A Note

I started writing here as practice for an exam I have in one month which will require me to digest a large amount of data and produce a policy recommendation in a limited amount of time. To prepare I began the practice of absorbing large amounts of data for its own sake, which is easy enough using the internet, but I needed a place to practice the writing side of the equation. Once I realized that if I'm successful on the exam I will have to take ownership of this blog, even if the last time I wrote here was 2004, I figured here is as good a place as any to practice. So if the subjects or style seem disconnected that is why.

When I first saw this article, I thought to myself ,"I really like that Thomas Barnett guy but he's way off the mark here." What bothers me is the idea that attacking middlemen is a new phase of globalization.

First off, Wal-Mart is not buying anything new. Ostensibly, they are still buying the same product from the same original sources. Secondly, they're not doing anything new; cutting out middlemen is a time honored tradition. Finally, what they're doing isn't necessarily any more productive.

"Not necessarily any more productive?" you say. "But middlemen contribute nothing, and take away from your profit."

And that is where the assumption falls apart. In the age of the Internet, all buyers and sellers are supposedly on an equal informational footing, the theory goes that anyone interested in buying a product can simply search hard enough for it on the Internet and get access to the same source as the middleman. Which certainly is a problem for some types of middlemen; those that solely buy from party A and sell to party B at an increased cost. But not all middlemen are created equal.

To start with, we can ignore the entire wholesale level. There's good reason that people make money buying 10 of something at $1 a piece and selling it one at a time for $2 a piece, it's called retail. And by that same token, the world needs people who buy 100 units at $0.85 and sell them 10 at a time for $1, that's called wholesale and without it no mom and pop shop would ever be able to stock their store with mass produced goods. But Big Box is so big that they are their own distributor, so they should already be cutting out this level.

To show what Wal-Mart is doing here I have to explain a common problem I often had sourcing products in China. Where does the middleman end and the factory begin. By law, all Chinese factories are required to transact export sales through a trading company. As obvious middlemen with obscure purpose trading companies were, therefore, always a first target for the inexperienced buyer that wanted to save a buck. But the trading companies perform a useful and necessary service in dealing with the export nature of the transaction; currency exchanges, freight consolidation, local taxes, export documentation and certification, etc. The problem wasn't the trading company, it was staying blind to the supplier, and as long as you could deal with them directly, you gained nothing by shaking the trading company. So in our first level you have middleman as formality facilitator. You either have to be really big to assume this role on your own behalf, or you have to already be in this role for this level of middleman to be shaken. Wal-Mart is as big as they get, so yeah they deserve to be making this extra 2-3%, but doing so is not new and not newsworthy.

And sometime when you drill down past the trading company you find a factory, exactly like the factories in your dreams, with time clocks, workers, factory floors and dorm rooms. And now you're dealing with the source directly. Or perhaps in an attempt to stay relevant that trading company that you shook is also acting as a sales rep and makes 2-3% on the transaction no matter what you do. And as every manufacturer already knows, you can lose the rep in the transaction, but you never give the customer the reps sales commission. That money is your marginal cost in sales, giving that up to big customers is an admission that you are narrowing your customer base. You make the sale today, but hamper your ability to make new sales tomorrow. So small buyers don't have the clout to cut out the sales level either, and big buyers remove it at the expense of their supplier's business stability.

These same factories also don't produce goods for their own sakes. When they do they are poorly designed and of low quality. Instead at its base, the factory is a set of production capabilities that people come to with things that need to be produced. These people, with the things that need to be produced, are also middlemen. This is what every major shoe, clothing and consumer product's company does. The official term for these middlemen is Brand (or sometimes Label), and they provide good design and consistent quality. To cut out that type of middleman is to cut yourself off from the source of product innovation, marketing and customer loyalty that the brand provides. Just because you bought the shoe from the same factory that made a Nike running shoe doesn't make it a Nike, or even as good. Or to put it differently, dropping the middleman in this case is like claiming that Bud Lite and Sam Adams are equal because they are made in the same brewery. If you want to cut out the middleman in this case, you need to step up and provide the design and quality control that the middleman brought to the equation, or take whatever sub par product the locals are selling. In this case, Wal-Mart can move in on the lesser known brands without much lost but stands to lose quite handily on anything well known or well protected by patent.

Then beyond the traditional factory, there are some factories that have no factory floor, instead they have a warehouse and some rudimentary QC facilities. Orders are placed with the factory owner, (the guy who owns the warehouse) and the owner contracts with dozens or even hundreds of local family businesses who then go and produce the product. The factory owner acts as quality control, only paying for those units that meet specification, and gathers up the relatively uniform product, packages it and ships it out. In China, I've seen this done for stuffed animals (this family makes only left arms, this one right arms, this one assembles....), lacquer boxes, plastic injection tooling and agricultural produce. Under this scenario, who is the middleman? Under the one I just described, it would be difficult to say that the factory owner is the middleman in the transaction, but that hypothetical factory owner is exactly who Wal-Mart is cutting out in this scenario.

The model I just described is exactly how agricultural produce export works. The middlemen who buy from the local farms, consolidate, grade (QC) and in some cases finance the production. They then turn around and market the product to a wider audience. Sure, there are large operations that can skip a few tiers in getting their product to market, but that's not everyone. Under the "distributed production" factory owner scenario, the farmer, home run shop or grandma doesn't have to finance their sales. They don't float inventory for the next guy in the chain. And when there is a QC problem, it is dealt with right then and there i.e. a sale not made. When larger problems arise, bad weather and whatnot, there are bonds of locality and time tying the two together so that doors aren't necessarily closed. In turn, this factory owner takes over the marketing and transactional risk. If Wal-Mart pushes out that particular middleman, they get joy of micromanaging an ever more complex supply chain and unlike what is claimed here, they are not necessarily decreasing risk and increasing supply chain security in the process.

Added together, I would agree that Wal-Mart could save about 5-15% across their supply chain when then entire process is done but I would bet that it is closer to the 5% range for a number of reasons.

• You bully local original suppliers too hard and they're liable to fold if they're small or not deal with you if they're bigger. don't bully them enough and you become Harbor Freight.
• Middlemen act as a stabilizing force in your supply chain. They absorb the manufacturers risk in transactional cost and marketing and the customers risk in quality control.
• Wal-Mart's middlemen are already very savvy folk. In many cases their margins are pushed so low in their deals with Wal-Mart, they may as well be well-paid employees, albeit ones not subject to labor laws.
• Wal-Mart already uses its middlemen as fall guys for things they themselves can't be associated with. Industrial espionage, customs requirements like country of origin markings, and intellectual property infringement are a few that come to mind.

Bottom line, because of how Wal-Mart does business, the move is risky with less upside than first appears, and certainly not new. If there is anything in the move that is worth considering as incremental progress in the road to globalization, it is the idea that they the entire Wal-Mart system is purchasing as a single entity across their global supply chain. Now that really is interesting, but the big surprise there is that they weren't doing that already.