of pricing differences by country and region?
What are buyer behaviors/needs/requirements across the channel?
To what extent do the various channels and operating/business units pollute each other?
How can perpetrators be identified?
Where in the process is there opportunity to interrupt a dubious transaction?
What systems and infrastructure exist to capture and manage the required information?
How would you characterize the firm's relationship with smaller vs. larger partners and emerging market partners vs. developed market partners?
How does the management model affect transactions with partners and customers?
What specific actions can be taken -- technical and other -- that could mitigate leakage?

3. Manufacturers' Operating Model: The structure of the extended supply chain employed by the manufacturer can also have a direct impact on the amount of grey market leakage. A number of parameters can positively and negatively impact leakage, including:

The economics of being a distributor
Number of tiers in the value chain
Number of partner hand-offs and coordination events
The degree of dependence the manufacture has on the distributor for end-user fulfillment and satisfaction
The extent of regional and cross-boarder coverage
The differences in local operating practices
The cost of managing and controlling small, distant distributors

While there is no one correct answer for each operating model parameter, the larger question is how does a manufacturer design a supply chain model such that all partners win if they play by the rules? In evaluating your operating model, a simple assessment can help determine the points of friction and how much tweaking your operating model may need. A key requirement for mitigating Grey market leakage is gaining end-to-end value chain/operational visibility and a developing a deep understanding of your operating model.

A Path Forward For Recapturing Revenues And Margins

There are a number of possible solutions for solving leakage issues. In order to develop the right implementation plan, you will need to first gain an understanding of the end-to-end value chain leakage drivers for your business. To do this requires a structured framework for analysis. We have applied just such a framework to conduct initial assessments and from there develop go-forward roadmaps and implementation programs for locking down and closing off grey market leakage.

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