The Hill Channel Partner Decision

Should FND make Hill its channel partner?
Hint: your numerical analysis can follow the following logic, based on which you can
draw your conclusions.
1. unit contribution margin for RX-10 & RX-50 under the direct-sales approach;
2. unit contribution margin for RX-10 & RX-50 under the channel sales approach;
3. incremental contribution margin for the two product models for ‘best (Q=5,000)’ and
‘worst (Q=2,500)’ scenarios, respectively.

ISSN 1940-204X
FND: The Hill Channel Partner Decision
Alfred J. Nanni, Jr.
Professor of Management Accounting and
Operational Performance
Babson College
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 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-
“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,
“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 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 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 missioncritical 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 aftersales 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 highcapacity, 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, 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 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—justin-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
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.