Channel economics

We were working with the financing subsidiary of a conglomerate. They had two divisions that gave loans for buying vehicles (mostly trucks, but also cars). One division used the direct channel. They had direct marketing agents (DMAs) who were paid a commission for getting the contract, and the division collected the monthly installments. The other used the dealer channel. The dealers would get the contract as well as collect the installments.

They wanted to cut costs, and asked us which channel had more flab. Since the company used IRR (internal rate of return), we defined the operating cost as the reduction in IRR. For example:

12% IRR paid by customer (through monthly installments)

9% IRR to subsidiary after reducing the cost of processing his loan

3% is therefore the operating cost.

After two months of analysis, we confirmed the subsidiary’s own opinion: the dealer channel had lower operating cost. The direct channel’s operating cost was 3.8% while the the dealer channel’s was 2.7%.

So we said the direct channel is flabby.

But the direct channel guys didn’t agree, and fought every inch of the decision.

“Do you think these figures are wrong?” I asked.

“Look, all we’re saying is, we KNOW they pay out huge commissions to dealers. We KNOW they’re overstaffed. They just CAN’T have a lower operating cost.”

I was tasked with resolving the issue. After a month of breaking the cost every single way, something interesting emerged. If we measured the operating cost per contract in Rupees, both divisions had the same cost per contract: Rs 18,500. That is, the total cost incurred in getting the customer and servicing the loan over the lifetime of the loan was Rs 18,500 in both divisions.

It turned out that the size of the loan was different: the dealer channel was still lending mainly for trucks, while the direct channel had entered the high growth passenger car market. Cars cost less than trucks. So while the dealer channel was paying 18,500 and getting interest on a large truck, the direct channel was paying the same 18,500 for less interest on smaller cars.

This is a strategic decision. The subsidiary had chosen to enter the car business knowing it would be less profitable but have higher growth.

But the story had a twist.

The 18,500 of operating cost per contract broke down as follows:

Dealer Direct
Getting the loan 5,000 7,000
Servicing the loan 13,500 11,500

The dealers are paid a servicing cost as a percentage of the loan. Servicing in the dealer channel is a variable cost. The direct channel, however, employs its own people, and incurs a higher cost only when it hires more people. About half of the costs are fixed. If the business doubles, the number of people you need increases only by about 50%. Servicing in the direct channel is more a fixed cost.

This subsidiary was planning to double their business in two years. At that point, the dealer channel would still cost Rs 18,500 per contract, but the direct channel would have come down to around Rs 13,000. So, going forward, the direct channel is really cheaper!

We told them to try and reduce the dealer commission.

Postscript: The subsidiary still went ahead and cut costs aggressively in the direct channel. It’s easier to fire your own people than to tell 500 dealers to reduce their commission, especially when you need them to also sell your trucks.

  1. jayant says:

    Just out of curiosity, how did the company’s (guess Tata Motors) car sales performed?

  2. S Anand says:

    Pretty good car sales, from what I hear. But the truck sales really boomed (nothing to do with our work, though).

  3. Madhu says:

    Just created a blog. Currently just a information provider

  4. S Anand says:

    What does ‘grandebelf’ mean?

  5. Madhu says:

    Grande = Big, Belf=Baby Elephant