Author: Bill Davis, Mass Integrated Systems (MIS)
Gray market sales of IT and electronics products have been on the rise for several years now. Gray market refers to "the flow of new goods through distribution channels other than those authorized or intended by the manufacturer or producer" 1. While this increase in gray market sales of IT and electronics products is viewed by many as problematic and requiring immediate attention, if one assumes a free market "where the price of an item is arranged by the mutual non-coerced consent of sellers and buyers, with the supply and demand of that item not being regulated by a government" 2, clearly there are companies benefiting from this so an increase in activity is not surprising. As independent distributors ("independents") usually get lumped in with the gray market, the goal of this paper is to examine the role independents play in the electronic component distribution market as well as explore some reasons for why components are now more widely available outside the franchise distribution ("franchises") channel.
Independents, also referred to as brokers, for better or worse find themselves at the center of any debate focusing on the gray market. In a positive light, many companies leverage independents when for whatever reason (e.g. product availability, cost, ability to deliver in a short timeframe, etc.) they can and have been delivering when the franchises are unable to. As the top 10 independents generated 2004 revenues in excess of $2.4B, clearly there's a market need that has emerged for their services that the franchises are not providing. Maybe it's due to the franchises' size or to the commitments they make to become a franchise distributor for a product, but the flexibility the independents have is serving them well in terms of establishing themselves as legitimate suppliers.
Add in the rest of the companies that would be considered independents and 2004 revenues probably exceeded $3B which is still just ~7.5% of the 2004 revenue generated by the top 25 franchises who had revenues in excess of $39.5B 3. While the reasons why the independents growth isn't fully understood, one can only assume it's because they are providing services that the market deems valuable and that no other distribution channel is providing. Comparing the revenues of the independents to the franchises shows they are hardly a threat to displace them as the primary suppliers of electronic components, but that being said one could say that independents are playing a critical role in helping maintain an efficient and transparent market. If the independents didn't exist, the franchises would have a cartel like grip on the electronic component distribution market. With independents bringing price pressure to the market, the franchises are driven to compete which benefits the end consumers.
While a majority of independents are honest and focus on sourcing components from original equipment manufacturers (OEM) excess as well as either directly from the manufacturers or franchises, there's no denying that a small minority have been known to source and sell counterfeit products. In the instances where an independent unknowingly delivers counterfeit components, it is heavily incentivized to take it's own corrective action since once uncovered the likely outcome is that they run the risk of losing their investment in the components as well as losing a customer, which clearly does not represent a sustainable business model. In instances where this occurs this can serve as the wake up call for the independent to be more careful in where it sources product as well as conduct more component testing before they get delivered to end customers.
In those instances where firms show a consistent pattern of distributing counterfeit components that do not function as required, not only will their customers and future prospects be unwilling to conduct business with them, they also stand to lose face amongst the other independents by being reported to one of several groups, the most prominent being the Electronic Reseller Association International (ERAI), http://www.erai.com/. The power of this type of peer pressure should not be underestimated in maintaining the industry's well being because without any end users or other independents willing to do business with a company, it won't be in business for long. Were it as simple as this, counterfeit electronic components would not be the issue they are today. What is happening in Asia, especially China, represents a significant driver of gray market activity and will be addressed later in this paper due to the unique socio-economic environment that has existed there for thousands of years and is only recently changing since the groundwork for China's economic reform started to get laid in the late 1970s.
Now that I have briefly touched on the role of independents and some of the self correcting mechanisms in place to ensure the electronic component distribution market functions in a sustainable manner, I am now going to turn my focus on why components are now more widely available outside the traditional franchise distribution channel.
A substantial challenge for any OEM is forecasting customer demand for it's products in it's own country so trying to do this accurately for a worldwide customer base is next to impossible. There isn't a company anywhere in the world today that can do this with 95% accuracy on a regular basis. Knowing that the forecast will always be inaccurate doesn't mean companies shouldn't still attempt to do this, after all the better they forecast demand the more effective they are in managing the company, but the lack of accuracy in their forecast means OEMs are constantly over/under producing. Only within the last 20+ years, since Dell emerged with it's build to order model, have companies started to shift their mindset from a build to stock mentality to letting customer demand drive how they manufacture and this is still very much a work in progress. As a result of the complexity involved and the downside risk of missing delivery of the right product to market at the right time, OEMs have been and will continue to produce excess inventory for the foreseeable future.
It's my belief that this overproduction by OEMs is one of the foremost reasons, if not the primary reason, for why the gray market exists today. When an OEM overproduces, it looks for assistance from the distribution channel to minimize the amount of inventory it has to carry. The authorized distributors, to cultivate good relations and ensure stable supply, "may purchase more units for end customers than they ultimately require and may sell them to brokers instead of returning the excess to the OEM". In addition, "OEMs with excess or end of life inventory need to make room for new products. This need can lead to two common gray market triggers: (1) using discount programs designed as an incentive for the authorized network to buy the inventory and (2) moving the product through brokers when legitimate channels are full" 4.
Up until recently, this overproduction has been an accepted cost of doing business by the OEMs to ensure they can meet opportunities as they emerge. That being said, the emergence of supply chain management hubs like E2open, http://www.e2open.com/, as well as improving capabilities from the supply chain software vendors (e.g. i2, JDA, Microsoft, Oracle, SAP, etc.) are enabling companies to focus more on manufacturing to meet customer demand as opposed to just building to stock. An excellent example of this is Seagate Technology and it's efforts to move towards a build to order model of production 5.
While still a work in progress, Seagate's use of E2open to procure > 60 million parts/day on average, enhance synchronization as well as improve the trustworthiness of the data being shared with it's trading partners is certainly a step in the right direction to minimize overproduction of inventory. This, in turn, should help reduce gray market activity in Seagate products as over time less inventory should be available through non authorized channels. While I am not suggesting that re-engineering their supply chain is an easy path for companies to pursue, until more OEMs start to focus on here there will most likely be plenty of excess inventory available to find it's way on to the gray market.
Another area that leads to increased gray market activity emerges from the decisions companies make when purchasing electronic components. Every purchase decision involves a trade off between quality and price with the assumption that higher quality products on average cost more as better and cheaper do not usually go hand in hand. The primary challenge that emerges involves the constant price pressure required by companies to stay competitive in their business. Wringing out costs from the supply chain is a way for companies to measure how effective they are at managing the expense side of the balance sheet, but it's usually difficult to get a lower cost without sacrificing quality. As an example, planned obsolescence can and has been used as a premeditated business strategy to generate higher returns through shorter product lifecycles and one that can be achieved by using lower quality, cheaper components.
While not true of every company, in many instances budgets are finalized at an executive level based upon how they are forecasting revenues and what level of expenses they can accept to meet their company's profitability targets. While the information gets fed up from the various departments and divisions, at the end of the day the senior executives are the ones paid to manage their firm's financial condition and often times they have some difficult choices to make in less than ideal circumstances. Trying to stay on top of everything in a sizable company is not possible so the executives do the best they can based on the information they have available. Because purchasing is usually treated as a cost center, efforts have most likely been made by the senior executives to reduce the impact of this in the name of expense management. As the budgets get passed back to the departments and divisions to be implemented, discrepancies arise between what the people responsible for executing the purchasing strategy need and what has been passed down from the strategic level.
The disconnect between the people who are responsible for the purchasing function where buying quality components is a priority and senior management whose focus is more on expense management and is usually too far removed from the day to day purchasing activities occurs all too frequently. And more often than not the executives whose priority is cost containment will win out so quality often becomes a casualty. When the primary measure of success for the purchasing function is expense management, blind eyes get turned to secure the best possible price. For instance, if a production line is going to be shut down waiting for parts, the pressure to bring in lower quality parts if they can be procured more quickly and for a lower cost to keep the line running increases.
In the timeline I had to complete this paper, I was unable to find a case study that highlighted a best practices purchasing environment where the purchasing staff are incentivized based on being faster, better and cheaper so if anyone has any insight here I would welcome the feedback 6. Mastering the subtleties of reducing costs and minimizing the impact to quality is a complex challenge so until senior management and the line managers can collaborate more effectively to balance these competing demands, the gray market will continue to grow as a channel for companies to meet their cost sensitive electronic component needs.
In terms of the gray market, nothing looms larger than China and it's seemingly indifferent approach to protecting intellectual property. While a tremendous amount of historical background is required to truly understand how China has arrived where it is today, that would be a substantial undertaking unto itself so for the purposes of this article the focus will be on quickly summarizing some of the more significant leaders/events that occurred in China during the 20th century which has contributed to today's predicament.
The Qing Dynasty ruled China from 1644 to 1911 and it's fall in 1912 essentially ended over 2000 years of imperial rule in the country. After such a long reign, China was now put in a position of having to figure out how it fit into a rapidly changing world, which introduced a great deal of instability into the country. Sun Yat-sen, widely regarded as the father of modern China, came into power in 1912 and led China until his death in 1925 at which time Chiang Kai-shek ascended to power as did his communist political rival Mao Zedong. Chiang Kai-shek's attempts to eradicate the communist party proved unsuccessful so from the late 1920s until the disasters of The Great Leap Forward in 1958 and The Cultural Revolution in 1966 slowly brought about Mao Zedong's decline, he was able to expand communism/collectivism throughout China until the rise of the more moderate Deng Xiaoping in the mid to late 1970s.
While Deng Xiaoping was still seen as a communist, it was he and other pragmatists within the Chinese Communist Party ("the public-property party") 7 who introduced economic reform to China. While socialism and The Great Leap Forward had not succeeded in substantially raising the standard of living of a primarily agrarian economy, Deng's "Socialism with Chinese Characteristics" 8 has succeeded in lowering the poverty rate from over 50% of the country in 1981 to less than 10% by 2000 9. China's brand of capitalism differs from the United States with it's emphasis on both privately owned and state owned enterprises. This is why having some understanding of where China has come from is critical to understanding how the country operates as it does today. At no other time in history has a country the size of China progressed so far economically in so little time. Trying to make the shift from a communist regime to a capitalist one, albeit with some interesting twists, would challenge any nation and in such a short period of time it's become quite clear that the concept of protecting intellectual property is not yet well established.
Perhaps this stems from China's communist/socialist ideology where common or group ownership is expected or the tremendous pressure China's socio-economic system has been under during the last 30 years or just a slow to develop legal system, but it's probably a combination of all three along with some other contributing factors. Regardless of the reasons, this lack of regard for the intellectual property of others is at the root of the electronic component counterfeit/gray market issues today, especially as more and more sourcing of electronic components is being done in China. Understanding that it was only a couple of months ago in March of 2007 that the National People's Congress enacted a law giving individuals the same legal protection for their property as the state helps put things in perspective. This law was 13 years in the making and while it is scheduled to take effect on October 1, 2007, it will take several more years for it to really establish protection of private property rights in China 10. Given it's taken this long just to ensure the basic property rights of it's citizenry, it's really not surprising that the lack of protection for intellectual property in the electronic component industry in China is as widespread as it is.
While by no means does this condone counterfeiting, it's a useful benchmark from which to understand where China is in terms of moving forward in protecting property, both real and intellectual. China's legal system is just starting to develop and it's going to take time for more effective property laws and deterrents to emerge. In many instances, China is moving at a break neck speed as what they have done in 30 years has taken other countries twice as long if not longer to accomplish similar protections. Currently, the government is in the process of formulating the initial national plan on intellectual property rights (IPR) and will publish these guidelines either later this year or early next 11. While not a complete solution, this represents a major step forward and combined with other efforts such as better enforcement of copyright violations at both the local and national levels, China is making progress to remedy the widespread intellectual property violations that occur. Will it be as quickly as companies would like to see, probably not, but it is being taken seriously and will continue to be addressed as China's leaders do realize the adverse impact this has on it's economic development. That being said, for the companies being impacted there are measures they can take to minimize violations of their intellectual property 12.
In summary, there are numerous reasons for the emergence of the gray market and electronic component counterfeiting issues, not all of which can be addressed fully in a short paper so the idea was to focus on three of the more prominent areas and how they are impacting the gray market's development. And in each case, while a solution is visible, that doesn't mean that it's going to be easy to address the underlying causes. As a result, it's highly likely that many of the same issues:
- Inability to accurately and consistently forecast demand by OEMs
- Organizational issues impacting the purchasing function
- China's growth into one of the world's leading economies
will still be primary drivers of the gray market several years from now. Hopefully this effort has also shown that independents are not a primary driver of gray market and counterfeiting activity. While not immune from these activities, independents are no different than any other profit seeking entity in that they are just responding to market opportunities that are not being capitalized on by other distribution channels. If these opportunities weren't widespread, the growth of independents into a multi billion-dollar industry could not have occurred.
Author Bill Davis
In his role at Mass Integrated Systems, Bill is responsible for the marketing and ecommerce initiatives of the company. Bill has 12+ years marketing, sales and product management experience in the supply chain planning/execution and B2B ecommerce software industry with innovative companies like NetMarket, Endura Software and i2 Technologies. Bill's current interests focus on the globalization of supply chain activities and the growing role of Asia, India and the Internet in this process.
Established in 2002, Mass Integrated Systems (MIS) is an independent stocking distributor of liquid crystal display panels (LCDs) and integrated circuits (ICs). MIS helps companies generate value from excess inventory on product that has reached end of life or is obsolete for their purposes. MIS facilitates the marketing and sale of electronic components, such as LCDs and ICs, to achieve financial recovery of those assets that would otherwise be discarded without realizing their maximum value.
1 Wikipedia, http://en.wikipedia.org/wiki/Grey-market
2 Wikipedia, http://en.wikipedia.org/wiki/Free_market
3 Electronics Supply & Manufacturing, 5/1/2005
4 The Grey Market, KPMG & The Anti-Gray Market Alliance, 2003
5 E2open, http://www.e2open.com/resources/resource_download.php?url=..%2Fdynassets%2Fresources%2Fen%2FE2open_Seagate_case_study.pdf
6 Bill Davis, Mass Integrated Systems, firstname.lastname@example.org or +1 978.997.4578
7 The Economist, China's Next Revolution, March 10th - 16th, pg. 9
8 Wkipedia, http://en.wikipedia.org/wiki/Socialism_with_Chinese_characteristics
9 Wikipedia, http://en.wikipedia.org/wiki/Chinese_economic_reform
10 China Daily, March 16, 2007, http://www.chinadaily.com.cn/bizchina/2007-03/16/content_829663.htm
11 China Daily, June 7, 2007, http://www.chinadaily.com.cn/bizchina/2007-06/07/content_889179.htm
12 Alliance for Gray Market and Counterfeit Abatement, Managing the Risks of Counterfeiting in the Information Technology Industry, http://www.agmaglobal.org/
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