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Gray Channels In China

Gray Channels. What they are, Why it hurts, What to do About it.

What Are Gray Channel Products?

Gray-market goods refer to goods which are sold outside normal distribution channels by unauthorized sellers.

Example:  China supplier receives an order for 10,000 units for a famous handbag brand.  The supplier produces 15,000 units and the extra 5000 units go “out the back door”.

The above example is malicious and unethical.  Gray market sales can often come in the form of parallel imports.  This occurs when the price of an item is significantly higher in one country than another. Consider the example of a branded camera purchased in Hong Kong (low sales tax) and sold in the Middle East.

Entrepreneurs buy the product where it is available cheaply, often at retail but sometimes at wholesale, and import it legally to the target market.  They then sell it at a price high enough to provide a profit but under the normal market price.  International efforts promoting free trade include reduced tariffs and harmonized national standards.  These facilitate this form of arbitrage; whenever manufacturers attempt to preserve highly disparate pricing.  Because of the nature of gray markets, it is difficult or impossible to track the precise numbers of gray-market sales.  Gray-market goods are often new, but some gray market goods are used.  A market in used goods is sometimes nicknamed a green market.

Importing certain legally restricted items such as prescription drugs or firearms would be categorized as black market, as would smuggling the goods into the target country to avoid import duties.  A related concept is bootlegging, the smuggling or transport of highly regulated goods, especially alcoholic beverages.  The term “bootlegging” is also often applied to the production or distribution of counterfeit or otherwise infringing goods.  Gray markets can sometimes develop for select video game consoles and titles whose demand temporarily outstrips supply and the local shops run out of stock.  This happens especially during the holiday season.  Other popular items, such as dolls can also be affected.  In such situations the gray market price may be considerably higher than the manufacturer’s suggested retail price. Online auction sites such as eBay have contributed to the emergence of the video game gray market.

Source

Real Life Example

Back in 2005, one of my colleague’s owned a beauty supply store in New York City.  The cost of rent in a busy first floor commercial space in Brooklyn, N.Y can easily exceed $4,000 USD.   Since most of the store was shelving, it didn’t consume a lot of electricity, except for the air conditioning unit.  The only workers were my colleague’s brother and himself.  They went about 8 months without a salary and even when they started profits it was only a few hundred dollars per week and they still had to pay their personal bills.  Monthly expenses to maintain the store were approximately $5,000USD.

The typical mark up on the products my colleague sold were 100% of the wholesale price. The companies of certain products that he carried required that his business maintain the retail price of their products at a 100% mark up to keep all prices in the retail space the same.  This prevented pricing wars between local businesses and showed the quality level of the product.  They believed customers would pay a premium for a quality product like theirs.

Customers wouldn’t shop at the beauty supply store as much as they would a food market.  Food is consumed everyday whereas beauty products usually don’t need to be replenished as often.  After a few months into the business, my colleague was approached by a friend who knew a Chinese businessman.  The Chinese businessman was interested in a handful of products which he wanted to purchase in bulk at 10% above wholesale; he was willing to purchase between $10,000 USD – $50,000 USD per month.  In order to keep the business afloat, the brothers agreed to the arrangement.  The Chinese businessman would ship the goods to China and resell them to customers below the retail price making himself a pretty good profit.

The companies who sold this premium product to various businesses took notice of the high volume of sales going through and sent a sales person to investigate.  The owners told the salespeople that they were conducting promotional activities to get the word out about the business and that seemed to be an acceptable answer.

The reason why those sales people didn’t push so much was because they made a commission from every order that, that retail space made.  The brothers would place large orders twice a month without needing the assistance of the sales people.  This was a great deal for the brothers since all the hard work of opening the account was done; they sat back and let the sales team place orders on their own.  The sales person would occasionally call the store and ask my colleague to place at least one order through her so he or she could show the boss that he or she was tending to the account.

What would eventually happen to this particular brand that the Chinese businessman was interested in?  That brand will eventually be ruined if that company doesn’t find ways to control who they sell to.  The customer doesn’t need to go into a high-end store and pay the $50 USD original retail price when they can go around the corner to the $.99 cents store and get the same product for $35 USD.   The high-end store will eventually stop carrying the product and the company will lose money.

The product was actually manufactured in the U.K. and sold to the U.S. market.  This may mean that it was manufactured to the tastes of a U.S. customer and not an Asian customer.  Which can potentially lead to a possible lawsuit for the company that makes it.

Effects of the Gray Market

The gray market can lead to a short term effect of quick profits for certain parties involved.  However, the long term effect will most likely result in less profits overall.  Gray markets can cause the companies’ products to compete with each other over the same brand.  Certain areas would have an oversupply of the product and require a price cut to move the product off shelves.  Customers think that they are getting a good deal with a gray market product but if that product requires ongoing services that aren’t available in his or her area, customers will actually lose out in the long run.

Unfortunately, this is not an uncommon problem but, there are ways to fix it.  A sourcing agency, that I am associated with, was recently brought in by a client to investigate a case and present a solution.  Here are some of the highlights for your reference.

Can you look at the products in the gray channel and know where they were made? 

In this case, investigations confirm that the majority of products in the gray channel were directly linked to the batches of production in China which were rejected by the buyer due to quality issues.

Strategy implemented:

1.     Purchase Order Templates were adjusted to clarify that rejected goods must be destroyed by supplier at their cost.

2.     3rd Party Inspectors would be hired to record the destruction.

3.     Client’s brand was registered in China. Previously registered only overseas.  With the IP now protected in China.  The brand holder can take legal action in China if needed.

4.     3rd Party Investigators were retained to monitor both Chinese and English language websites like TaoBao.com and T-mall as well as the websites of the contract manufacturers to look for unauthorized products.

5.     3rd Party Investigators were retained to monitor trade shows in China and HK to look for unlicensed products.

6.     Brand holder clarified its marketing materials and product packaging to state that only product purchased from authorized distributors are under warranty.  In this fashion the demand side could also play a role in preventing gray channels.

7.     Between production runs the tooling was removed from the factory and stored at a 3rd party facility in China to avoid unauthorized production. (Visit http://www.psschina.com/about/virtual-tour/services-and-pricing/tool-and-die-steward/ to lean about the “Tool & Die Steward.”)

Important Concepts:

Before the adjustments above, the suppliers were essentially selling rejects out the factory back door to subsidize their costs of production.  In some cases, because of the tight quality requirements of the buyer combined with the poor quality system of the supplier, this back door income was a significant source of revenue for the suppliers. Cutting off this source of revenue was hard medicine for the supplier to swallow.   Two methods proved successful to remedy the situation.

Some suppliers were dropped and a sourcing feasibility study was conducted to find more professional replacement  suppliers who could meet targets for price, quality, lead-time and trust.

The suppliers worth continuing to do business with were given a sit down to explain why it was good for the supplier as well as the buyer to cut out the gray channels.  Key points included:

  • Unlicensed products cannibalize revenue of the brand owners.  If they lose money, they can’t place as many orders to the factory.
  • Brand holder is no longer tolerating unlicensed products and the parties involved face significant financial risk when caught.
  • The defective goods finding their way into the market is hurting brand reputation.  If the brand reputation is gone, the orders for everybody will be lost.

Perhaps the most important message conveyed to the suppliers is that the brand wanted to have a stable long term relationships with partners who could be trusted.  To show their commitment to the suppliers, and to help the suppliers, the brand owners provided the following:

  • Accurate annual forecasting and projections.  Suppliers love stability almost as much as they love volume.
  • Technical support and training to help suppliers upgrade their quality systems and finally understand that avoiding defects in the first place, not selling defects out the back door, is the best way to protect the supplier’s margin.
  • Periodic engineering reviews with suppliers to look for ways to reduce costs in production methods and materials, yet not compromise quality.  The savings were shared between the factory and brand holder.

Essentially nobody wants his or her products to fall into the wrong hands and end up in the gray market.  There are many options buyers have; one option is to have multiple suppliers make different components and assemble your product at a central location.  Yes, will cost a little more but it will dramatically reduce the chances of ruining your brand in the long run.

Mike Bellamy is an Advisory Board Member & Featured Blogger at the not-for-profit China Sourcing Information Center (www.ChinaSourcingInfo.org). He is also the author of, “The Essential Reference Guide to China Sourcing” (chinasourcinginfo.org/book) and founder of PassageMaker Sourcing Solutions (www.PSSchina.com )

Shaher Husein joined CSIC/ PassageMaker as a Content Manager/ Account Manager in 2012 to fully immerse himself in China and international trade.  He has a Bachelors in Business, Management and Finance from Brooklyn College.  Shaher speaks English and Arabic and is based in Shenzhen.

 




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