The Internet and the revolution in distribution: a cross-industry examination

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1 Technology in Society 21 (1999) The Internet and the revolution in distribution: a cross-industry examination Bharat Rao * Institute for Technology and Enterprise, Polytechnic University, New York, NY 10004, USA Abstract Distributors and channels of distribution have existed since time immemorial. Channels of distribution have existed to get products to consumers cheaper, faster, and more effectively. Distribution encompasses various types of activities, depending on the type of and point in the supply chain where value is added. A supply chain constitutes a set of activities ranging from production and manufacturing, to logistics, warehousing, transportation, and final delivery of goods to the customer (Handfield RB, Nichols EL. Introduction to supply chain management. Upper Saddle River, NJ: Prentice-Hall, 1999). Through their interactions with suppliers, manufacturers, and end customers, distributors thus perform an important intermediary role in matching supply with demand. In this paper, the impact of the Internet on the value chain is discussed. In order to explore issues pertaining to this transformation in greater detail, three industries that have been either radically altered by the Internet, or that are facing tremendous challenges as they head into the future, are considered. They are (a) the retailing industry, (b) banking, brokerage and financial services, and (c) the music industry. The objective is to elicit the underlying managerial implications and imperatives through this cross-industry examination Elsevier Science Ltd. All rights reserved. Keywords: Internet; Supply chain; Value chain; Electronic retailing; e-commerce; Managerial transformation 1. Introduction The Internet has emerged in the recent past as a dynamic medium for channeling transactions between customers and firms in a virtual marketplace. In particular, the * Tel.: ; fax: address: (B. Rao) X/99/$ - see front matter Elsevier Science Ltd. All rights reserved. PII: S X(99)

2 288 B. Rao / Technology in Society 21 (1999) World Wide has emerged as a powerful new channel for distribution, rendering many intermediaries obsolete, and radically revamping the value chain in several industries. The growth of the Web has been phenomenal, and there has been a corresponding growth in commerce on this robust platform. Online shopping revenues are expected to rise dramatically in the near future, from a projected $US11 billion in 1999 to US$41 billion in 2002 [1]. While some firms and industries have rapidly absorbed this new paradigm of competition, there are several others that have been slow to respond to change. This has been partly due to structural reasons, but also in part due to an inability and unwillingness by entrenched players to grasp the magnitude and speed of change imposed by competition in such a networked economy. The Internet is challenging the traditional distribution structures that firms have employed to get goods and services to market. In addition, it is forcing firms to reevaluate their value proposition to customers, and meet the challenges of more nimble rivals. In this paper, we describe how the Internet has impacted channels of distribution in three major industries: retailing, banking, brokerage and financial services, and music distribution. Based on this analysis, we draw managerial lessons for firms competing in the new marketspace [2 4] Channels of distribution In the world of physical distribution, distributors provide the important functions of breaking bulk, and mixing in channels. Breaking bulk enables reduced transportation costs in the channel as it permits volume shipments from the manufacturer to the distributor, which typically cost less on a per-unit basis. By doing so, manufacturers are free to concentrate on their core business strengths, and customers can pick and choose the mix of products they need through such a channel intermediary. Mixing also permits volume shipments to occur between manufacturers to originalequipment manufacturers (OEMs) and downstream business customers even though the quantity shipped between a specific manufacturer OEM pair could be quite low [5]. Distributors also enable channels to operate with lower safety stock, as inventory is centralized, leading to greater efficiencies. This is an important benefit as inventory-carrying costs in some industries can range in the billions of dollars every year. In many industries, distributors provide and reduce the role for inventory financing in the channel by extending credit to customers, who would have otherwise been unable to procure material directly from the upstream manufacturer. They also reduce the need for numerous interactions between the final customer and manufacturer, as they effectively become a clearing-house or portal for interaction with the final customer. Finally, many distributors provide value-added services like extending credit, technical and customer support, and training. This makes distributors an indispensable part of many industries. In the electronic world, corresponding network economies exist, and several intermediaries have begun to exploit them to their advantage. However, the nature of these economies are very different from those in vertical channels, and are based more on the impact of speed, connectivity and critical mass. Many innovative market

3 B. Rao / Technology in Society 21 (1999) mechanisms have emerged to match supply with demand, facilitated primarily by the Internet. These range from pure info-mediaries that have negligible physical infrastructure, to hybrid intermediaries who rely on both info-mediation and some elements of physical distribution. In the former category, online auction sites ebay (http://www.ebay.com/) and Onsale.com (http://www.onsale.com/) have created virtual marketplaces that primarily match buyers and sellers without touching the merchandise. Customers arrange for shipment through high-speed logistics intermediaries, who in turn derive scale economies based on the traffic in their networks. In the latter category of hybrid intermediaries, we find a majority of online retailers like Amazon.com (http://www.amazon.com/), Eddie Bauer (http://www.eddiebauer.com/), Gap Online (http://www.gap.com/), etc. who extend the info-mediation aspect onto the physical world through online sales, catalog sales, and a store network if necessary. The growth of direct marketing channels like online retailing and catalog sales has also led to the emergence of world-class third party logistics intermediaries like FedEx (http://www.fedex.com/), for example, who substitute inventory for information, and provide superior abilities in moving shipments around the globe [6]. The availability of instant information, and the connectivity offered by the Internet are now challenging many aspects of distribution that were taken for granted. First, information is pervasive and relatively easy to share and access across business software platforms due to the open communication protocols of the Internet, and a convergence in standards even in proprietary enterprise planning systems. Second, firms around the globe are relying on just-in-time procurement, and deliveries, thereby freeing the traditional channels of unwanted inventory. The emphasis has shifted to inventory velocity (the speed at which inventory moves through the supply chain), as opposed to the total amount of inventory available at any point in time. This enables lower inventory holding costs, faster inventory turns, and an ability to respond faster to sudden changes in demand. Finally, high-speed logistics intermediaries (e.g. FedEx) are taking on the role of physical distribution, and further reducing the need for inventory stockpiles in channels in the process. In doing so, they are taking upon value-added functions like virtual warehousing, vendor-managed inventory, and merge-in-transit. The growth and maturity of Web-related technologies has played a major role in the new way companies are approaching the distribution process, both in the physical and digital worlds. In the past, information gathering and processing was relatively slow because of the limits imposed by human workers, and the vertical nature of many industries. Today, information can be transferred, grouped, filed by various categories and can be retrieved and shared in large volumes in a matter of seconds. This has caused minor revolutions in many industries. In addition, the application of technology-based supply chain management practices has begun to slowly undermine the traditional roles played by the numerous middlemen that are involved in the supply chain. Unless middlemen identify and exploit their value-added capabilities, they face increasing challenges from their technology-smart rivals. The Internet has been the driver for new types of value provision given its inherent characteristics, and has led to the deconstruction of the value chain in many indus-

4 290 B. Rao / Technology in Society 21 (1999) tries. It has enabled new forms of businesses, and also different types of transition from the physical world to the virtual world. In this paper, the discussion is centered around the role of the Internet on distribution channels that deal with physical, hybrid and purely informational goods, or soft goods. We describe each of these in the following sections. In each section, we touch upon developments in the industry in question, and seek to identify the underlying dynamics of managerial response to this value chain deconstruction. 2. Online retailing We will never allow ourselves to be reduced to a role as a mere showroom for goods sold over the Internet by vendors or others. Selling over the Internet can destroy years of investment retailers have made jointly with vendors building product brands. It can turn once desirable brands, unprofitable. The reality of the Internet today is this: sales are low; it s an inferior channel for most merchandise and it can commoditize your brand. (Jerry Storch, President, Credit and New Businesses, Dayton Hudson Corp., 25 June 1998, PR Newswire.) The retailing industry is immense. Annual GAF 1 retailing revenues in the US amounted to US$685 billion in 1997 [1]. There are several characteristics that make traditional retailing unique from the customer viewpoint. First and foremost, the retail environment provides the sensory stimuli of touch and feel (and smell). For many product categories (e.g. specialty apparel, furniture, or perfumes), this aspect provides the customer with valuable data points before the purchase decision can be made. In addition, the customer might interact with in-store personnel, who might assist him or her in the purchase process, or provide additional information. In the case of apparel, customers can also try out the product right at the store, while booklovers can browse through several pages of their favorite titles before making a decision to buy the product. Once the product is selected and the purchase decision made, the customer can walk out of the store with the merchandise in hand. In addition, the physical store setting offers instant gratification to the customer. Given these obvious advantages of physical in-store retailing, one might argue that it is difficult, if not impossible for online retailers to make any headway. This is far from the truth. Online retailing has taken off as a high-growth industry. In 1998, consumer retail spending on the Internet reached US$7.8 billion, surpassing earlier projections of US$6 billion [1]. There has been a proliferation of shopping sites on the Internet. Although conven- 1 GAF represents those retail formats where the bulk of consumer goods shopping takes place. These formats include general merchandise, department, apparel, furniture, and miscellaneous shopping goods stores. It does not include automobile sales or restaurants [1].

5 B. Rao / Technology in Society 21 (1999) tional retailers initially sought to resist the changes brought about by the Internet, many of them have now plunged headlong into online retail Shopping online: key elements Characteristics of online consumers play an important role in their adoption of the shopping model. Consumers on the Web are getting smarter in using e-tailers (and online search engines and agents) for convenience and comparison-shopping. Initial research suggests that they are also less likely to have qualms about not buying from a physical retail outlet, and are opting for the more convenient alternative [7]. In addition to cost-conscious comparison shoppers, the e-tail model is also attracting a growing segment of customers who are technologically competent, place a high emphasis on convenience, and are willing to pay a premium price if they find the product they are looking for. This suggests that there could be an ongoing migration of these cash cows from retail shopping to e-tail. A study by Jupiter Communications suggests that the average household income of online consumers is much higher than that of a traditional retail shopper. In 1998, the median age of an online shopper was 33 years, with an average household income of US$59,000 [8]. It is therefore necessary to re-examine the basic issues confronting e-tailers and traditional brick-and-mortar retailers as they seek to innovate online. The main features of online retailing include: largely virtual interactions between buyer and seller; the provision of a range of services by the seller that seek to enhance the quality of interaction over conventional channels like in-store retailing; a set of complex networked linkages between various facets of the value chain; and the use of speed and content as key ingredients of competitive differentiation by online retailers. There are several unique elements that make online shopping different from traditional retailing. Online retailing offers convenience and expanded product variety, and makes it easier for consumers to access and compare data from multiple sources. Visiting three online retailers, for example, would take less time than driving up to one physical store. Search capabilities within online stores replace physical browsing through endless aisles at a traditional retailer, especially if the product is hard-tofind or out-of-stock. Further, electronic shopping malls like the Yahoo! Visa Shopping Guide (http://shopping.yahoo.com/) or Shop-the-Web at Amazon.com (http://shoptheweb.amazon.com/) now provide comparative data at the customer s fingertips, either through proprietary or external search agent software [9]. The immediate challenges of such capabilities for the retail and online retail environments include: (a) the erosion of brand equity and customer loyalty, (b) cannibalization of in-store retail sales, and (c) price competition. These challenges have already being experienced by a number of business, ranging

6 292 B. Rao / Technology in Society 21 (1999) from specialty retailers who deal exclusively in hard goods, to full-service stock brokerages who deal mainly in info-mediation and knowledge transfer. Such threats might be countered to some extent by investments in marketing and brand equity building, and extracting a premium based on customer service capabilities. Online guides and recommendations could also play a role in reaching selective customers [witness the transformation of Zagat Restaurant (http://www.zagat.com) from a paperbound publication, to cross-marketing alliances with city guides like Sidewalk.com (http://www.sidewalk.com/)]. At Amazon.com, for example, advertising and expenses are around 50% of its revenues, with an acquisition cost of US$12 per new customer [10]. On top of developments like the profusion of well branded retailers that could command enhanced margins once they establish market share, the Internet has also given rise to a number of retailers that stretch conventional revenue models to the limit by selling products at extremely low prices. Buy.com, for example, offers all products at or below cost. By relying on massive infusion of capital and minimal operating expenses, and a revenue stream bolstered by advertising dollars, Buy.com has established a strong presence in product categories like hardware, software and peripherals. Several other companies have followed suit. Egghead, for example, closed down its physical store operations in 1998, and began to offer its products through Egghead.com, its online avatar. These trends present clear threats to undifferentiated players, and, ironically, players in the physical domain that lack or are contemplating a significant e-tail presence. Traditional retailers might cry foul, but this might very well be the new shopping paradigm they have to face as premium customers begin to accept the e-tail alternative in larger numbers [11]. The good news to pure retailers is that most pure online retailers and their hybrid counterparts (with both retail and e-tail operations) face challenges in offering deep discounts over a sustained period of time, which could undermine their financial viability. However, some online retailers seem to be willing to wait for a long time before their businesses turn in a profit. Some studies have shown that Web shopping might be convenient, but, on the average, pricier than the physical alternative [12]; as discussed earlier, newer models that are based on advertising derived revenues often sell products at or below cost (e.g. Buy.com). As pointed out earlier, in-store retailing has traditional strengths that are harder to imitate in the online world (like merchandising or assortment planning, for example, which are discussed later in the paper). But the retailing industry could do well to change its game plan to adjust to these new challenges posed by online businesses [13] Implications for traditional retailers There are several ways in which they can respond to the challenges posed by the Internet. First, retailers need to make a Go/No-Go decision on whether they should have an e-tail storefront. If they go ahead with establishing an online presence, the main challenges will be on the operational and marketing fronts. Initial research suggests that the addition of an e-tail channel might be relatively easy if the company has cataloging experience. For example, traditional catalogers like L.L. Bean

7 B. Rao / Technology in Society 21 (1999) (http://www.llbean.com/) have had tremendous success in adding an online channel. Such businesses also have well established and integrated linkages with third-party logistics intermediaries like FedEx, a factor which is critical to e-tail success [14]. Fig. 1 shows some examples of firms that have had successful transitions into e-tailing. Second, they can use their e-tail storefronts to capture valuable customer demand data, and conduct pricing and promotional experiments. Consumers are often willing to spend significant time in personalizing their experience, and this is a clear opportunity to hear the voice of the customer. This is greatly facilitated by several offthe-shelf tools that capture and analyze data from online visits. These tools are also being provided by services like Yahoo! Store (http://store.yahoo.com/) and icat (http://www.icat.com/). It has been pointed out that matching supply with demand remains one of the critical strategic imperatives for retailing [15]. Online retailing is no exception, and e-tailers should use the tools at their disposal to sharpen their performance on this dimension. Finally, when executed properly, retailing can be a market for the imagination. A number of innovative retailers have created unique shopping experiences within the walls of the store. Retail chains like REI (http://www.rei.com/), for example, have excelled in creating a truly unique shopping experience that leverages their knowledge of the customer, and the contextual setting of consumption. REI, a merchandiser of outdoor recreation equipment and goods, boasts a 100,000 square-foot flagship store that includes an indoor mountain-bike track, a full-scale standalone climbing wall, and a rain room to test raincoats and outdoor apparel. Its customers are also members of a cooperative, and share profits generated at the store. In the case of an upscale retailer like Saks Fifth Avenue, customers are provided custom tailoring and fitting of quality apparel, and such value-added services can become a key driver of repeat business. Such services are extremely hard to imitate, not only by competing store chains in the physical world, but hardly at all in the emerging world of online Fig. 1. Possible transitions to e-tailing.

8 294 B. Rao / Technology in Society 21 (1999) retailing. In the case of Norwalk Furniture, a manufacturer and retailer of custom upholstered furniture, physical stores are equipped with computers that enable customers to design their piece of furniture, based on their selection of styles, fabrics and other accessories. This is fed back into Norwalk s made-to-order manufacturing capability for over a million different combinations of styles, firmness, and fabrics [16]. In addition to the online retailing models discussed earlier, there have also emerged a number of innovative businesses that capitalize on their role as info-mediaries in a fragmenting distribution environment. These include online auctions like ebay and Onsale.com, aggregators like Priceline.com (http://www.priceline.com/) and iship.com (http://www.iship.com/), and a number of virtual business to business marketplace models like PlasticsNet (http://www.plasticsnet.com/) and CommerceNet (http://www.commercenet.com/). Online auctions bring together geographically dispersed buyers and sellers who trade in thousands of products. As info-mediaries, ebay and Onsale do not physically touch the merchandise, but make money off every transaction. Priceline.com, on the other hand, allows customers to decide the maximum price they would be willing to pay for airline tickets, car reservations, hotel rooms, vacations, etc.; based on these bids, the orders are fulfilled if they are attractive enough to the seller. Although Priceline lost US$90.7 million in revenues from its inception in April 98, to December 98, its revenues grew dramatically to US$35.2 million during the same period. When Priceline went public in early 1999, its IPO put its market capitalization at around US$80 billion, which is more than the combined market capitalization of three of the major airlines whose tickets Priceline sells through its service. The valuations might seem unreasonable, but on closer analysis, such companies are radically altering the way supply is matched with demand in a competitive marketplace. Finally, virtual marketplaces like PlasticsNet and CommerceNet enable business to business commerce transactions online, and speed the flow of products and services through the supply chain. This has accelerated the move towards dedicated trading partner networks, which are real-time and highly integrated into the business processes of collaborating firms, and suppliers and other intermediaries. As major players in many industries move away from legacy systems, and onto standardized, open technology platforms, it is likely that business-to-business virtual marketplaces will represent a substantial growth area in the future. 3. Banking, brokerage and financial services The do-it-yourself model, centered around Internet trading, I think should be regarded as a serious threat to American financial lives. This approach to financial decision making doesn t serve clients particularly well. As far as we re concerned, it s not likely to create long-lasting value. (Launny Steffans, Vice-Chariman, Merrill Lynch, speaking at the PC Expo, 1998.)

9 B. Rao / Technology in Society 21 (1999) An industry that has been radically altered by the advent of electronic commerce is the arena of banking, brokerage and financial services. In addition to the spectacular growth of the Internet, analysts point to the strong bull market since the early 1990s, and a growing customer appetite for investment related information and services that has aided the growth of this industry. Traditional players have been forced to rethink their business models and uncover true measures of value they provide to customers. While some have been successful at handling the competition, others are facing immediate and long-term threats that could lead to a major consolidation in the event of a market downturn. The Securities Brokerage Industry comprised of nearly 7800 firms at the end of 1997, with a total capital of US$92.5 billion. Some of the leaders in this arena include Merrill Lynch, Goldman Sachs & Co., Morgan Stanley, Dean Witter & Co., and Salomon Smith Barney. In the past, these firms earned fixed fees based on the number of securities traded for their clients, based on a schedule set forth by the Securities and Exchange Commission. After the SEC eliminated the fixed free schedule in 1975, intense competition in the commission structure of many brokerages ensued, leading to lower commissions on transactions, and an unbundling of services offered. However, the big players still continued to maintain and grow their client bases, which were characterized by institutional and corporate accounts, and high net-worth individuals, who relied on the knowledge, advice, and availability of the firms expertise, and paid them a hefty commission for it. With the advent of the Internet, the level of competition has increased, given the widespread availability of information, and the separation of many components of services (e.g. research, mutual funds, personal advice, transaction execution, and commissions), as well as the creation of a grass roots individual investor market. Firms like e-trade (http://www.etrade.com), Ameritrade (http://ww.ameritrade.com/) and Charles Schwab (http://www.schwab.com/) offer investors a range of products and services that would have been unimaginable a few years ago. The value chain has been disassembled to accommodate various classes of brokerage services, depending on the depth of service customers are looking for, and the price they are willing to pay for these services. An informed investor can now get research from disparate sources for a small fee, and use this research to execute trades through a low-commission online brokerage. A number of different business models have emerged to serve this changing market. The four common categories of brokerages today include: (a) full service brokers, (b) discount brokers, (c) deep discount brokers, and (d) electronic deep discount brokers. Full service brokers provide a wide range of services including proprietary research and analysis, a professionally managed investment strategy, superior customer service, and trading in a variety of financial instruments. This umbrella of services comes with a hefty price tag, and certain restrictions like a minimum account balance. Discount brokers, on the other hand, provide a watered down version of the above offerings, but are getting increasingly sophisticated through their use of technology. They typically offer syndicated and in some cases, in-house investment research, portfolio management, and online and telephone customer service. The trading commissions are a fraction of those charged by full service brokerages. Deep

10 296 B. Rao / Technology in Society 21 (1999) discount brokerages are in the business of reducing transaction costs, i.e. trading commissions. As pointed out earlier, many sophisticated investors and traders prefer this option, as they are capable enough to do their own research and analysis, and use the brokerage mainly for speedy execution. Electronic deep discount brokerages reduce these transaction costs even further. Through the use of the Internet, they also offer a range of research and industry and securities information, at a fraction of the price of the full service brokerage. American consumers now routinely conduct banking and investment transactions through the Internet, check their account balances and portfolios online, seek out investment research and advice, and participate in online communities that enhance their knowledge of the financial and investing environment. In the early stages of evolution of this digital financial model, a number of banks began offering proprietary software through which customers could access their account information and conduct transactions online. A key driver of this phenomenon was the radically reduced cost of conducting such transactions. A trip by a customer to a retail bank location costs the bank approximately US$5 per transaction, and a phone call costs US$1 per transaction, while an online transaction costs a mere 10 cents. Financial online intermediaries like e-banks or e-brokerages can also offer indepth and tailored information matching their clients investment needs and financial profile to specific investment products or services they have to offer. Over time, one would expect this to lead to customer loyalty, increased switching costs, and a unique branding opportunity that would enable the bank (or brokerage) to provide a host of services and products in various categories. In fact, a number of players in this industry have gone in that direction, and moved into complementary (and not-socomplementary) areas including insurance, mortgages, online retailing, travel information reservations, and entertainment services. Banks like Wells Fargo (http://www.wellsfargo.com/) have been able to innovate both online and in physical space [17]. Physical branches of Wells Fargo boast of piped music and fresh Starbucks coffee, while the online version has links to the Museum Store, where customers can buy memorabilia. Wells Fargo boasts a total of 620,000 customers for its home banking service, followed closely by NationsBank with 500,000 customers, and Citibank with 350,000 customers [18]. Contrary to the expectation that competition would come from established players like Bank of America, banks like Wells Fargo will find the main challenges coming from finance portals like Yahoo Finance (http://quote.yahoo.com/), Quicken.com (http://www.quicken.com/) and Microsoft MoneyCentral (http://www.moneycentral.com/). These trends attest to the rapidly changing dynamics of both the banking and financial services industry Industry response The mainstream American banking and financial services industry has been slow in responding to the impact of the Internet. It is only recently that the industry woke up to both the threats and opportunities that have been created by the Internet. This is an industry where costs and pricing structures matter, and have a direct and

11 B. Rao / Technology in Society 21 (1999) measurable connection to the ultimate growth in revenues and customer base. Nevertheless, full service firms are not threatened as much by the fall in transaction prices engendered by the Internet. They may be simply missing out on a growth area of the market, and of reaching new customer segments with vastly different needs over their lifetimes. This may be due in part to the fact that several of the major investment firms and brokerages operate on a strictly hierarchical model that rewards individual performance. Some observers posit that this could prove a serious threat to product and process innovation within these firms, and to meet the challenges imposed by more nimble competitors. Others point to the entrenched connections between many of these financial organizations and the leading firms in most industries. They typically provide underwriting services to many of these firms, as well as analysis of these firms to investors who are their clients. It is unlikely that either their organizational or reward structures will change in the near future, and it remains to be seen if this organizational model will survive further competition in the financial services marketplace. The big investment and brokerage firms cannot take the status quo for granted anymore. Online brokers are taking a closer look at lucrative areas like underwriting, and any success they have in this area will be at the expense of the entrenched players [18]. It is a matter of time before they begin to make forays into areas like insurance, mortgages, and other financial products and derivatives. At the present time, however, the multitude of e-brokerages that has sprung up need to look into the prospects of shifting their focus from pricing to customer service, and increase their reach to other segments of the market. Over time, it is quite likely that electronic brokerages will draw in traditional clients that see the advantages inherent in their models, but are willing to rely on their own or outsourced research. One of the oftrepeated challenges for Internet brokerages is their ability to sustain high levels of traffic on their servers, in a reliable and time-sensitive fashion. Several of them need to invest more in technology that is fail-safe and robust, and has the ability to grow with the needs of their changing business models. Several common functions and services associated with banks, brokerages, financial underwriting and IPOs, venture capital, financial research and analysis, and the distribution of a vast array of financial products and services including mutual funds and retirement plans, will find the Internet the next major areas for expansion. Innovative firms like Wells Fargo, Bloomberg (http://www.bloomberg.com/), TheStreet.com (http://www.thestreet.com/), Wit Capital (http://www.witcapital.com/), and Garage.com (http://www.garage.com/), are merely the first wave of the dramatic changes buffeting this industry. 4. Online music distribution Gotta li l rhyme but we barely get a dime - (Lyrics from Public Enemy s album Swindler s Lust. (Chuck D, a member of this group, is one of the most vocal advocates of online music distribution, and recently released a new album in the MP3 format.)

12 298 B. Rao / Technology in Society 21 (1999) Several threats in late 1998 and early 1999 looked significant enough to undermine the very foundations of the music industry, and the way business was done. First, consumers routinely purchased their music online, through online retailers like CDNow (http://www.cdnow.com/), and Amazon.com (http://www.amazon.com/). This had led to increased price competition in general, and the undermining of the traditional retail channels like Tower Records and Virgin Megastores. Many retailers had to rethink their revenue model either due to the advent of pure online retailers or their own migration to the hybrid physical-online model [19]. Second, the Internet had brought a more immediate and perhaps more serious threat: the online, and in a majority of cases, illegal distribution of music through compressed audio formats, accessible to anyone with a connection to the Internet Standards (or lack thereof) Streaming audio and compression technologies have made spectacular progress since their inception in late 1995 and early The earliest signs that near CDquality music could be transmitted on the Internet came from RealAudio 5.0, a program developed by Real Networks (http://www.real.com/). With this program files could be stored and streamed relatively efficiently across on a 28.8K modem. Although the quality of sound transmitted in this manner was not perfect by any means, this was just a hint of the developments to follow. In a few months the spectacularly successful MP3 format had emerged. Under this format, files were compressed in compliance with the standards established by the Moving Picture Experts Group (http://www.tnt.uni-hanover.de/project/mp3/audio). Established in January 1998 by the International Organization for Standardization (ISO), MPEG had grown to include some 350 experts, hailing from academia and 200 companies and organizations around the world. The MP3 format allowed for an almost tenfold reduction in file size from previous methods of compression, without a discernible loss in quality. Most commercial music singles could now be stored and transmitted in file sizes of less than 5 MB. The rapid acceptance of MP3, and the proliferation of the so-called ripper-programs that enabled audiophiles to copy tracks from CD-ROMs and post them online, had turned the music trickle into a flood. Extensive libraries of music were soon available online, and music buffs could locate and retrieve files of their favorite music in a matter of minutes. In late 1998, the MP3 phenomenon had gone mainstream on the Internet, when the Internet portal Lycos.com began to offer a unique MP3 search engine (http://mp3.lycos.com). Soon, other search engines with more features began to emerge: some, for example, offered search capabilities based on lyrics someone might remember from a music single they had heard. Such unprecedented access to music content meant that Internet users with relatively fast connections could set up extensive play-lists of their favorite music in a matter of days, if not hours. The growing traffic in MP3s was clearly illegal and violated copyright laws. MP3 had proliferated virus-like in a networked environment where legislation and policing were not forthcoming, efforts that would have been almost impossible to enforce. MP3 also gained widespread attention when Michael Robertson, a pioneer and evan-

13 B. Rao / Technology in Society 21 (1999) gelist of the format, established a web-site dedicated to resources for MP3 buffs (http://www.mp3.com/). In addition to the illegal traffic in MP3, the ease of generating new music in this format encouraged artists to post their tracks online, in a matter of minutes after recording it, if necessary. With 500,000 music files available for free download (and growing exponentially) on the Internet by February 1998, it was clear that MP3 had arrived in a big way. By April 1999, MP3.com had logged more than 21 million legal downloads of files posted on its web site. Insofar as final distribution was concerned, the trend was towards the ubiquitous availability of music. Rio, a portable MP3 player (a Walkman sized device) that retailed for US$199, would enable users to download their own play lists as and when required. The empeg-car player was geared toward the car user. A future version promised the ready availability of 500 albums (or over 7000 singles) for the road at CD quality (http://www.empeg.com/). Further advances in storage technology (like flash memory sticks developed by Sony, for example) were just around the corner. As recently as May 1999, Real Networks began the free distribution of Real JukeBox, a piece of software that would allow consumers to digitize and store their entire music collections on their computers, and, if necessary, transmit them with great ease over the Internet. Although Real Networks expected consumers to abide by the honor system and not make additional copies, it was quite probable that this program would result in further trade in illegal MP3s files over the Web. In addition to the revolution in the distribution of music, the new online medium was beginning to alter the way content was created and promoted. A number of bands had gravitated toward the MP3 format, creating and promoting new singles online, due to cost and reach considerations. This enabled even small bands to make their presence felt in a competitive landscape. Some bands like Widespread Panic complemented this type of promotion with online marketing efforts, often aided by a loyal group of fans who managed web sites, arranged for mass mailings, helped out at live events, and spread the word online to existing and prospective fans [20]. This type of grassroots enthusiasm and viral marketing tactics had also led to impressive turnouts at live musical events later held by the same band, and others who had embraced the online medium. It is very likely that small to medium sized bands could easily migrate to the online distribution format in the future, in order to attract and gain an initial audience, and ultimately build their identity. By initially promoting their music with free MP3 files, and distributing subsequent content using a copy protected format, they could establish a presence in a relatively short time span. The arrival of a safe, secure standard for distribution would be vital for moving toward being recognized and earning deserved financial rewards Industry response Reacting to the changes brought on by the new technologies, the music industry has been scrambling to react to the far-reaching effect these developments have on their business and revenue models. By early 1999, IBM had developed a new compression technology that would compete with MP3. IBM had launched the Electronic

14 300 B. Rao / Technology in Society 21 (1999) Music Management System (EMMS) that would enable entire albums to be distributed online. Developed in collaboration with Warner Music, Universal, EMI, Sony and BMG (the Madison Project) it will take some time before the success of this initiative can be assessed. IBM has already indicated that this format would not be compatible with current MP3 devices like the Rio, which makes the acceptance of this format extremely unattractive to existing MP3 consumers. One of the assumptions of this plan was that the delivery of music would increasingly move to broadband. At the end of 1998, broadband technologies penetrated around 1.3% of on-line households in the US. It was projected that this figure would swell to 30% of on-line households by 2002 [21]. It was likely that time and infrastructural hurdles would test this assumption across a broad spectrum of the market. The other assumption, that the security of this method of digital delivery would be foolproof, was yet to be tested as EMMS was still in a developmental phase. Also, any method that relied purely on software encryption was vulnerable to future break-ins. Industry groups were also echoing these concerns. Noting that the music business and its artists were the biggest victims of MP3 and the Internet culture of unlicensed use, the Recording Industry Association of America (RIIA), was vehemently fighting the illegal use of MP3 for music distribution. Further, the RIAA had launched the Secure Digital Music Initiative in December 1998, with a view to developing a secure audio format that would prevent illegal copying. The success of this project was questioned by industry analysts, given the proliferation of formats like MP3 and the difficulties in enforcement. Other competing formats that had emerged on the horizon were Liquid Audio (http://www.liquidaudio.com/) and AT& T s a2b platform. The music industry has been caught unawares by the revolution in online distribution. They have not realized that the technological changes affecting their industry are of a fundamental and revolutionary nature. These developments threaten to change the relationships between artists, labels, distributors, retailers, and consumers. The Internet is fast shifting power away from the big labels to artists, and to the info-mediaries who keep tabs on changing consumer tastes, and influence music selection and consumption. These intermediaries labeled for convenience as music portals will evolve to play a combination of roles, including online retailing, online labels, and informational and community resources (Rao, et al, 1999b.). In the future, it is quite likely that the emphasis will shift from passive and topdown music sales to active, and interactive music experiences that encompass activities like custom music delivery, live events, and subscription based models of music consumption using the Internet. Alliances and partnerships will emerge between major online music retailers, music portals and other content providers like Rolling Stone Magazine and MTV Networks. Radio will continue to play a major role in popularizing music, and consumers will be able to download (and purchase) music in a matter of seconds in their homes or cars. Retailers operating in the physical space, like Virgin Megastores, for example, will need to move more aggressively into live in-store concerts and events and offer more music sampling stations with

15 B. Rao / Technology in Society 21 (1999) even deeper selections of music. They might consider fusing such sampling stations with portable music devices, and custom CD capabilities. 5. Lessons learned The industries described in this paper are just three in number, but the Internet is changing the business dynamic in almost every industry. Several small, innovative firms have shown that they understand the Internet and have learned to compete in and exploit the advantages of a networked economy. At the same time a number of established firms are finding it very hard to assess the changes affecting their businesses, to answer fundamental questions about if and how they should embrace the change, and to develop new and appropriate strategies. Given the radical nature of these trends, it becomes important to discern the key managerial implications dictated by this technological change. That is what we will focus on in this section. What type of organizational structure, culture, and skills do firms need to thrive in a networked economy? First, a firm that seeks to operate on Internet time needs an organizational structure that is dynamic and flexible. Product development cycles need to be compressed whether in developing a new piece of software, or a new generation of airplanes. In fact, the Boeing Company is one of the biggest users of the Internet in integrating disparate aspects of the business, and of the product development process. Given the speed of change that a networked model of competition engenders, managers not only need to identify market opportunities carefully, but must also be willing and able to make speedy transitions once they have identified the niche they would like to compete in. Using technological excellence and knowhow, they can leverage their position by partnering with more established players to extend their market reach and impact. Being first to market, or a close follower, enables Internet firms to specialize initially in a few market segments, and then rapidly expand market share through economies of scale and partnering. This effectively raises the barriers to entry for future competition (Fig. 2) Co-creation with the customer: understanding Internet time Time is of the essence in Internet competition. The ability to rapidly innovate in the marketplace ahead of competitors will be a key skill to acquire and nurture. On the Internet, establishing a technological or market lead of a few months can be very detrimental to the future moves by a competitor. The rate of innovation diffusion through this electronic medium is much faster than through traditional channels, and requires that firms be acutely aware of their time to market, and the time to market response. In addition, many web-based businesses have discovered that Internet customers make their views and opinions known, and are extremely involved with their experience as consumers. The feedback loops between buyers and sellers are shrinking fast, and so are the boundaries between production and consumption. Firms that seek to compete in this domain need to understand the dynamics of viral digital marketing, and the formation of extremely loyal customer communities. By

16 302 B. Rao / Technology in Society 21 (1999) Fig. 2. Deconstruction of the value chain: sample constituents and linkages. constantly listening to what customers have to say, observing their purchase and consumption behavior, and interacting with them in a dynamic environment, they will be able to fine-tune the products or services they offer. Customer feedback on the Web makes old methods of customer response the equivalent of putting a note in a bottle and hoping someone will find it, let alone read it (Alan Weber, Founding Editor, Fast Company, speaking at a Roundtable on New Media; Institute for Technology and Enterprise, 1998.) Creating products and services with active and continuous involvement of the customer thus becomes one of the keys to competitive success. Firms like Yahoo and Microsoft, for example, actively use customers in every stage of product development [22]. The beta-test mentality has been poorly understood by businesses seeking to make the transition from the physical to the online world. Comprehensive testing, constant fine-tuning of products and services, and churning new generations of products and services over time is characteristic of businesses thriving in Internet time. Managers should take full advantage of the opportunities offered by involving end-users as they shape their final offering. Co-creation with the final customer reduces product development costs, and also helps create something that the market really wants. James Cramer, the chairman of TheStreet.com (http://www.thestreet.com/), an online financial site specializing in news and analysis, sums it up concisely, In the online world, everything is turned upside down. The reader is the client. I say it again, because it is astonishing: The reader is the client. When I get my

17 B. Rao / Technology in Society 21 (1999) ,000 s a day, I know who the client is. When we get bombarded by input every time we put an inquiry up, when we get told what to do and how to do it by paying readers, the client is the only way to describe it. (James Cramer, Chairman of TheStreet.com, an online provider of financial news, research and analysis, speaking at the Jupiter Financial Services Forum; Source Media, 1998.) 5.2. Unrelenting market focus Marketing is crucial to the growth of a company, from developing customer relations to promoting a successful brand. Senior executives must adapt to the everchanging demand of the market. Extremely low switching costs for online customers challenges managers to accept the mantra of customer-orientation. Internet-based competition operates on a very accelerated timeframe where customers have the power to create market leader status in a very short span of time. The entire organization, from senior management to salespeople, must constantly pool knowledge in order to recognize new market demand and create goods and services to fulfill that unique demand. Success in increasing-returns primarily depends on recognizing trends and developing products accordingly. The advantage of direct customer links enables companies to conduct electronic surveys to forecast trends for their goods and services. Dynamism, responsiveness, the ability to listen to the customer, and relationship management skills are valued competencies in a networked economy. A personal message from Jeff Bezos, CEO of Amazon.com to its customers best summarizes this orientation, In everything we do, we ll try to be the best, the most innovative, and the most customer-obsessed. That s as true as ever for books; it s true for music and videos; it s true for auctions; and it ll be true for everything new we do. (Jeff Bezos, CEO, Amazon.com, in a personal to Amazon.com customers, announcing the launch of auction services, April 1999.) Information technology enables firms to market one-to-one. Historically, companies have acknowledged that the retention of customers is of strategic value, given the stream of revenues such customers can bring over their lifetimes. Internet-based companies have the unique potential to reach a global audience with highly tailored marketing messages. Web sites are tools not only to sell goods and services, but also to acquire detailed customer information. Such granular information, when correctly warehoused, mined, and utilized, enables managers to be responsive to customers needs by creating new products and services, as well as augmenting existing ones. Also, customer loyalty increases as companies build a more detailed profile of individual needs and values. The advantage of creating such profiles (including transaction history, gift transactions, custom lists, etc.) for online retailers, financial services, or music clubs, is that they can be used to call the attention of customers

18 304 B. Rao / Technology in Society 21 (1999) to related products and services and targeted promotions, that increase the chances of response and retention. By treating customers as partners, respecting their privacy, and explicitly valuing their contributions, successful firms in the online world have been able to create a superior purchasing experience. Happy Birthday, Your Team Won, Your Stock Crashed. (Headline of a newspaper article on personalization on the Web, New York Times, 1998.) 6. Conclusions The advent of the Internet has transformed industries and redefined the rules of competition. The old rules of distribution still exist, but they have also given way to new channels and info-mediaries, and changed the nature of relationships between businesses and consumers. Given current trends the Internet s influence will continue to grow into the foreseeable future as businesses collaborate with suppliers and partners; source, produce and distribute products and services globally, and leverage the inherent advantages of networked competition. Consumers will be the driving force of this change by purchasing physical and knowledge goods, communicating globally, and participating in dynamic virtual marketplaces enabled by the growth of the Internet. Public policy implications of these developments have to be addressed with care and determination as commerce moves online in a big way. These include the role of regulation, the protection of intellectual property, taxation, security and privacy, and the changing nature of global trade. Wise decisions will support a continued robust growth in electronic commerce. In summary, we offer the following guidelines to firms competing in the networked economy: Firms should work with their customers to create and improve new products and services. Customers should be treated with respect, and their privacy and intellectual contributions valued throughout the organization. Firms should work cooperatively with their suppliers, partners, and customers and find the best way to create high-quality products and services, pattern them to individual customer needs and deliver them in a timely fashion. As boundaries between these traditional constituents blur, it is important for firms to continuously evaluate their position in, and contribution to, the segment of the value chain they compete in. Firms must constantly scan the environment and the competitive landscape to look for opportunities and be willing to change and deliver products and services in new ways. Firms must build in a set of unique brand attributes, and strive to deliver superior consumption experiences using the Internet as the means to that end.

19 B. Rao / Technology in Society 21 (1999) Firms must allocate substantial resources to recruiting the best talent, nurture a culture of continuous product and process innovation, and encourage creativity. In addition to an excellent working environment, the willingness to change and to anticipate their competitors strategies will be critical to a firm s success. References [1] National Retail Federation Holiday sales data. URL: 15 May [2] Rayport J, Sviolka J. Exploiting the virtual value chain. Harvard Business Review 1995;Nov Dec:75. [3] Hoffman DL, Novak TP, Chatterjee P. Commercial scenarios for the Web: opportunities and challenges. Journal of Computer-Mediated Communication 1995;1:3 (URL: [5/15/99]). [4] Ghosh, S. Making business sense of the Internet. Harvard Business Review 1998;March. [5] Ballou RH. Business logistics management. Englewood Cliffs, NJ: Prentice-Hall, [6] Rao BP, Parikh M, Navoth Z. Re-inventing music distribution. In: Proceedings of the Fifth Americas Conference on Information Systems, Association of Information Systems, Milwaukee, WI, August, [7] Myerson AR. CompUSA: revising computer retailing. The New York Times, 29 June [8] Jupiter Communications Online Shopping Report: projection profiles, competitive analysis, Research Study Digital Commerce Strategies, Ken Cassar and Nicole Vanderbilt, December. [9] Guttman RH, Moukas AG, Maes P. Agents as mediators in electronic commerce. Electronic Markets 1998;8(2):22 7. [10] Dignan L. E-tailing: Amazon.com s push to profits. ZD Net Interactive Investor, 15 July [11] Meeker M. The Internet retailing report. US Equity Investment Research, Morgan Stanley, 28 May [12] Green H, DeGeorge G, Barrett A. The virtual mall gets real. BusinessWeek, 26 January [13] Alba J, Lynch J, Weitz B, Janiszewski C, Lutz R, Sawyer A, Wood S. Interactive home shopping: consumer, retailer, and manufacturer incentives to participate in electronic marketplaces. Journal of Marketing 1997;61(3):38. [14] Rao B, Horwitch M, Navoth Z. Developing a world class distribution, logistics and electronic commerce infrastructure. In: Schmid BF, Selz D, editors. EM electronic commerce in the Americas., [15] Fisher M, Hammond JH, Obermeyer WR, Raman A. Making supply meet demand in an uncertain world. Harvard Business Review 1994;May June (#94302). [16] Rao B, Blasberg J, Salmon W, Raman A. Norwalk furniture (A). Harvard Business School, Boston, MA, 1997, Case # [17] Kaplan R, Tempest N. Wells Fargo online financial services (A). Harvard Business School, 1998 Case # [18] The Industry Standard. Money changes everything, 10 May 1999 (URL: [5/15/99]). [19] Rao B. Developing an effective e-tailing strategy. In: Schmid BF, Selz D, editors. Electronic commerce in the Americas., [20] Wall Street Journal. No MTV for widespread panic, just loads of worshipful fans, 17 February [21] Forrester Research. Consumers are ready for broadband technologies. Consumers and Technographics Data Insights 1998;1(15). [22] Iansiti M, McCormack A. Living on Internet time: product development at Netscape, Yahoo!, NetDynamics, and Microsoft. Harvard Business School, 1997 Case # Bharat Rao is an Assistant Professor of Management at the Polytechnic University in New York City. He

20 306 B. Rao / Technology in Society 21 (1999) leads several strategic research initiatives for the University s Institute for Technology and Enterprise in the areas of electronic retailing, supply chain management, strategic alliances and new product development. He earned a Ph.D. in Marketing and Strategic Management from The University of Georgia, and was a postdoctoral Research Associate at the Harvard Business School. His research has been published in the International Journal of Electronic Markets, International Business Review, Journal of the Academy of Marketing Science, and in conference proceedings of the IEEE Engineering Management Society, American Marketing Association, Association of Management and TIMS-ORSA. He is the author of several business case studies, in both paper and digital formats, published by the Harvard Business School and the Institute for Technology and Enterprise.

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