FND Hill has two options to enter the small business market; through a partnership or through direct sales.

Tables

INTRODUCTION

Big Data and the cloud are the watchwords for the future. The

capability to use and store Big Data means ever-increasing demand

for state-of-the-art data storage. Our Parallax systems continue to

lead the pack. The cloud will bring high demand not only for data

storage but also for our industry-leading virtualization software

that lets it all happen seamlessly and invisibly to the user. We are

positioned for major continued growth as these trends accelerate.

The future is bright for FND!

In 2004, Raphaella Munoz, vice president and director

of the Herald Division of FND Corporation, and her

top-management team had just heard those words from

Jack Pizzuti, chief executive officer (CEO) of FND. He

was speaking from a large auditorium in San Francisco,

California, at the headquarters of the Software Division, but

his address was webcasted to all of FND’s facilities around

the world. Cheering could be heard from the San Francisco

audience, but the mood in the Herald Division conference

room was much more somber.

Herald products had not been mentioned once in

Pizzuti’s 45-minute address. Herald made and sold FND’s

second-tier storage systems. The systems were very-high

quality and led FND’s competitors in terms of reliability

and cost of operation, but the systems did not contain the

latest leading-edge technology, unlike the Parallax systems.

Herald systems were targeted to serve the less-strenuous

needs of departmental offices or remote business offices of

the Fortune 1000 firms that bought Parallax systems for their

corporate data centers. The managers in the room realized

that Herald products might be the tier of products most

likely to be negatively affected by a trend to cloud storage.

Munoz clicked off the webcast and turned to her team.

“I have decided that we need to mount a concerted effort to

press more strongly into the small-to-medium business (SMB)

market. To date, our business has been focused on very large

companies. We dominate that market, but it is becoming

saturated and is likely to be slowly eroded by cloud-based

storage. That is not going to happen very quickly. It will take

many years for the majority of organizations to become ready

to adopt cloud storage. Most IT (information technology)

buyers tend to be quite conservative. But before that happens,

we need to strike quickly and expand our market footprint;

and the time is now. The big numbers of potential new clients

are in SMB. We need to significantly expand our market

presence in that segment as soon as possible.”

Tina Johnson, chief sales and marketing officer in the

Herald Division, reacted first. “You are right. That is a

huge market, but it is made up of many quite different

subsegments. One of our salespeople just completed a sale

to a firm with only 16 employees, but it is an internet-based

company and bought 5 of our top-of-the-line RX-50s. That

is a $750,000 deal! The selling process took a long time, and

the customer had many technical questions. On the other

hand, another recent SMB sale involved a large regional

heating, ventilation, and air conditioning (HVAC) equipment

service company. The salesperson expected this to be a big

sale, too. The company has more than 200 employees. In the

end, the customer only bought an entry-level RX-10. The

salesperson said that this customer needed to be educated

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FND: The Hill Channel Partner Decision

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Alfred J. Nanni, Jr. Professor of Management Accounting and Operational Performance Babson College

about basic system storage and that the resulting sale took

some time but not much expertise. In my opinion, that was

a huge waste of the salesperson’s time and effort. My sales

force is not designed to chase those tiny sales.”

For basic information about the RX-10 and RX-50

product lines, see Table 1. These products are the high and

low ends of the RX series of products.

Ken Nakane, manager of the Herald Service Group, reacted

to Johnson’s comment: “We see the same sort of thing in

warranty service. More-sophisticated customers tend to have

more-complicated service needs. On the other hand, some

warranty repairs on RX-10s are almost a do-it-yourself level of

difficulty, but we still have to use our existing highly trained and

expensive service technicians. That makes the simpler products

relatively more expensive to service. Here is a cost and time

analysis of warranty-related service costs for the RX-10 and the

RX-50 that our financial planning and analysis (FP&A) group

put together (see Table 2). This illustrates my point.”

“Speaking of FP&A, they also studied the time our sales

team puts in on each bid,” Johnson interrupted. “You can

see that a similar pattern in relative costs shows up for selling

small vs. big machines (see Table 3).”

Gil Santiago, the chief financial officer (CFO) of the

Herald Division, spoke next, turning to face Munoz:

“Regardless of how much cost sales and service absorb in

this potentially large SMB market, the critical issue we have

to face if we are going to significantly increase our effort

is that we really do not have any excess sales and service

personnel. We have staffed ourselves very tightly to maintain

our final margins. The purpose of having my FP&A group

do those fully loaded activity-based costing (ABC) analyses

was to get an idea about how much we need to budget as

we increase staff in those two areas. If we expect to increase

sales in the SMB market, we can expect our sales and service

personnel costs to increase, as well. There will be training

costs, too, but they are baked into those fully loaded rates.”

“That is not an issue for manufacturing,” said Bhavna

Choudhary, vice president for manufacturing in the Herald

Division. “As you know, we added lots of capacity a couple

of years back, but demand has not yet risen to fill that

capacity. Furthermore, we are continually improving our

process efficiency, which actually expands effective capacity.

Right now, we could produce at least 25,000 more RX-50s

every year without adding any fixed costs. We could easily

make more than 35,000 additional RX-10s.”

“But most of our product costs are variable costs anyway,

aren’t they?” asked Munoz.

“That is true,” Choudhary replied. “We mostly just do

assembly, testing, and software loading. Our supply partners

make all of the components.”

Munoz stood and placed her hands on the table. “We are

going into the SMB market, and we are going in strong. The

question is, how do we organize ourselves to successfully do

it? We have been talking about simply utilizing our current

direct sales and customer support model, and expanding

our headcount as necessary. That might work for customers

like that internet business Tina mentioned, but they are

an outlier in the SMB market. There is an almost instantly

effective alternative, though. We could partner with a single,

dominant value-added reseller (VAR) to act as our retailer.”

Johnson reacted immediately: “VARs are an effective

way to reach particular segments, but who has the capacity,

interest, and existing market penetration to do that job for

us? Beyond that, using a VAR means big sales discounts, and

it means cutting out my sales force for some customers. If

we do that, I strongly feel that we would still need to pay our

salespeople commissions for VAR sales that are made in their

territories. I have worked too hard to create a highly capable

and energetic sales group. They are responsible for billions

of dollars in annual revenue. We cannot risk demoralizing

them and potentially losing them to our competitors. This

move could undercut their motivation unless we show them

that it is a win for them, not a threat.”

“I am glad you asked that question,” Munoz responded.

“Actually, I have been in early discussions with Hill

Computers. You know the company has a close relationship

with us. Its management buys a lot of our enterprise

equipment and related service and software for the

company’s own use. We buy desktops, laptops, and related

software exclusively from Hill Computers. Hill has the

capacity and the market penetration into the SMB market.”

“How would we service products sold through Hill?”

asked Nakane.

“We wouldn’t; we would supply the parts, but Hill would

handle the service,” replied Munoz. “And, yes, Hill will get a

big channel discount—35% less than our standard direct sales

price to be exact. That should give the company enough profit

incentive and allow it to deliver and service the units, too.”

“But there is a real risk of losing all of the customers Hill

sells to. Hill can be ruthless if they see a good opportunity

for profit growth. Do you remember what happened to

Textmar printers? Hill sold Textmar for a while in the late

1990s and then decided to make nearly identical printers

themselves. All of a sudden, Textmar lost the majority of its

sales volume. Do you want that to happen to us? We make

great products, but they are assembled from supplier parts. It

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would not be that complicated, for example, for Hill to make

RX-10 clones,” Choudhary said.

“Let’s see what we are talking about before we worry

about losing it,” Munoz replied. “The people I have been

talking to at Hill think the potential volume is 2,500 to 5,000

RX units in the next year. Some of those units would likely

be sales that we could otherwise make ourselves but no more

than 25% at most. And, Johnson, before you protest, that

certainly would be a noticeable bite from your sales force. I

would at least consider letting them take a commission on

sales delivered in their territories, as long as it was based on

our price to Hill and not on the standard direct sale price.”

There was silence in the room. Santiago eventually spoke

up: “I can assemble a team from my FP&A group to look

into this. Let me do that and get a report back from them in

a few days.”

“Good,” replied Munoz. “Let’s see what they come back

with.”

FND CORPORATION

FND Corporation was founded in the 1980s as a manufacturer

of sophisticated direct-access storage devices. This hardware is

the large-scale analog of the hard disks in a laptop computer.

Early in its history, FND management learned how

to target their products and sales to large enterprises and

developed internal organization to support the value

proposition. Products were designed to be extremely reliable

since these businesses needed “7 × 24” uptime for their

mission-critical applications. Since these customers were

very large, they had large teams of skilled professional

IT workers and large (sometimes multiple) data centers.

These IT professionals found FND’s hardware to be

technologically superior to the competition’s, with higher

reliability and significantly lower power consumption and

other data-center-related overhead.

That value proposition resonated very strongly with

Fortune 1000 customers. Within 10 years, FND dominated the

worldwide market for so-called “enterprise” storage hardware.

The FND sales force was highly trained, in terms of

both IT and business and finance skills. Sales negotiations

on these products and services were “high-touch,” often

involving multiple site visits, various presentations and

analyses, and weeks or months of discussions. Additionally,

since any after-sales problems that arose had the potential

to be complicated by interactions between FND’s

storage products and the rest of a customer’s IT operating

environment, FND put together a highly skilled, high-touch,

rapid-response customer support system.

FND rapidly began expanding its offerings with other

kinds of storage and with software and service support to

the same customers. The primary avenue for developing the

product and service lines for this expansion was acquisition.

FND’s first major acquisition was Herald Machines, which

made storage devices that fit the needs of subunit offices of

large businesses better than FND’s existing high-capacity,

high-performance corporate data center products. The Herald

RX product line, however, was also a natural fit for the needs

of small- to medium-sized businesses—the SMB market.

In contrast to the enterprise market, the SMB market was

often characterized by less-sophisticated and less-complex

applications. SMB customers, especially the smaller ones,

were more likely to be concerned with product purchase price

than with value characteristics like unit footprint or operating

cost. They needed reliability, too, but smaller businesses

often ran their machines one shift per day, five days per week,

not 24 hours per day. SMB customers did not have large or

particularly sophisticated IT staff members. In fact, for the

smallest customers, the IT department often consisted of

the business office manager or bookkeeper, who performed

IT duties as part of a larger set of responsibilities. These

customers, then, were really looking for computer system

“appliances,” not complicated machine/software systems.

In the SMB market, the sales transaction was often more

like a retail purchase than a drawn-out negotiation. This

required less salesman time per sale on average than sales

in the enterprise market, but more salesperson time per

dollar of revenue. On the after-sales service side, much of

the demand from SMB customers was for assistance related

to errors in basic care and operation. These kinds of issues

almost never arose with enterprise customers.

Unfortunately, the solutions required a very different

nature of discussion and interface from that which the

support teams experienced with enterprise customers. It also

required far less specialized technical skill and knowledge

than that possessed by the support staff FND employed.

HILL COMPUTERS

Hill Computers, like FND, was founded in the 1980s, shortly

after IBM released the first commercially successful personal

computer (PC). With that product introduction, desktop

computers immediately became an important business and

personal tool. By today’s standards, these computers were

very expensive and not at all powerful. IBM’s approach was

to make its PCs from commonly available standard parts,

which created opportunities for businesses making “PC

clones.” Quentin Hill began assembling good-quality PC

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clones for friends and fellow students in his dorm room in

college. Since he had little space and little money, he crafted

a business model where he would take payment, buy the

parts, and quickly assemble the computers to order. His

business expanded quickly, and soon Hill Computers had its

own large assembly facility.

As it grew, Hill Computers maintained its focus on the

original customer value proposition—just-in-time (JIT)

made-to-order products at low prices. To keep sales costs

low, Quentin first relied on only telephone and mail-orders.

As internet use began to grow, Hill Computers quickly

established a web presence. The company continued to

grow at double-digit rates. By 2000, Hill Computers made

more than 90% of its sales online and was one of the biggest

computer companies in the world.

Although Hill was generally known for selling to

consumers and small businesses, it sold to larger businesses

as well. The actual final sales to big business customers,

however, looked very much like sales to individual

consumers. Hill’s corporate sales force would talk to chief

information officers (CIOs) and top IT managers in large

businesses. Those managers would then establish parameters

for what types of hardware and software that employees in

their company could buy online. Hill would then set up a

password-protected company webpage for that customer.

Department managers and even individual employees at the

customer company could then order computer equipment

like desktop computers, laptops, and printers and charge

their department business credit cards. The funds would

then be drawn from the departmental budgets.

This arrangement was valuable to the IT managers. It

took IT personnel out of individual employee computer

acquisition and distribution, a time-consuming but low-skill

activity. It also allowed for standardization of the company’s

PC hardware and software, simplifying internal maintenance

and service requirements and thereby reducing the need for

extensive service training. IT managers, however, typically

retained exclusive purchasing authority over strategic (and

high-priced) IT capital equipment.

The arrangement was also valuable to the equipment

users, who could select the equipment that best fit their

needs without bothersome and time-consuming consultation

with the IT staff, as long as the purchase price was within

their budget authority. Industry analysts claimed that part

of Hill’s pricing strategy was to position product prices just

below typical budget authorization ceilings (e.g., US$1,000,

US$5,000, US$10,000, or US$20,000) so that potential buyers

would be free to place the order without initiating further

internal review and approval.

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Table 1. Basic Information About Herald Products

RX-10 RX-50

Position in product line Entry-level Top end

Average selling price $18,000 $150,000

Variable manufacturing costs/unit $9,000 $63,000

Variable unit installation cost $900 $1,400

Sales commission rate 5% 5%

Note: All monetary values are expressed in U.S. dollars.

Table 2. Comparative ABC Warranty Service Costs per Average Service Call

Fully Loaded ABC Rate

Per Productive Hour*

ABC Driver Count Product Profiles

RX-10 RX-50

Service labor type/class

Remote (call center) level 1 $30 0.4 hours 0.7 hours

Remote (phone) level 2 $85 0.3 hours 0.8 hours

Field technician $130 3.9 hours 6.1 hours

Parts $300 $500

Historical service call rate during Warranty 1% 3%

* Fully loaded costs include salaries or wages plus benefits, employment costs, and the costs of associated dedicated tools and assets for that employee. Productive hours are the hours spent performing the job the employee was hired to do. On an annual basis, they are paid hours less holidays, vacation, sick time, training, and administrative compliance hours.

Note: All monetary values are expressed in U.S. dollars.

Table 3: ABC Sales Profile Data Average per Successful Sales Event

Fully Loaded ABC Rate

Per Productive Hour*

ABC Driver Count Product Profiles

RX-10 RX-50

Service labor

Lead salesperson $125 8.0 hours 24.0 hours

Sales support staff $73 5.0 hours 17.0 hours

* Fully loaded costs include salaries or wages plus benefits, employment costs, and the costs of associated dedicated tools and assets for that employee. Productive hours are the hours spent performing the job the employee was hired to do. On an annual basis, they are paid hours less holidays, vacation, sick time, training, and administrative compliance hours. For sales, the time consumed pursuing “dead end” leads is included in the successful event averages.

Note: All monetary values are expressed in U.S. dollars.