ALTERNATE DISTRIBUTIONSTRATEGIES FOR 1

DIGITIZATION OF

MUSIC HAS CREATED

OPPORTUNITIES TO

REENGINEER THE

SUPPLY CHAIN AND

IMPROVE ITS EFFICIENCY.

BUT HOW WILL IT

PLAY OUT?

The music industry is undergoing a tumultuous period, as

modern communications technologies create new opportu-

nities as well as significant challenges for established indus-

try players. Many attribute the recent decline of the music

market, which fell from $39.7 billion in 1995 to $37 bil-

lion in 2000 [4, 5, 7], to the availability of free online

music. The downloading of music, once considered a mere

nuisance, is now recognized as life-threatening to the indus-

try. Some 29% of adults have downloaded music over the

Internet, and over 53% of teenagers rely on it as their pri-

mary means of acquiring music [2], which helps explain the

significant drop in sales to the teenage segment in recent

years. If teenagers continue such practices in their adult

years, we will see considerable erosion of traditional sales.

The Recording Industry Association of Americas(RIAA) drastic legal measures forcing the closure ofNapster and other peer-to-peer (P2P) music-sharingbusinesses may have temporarily stopped the hemor-rhaging, while clearly highlighting industry's crucialneed to improve its understandingof customer needs, and to provideproducts and services that meetthose needs. Since the crux of theproblem relates to reorganizingthe supply chain, this article pto-vides a description of the currentsupply chain and examines vari-ous digital distribution strategies.

The three major categories ofplayers in the music industry sup-ply chain are content creators,content developers and marketers,and distributors/retailers. Thecontent creators include com-posers, lyricists, and artists. Thecontent developers, which includethe music publishing and recordcompanies, are central to theindustry. They purchase the musi-cal rights, identify and developperforming artists, record musicin studios, manufacture and dis-tribute the music, and advertiseand promote music through vari-ous channels. Five large playersdominate content development: Sony, Warnet, Univer-sal, BMG, and EMI. The distributors include bothrecord companies and large national retail chains.Retail outlets owned by record companies, along withlarge national retail chains, account for over 85% ofrecord sales, while record clubs and mail order busi-nesses account for about 12%, and online retailers

interactive Internet provides opportunities tor usingthe promotional channel as a sales channel for down-loading music.

Surveys of consumers, especially college studentsand teenagers, have foiuid that CDs are perceived as

Physical Record Co. / Record Co. / Artist /Distribution Retailer / Customer Customer

Customer

Total Cost: $15-$ 18

Retail Cost: $5,25-$6.5

Margin: $0.8-$ 1.0

Staff: $ 1.2-$ 1.45

Distribution: $1.2-$ 1.45

Score rent: $2.25-$2,75

Advertising/Marketing: $2-$4

Distribution: $1.2-$ 1.60

Manufacturing: $0.75

Studio: $1

Royalty: $2.

Overhead: $2.

Record Co. Margin: $0.5-$0.7

Total

100%

35%

20%

7%

5%

6%

12%

12%

4%

100%

100%

30%'̂

20%

6%

12%

12%

4%

84%

100%

10%''

15%'

6%

12%

10%*̂

4%

57%

100%

10%

5%=

6%

12%

34%All values are approximace averages to illustrate the break-up oí cosis. The actual figures may vary from album to album.Assumes there is some saning in retail store operations^ includes cost of kiosks and systems.Assumes there is no retail operations; includes cost for online Web site operationAssumes there is some efficiency in advertising due to I : I relationship.Assumes some saving in overhead due Co reduction in record company operations,

^Assumes no traditional advertising: includes some independent advertising.

Table l . Costbreakdown of digital

distribution.

expensive. This may be because "the commercial valueof music is being widely devalued by mass copying andpiracy," as one industry expert claimed [9]. Anotherreason for this perception may be that consumers findonly two to three songs of value on a CD. The avail-abilit)̂ of MP3 technologies, digital downloading, andCD writing have empowered customers and changedtheir buying behavior.

An examination oi the cost structure of the industrysuggests potenti;il opportunities to improve efficiencyin the supply chain. As illustrated in Table 1, which

account for 1% of sales [7]. Record companies have a provides a breakdown of the cost structure using aver-significant influence on the demand chain as well as thesupply chain, but in recent years, a significant marketshare of unaccounted music sales has shifted to P2Pmusic sites.

Customers consume music in two forms, eidier as aproduct they own, perhaps in the form of a CD, or asa service, through a radio station. The latter is used asa promotional channel to create awareness and enticethe consumer to own the product. The market can bebroadly categorized as consisting of two segments:casual listener and music owner. It is conceivable for acustomer to belong to both segments: as a casual radiolistener for some music, and a music owner for othermusic. The revenue flow occurs only when the radiolistener is converted to a music owner. The two-way

ages based on various published sources [6, 7], themanufacturing cost is only about 5% of total cost, andthe artists and composers receive about 12% as royalty.Meanwhile, retail oudet costs such as labor, rent, andlocal inventory account for 35% of the selling price.After taking into account price markdowns and inven-tory write-offs, operating profits range from 4%-6% ofsales. Ajiother large percentage of the cost (20%) isdirected toward advertising and promotion.

Analysis of these cost figures reveals the variable cost(25%) is relatively small compared to the fixed cost(75%), which is significant since as much as60%-80% of music titles are considered failures thatdo not recover fixed costs. Most consumers lack aware-ness of die inherent risk in this business; they do not

9 0 September 200}/Vol. 46. No. 9 COMMUNICATIONS OF THE ACM

RECORD COMPANIES, INSTEAD OEDISTRIBUTING MUSIC EOR OWNERSHIP, MAY USE

THE AUDIO STREAMING MODE TO REACH LISTENERSEOR A MONTHLY SUBSCRIPTION. SINCE I S P S WILL

BE DELIVERING THE MUSIC TO THE CUSTOMER,THEY MAY OFEER IT AS AN ADDITIONAL SERVICE

TO OBTAIN EXTRA REVENUES.

realize, for example, that the profits fi-om successfulrecords help compensate for the losses from failures.

Digital Distribution StrategiesVarious strategics exist to digitally distribute musicthrough the supply chain, which has three major par-ticipants: content creators or artists, record companies,and retailers. Apart from technological issues, multiplemarketing and sociological issues must be addressed toensure digital distribution is successfiii. Focusing onlyon supply chain efficiency may provide a solution thatcannot be implemented due to other constraints. Sixdigital music distribution strategies, graphically illus-trated in the figure, are described here in detail.

Record company-retailer-aistomer. This strategy can

Artists I * Record Co. n ^ Retailer "nCuicomer

Figure la. Record Co I Retailer / Customer

Figure I b. Record Co / Customer

Figure Id. Artist / Customer

Figure If. Audio.«n-demand

be considered the first phase in the evolution to digitaldistribution, Wiúi minimal disruption to the supplychain. Music is digitally distributed from the recordcompany to the retailer, and the customer choosesdesired songs and creates a CD in a Idosk in the retailstore. The retailer ain also retain its traditional retailsales of packaged CDs. Overall, a cost savings of about16% can be expected, as shown in Table 1, mostly fromreductions in manufacturing, distribution, and in-storeinventory costs. Music files could be downloaded onrequest from a central server in the record company, orthe files could be stored in a local server. The formercreates economies of scale and reduces system infra-structure and cost for the retail store. However, theretail store must have a high-bandwidth connection to

ensure reasonable download time.This strategy requires some

changes in customer behavior.Customers must be willing toinvest time to evaluate songs andfor the in-store CD creation. Somecustomers may choose to buypackaged CDs because the costsavings from a customized CDmay not be commensurate withthe extra time and effort involvedin creating a CD. Customersaccustomed to downloadingmusic at home may view thisoption as inconvenient and Inflex-ible. The primary drawback of thisstrategy is that it does not fullyexploit the technology potential tocreate an efficient supply chain.The benefits of this strategy aremany:

OnlineReuiler

Figure I c. Record Co I Intermediary / Customer

Online

Figure I e. Artist ' Intermediary / Customer

Digital distribution strategies.• It offers the fiexibility to createcustomized CDs without sacri-

COMMUNICATIONS OF THE ACH September 2003/Vol. 46. No 9

Record Co / Retailer / Record Co /Customer Customer

Record GB^l^HH'Artist /Intermediary / CustomerCustomer

Artist /Intermediary /Customer

Audio-on-Demand

Customer

Pro

Phj'sically browse/listen comusic before buyingEas/ shopping for non-tech, cuslomersAwareness of new artists

Online convenienceFlexibility—buy songsvs. Full albumsLower prices

' Convenient; one-stopshopping

' Online communityinformation on artists

' Direct link; lowerprices

Convenieishopping

* One-siop shopping* No owneiship-playlist

can change* Less costly

Con Inconvenient—trip to storeCannot create own CD sthomeHigher prite

' Slow download' Lower music quality' Visit multiple sites: noone-stop shopping.

' Cost—intermediary' Slow download' Lower quality music

' Inconvenient: visitmultiple sites

' Slow download' Lack of Info, on artists

Good srtlsu may notparticipate / ContractsIntermediary» Extra costSlow download

• Quality of connection* Cannot transfer to

multiple devices

Retailer

Pro

Role In supply chainL0C3I custOmiiatJon reduces

Con Not cost competitive Disintermediated D is intermediated Disintermediated Di sintern) ediated Disi ncermedlated

RecordCompany

Pro

' More visibility lor artists/albums

' Quality recording' Control Illegal copying' Reach non-tech audience

Efficient supply chainDirect link to customerNo InventoryLess cost, greater margin

Outsourced digital dis-.infrastructureNo inventoryReduced physicaldistribution cost

Efficient supply chainNo illegal copying(streaming only]No inventoryLess cost/ereater mar

Con Not cost competitiveObsolete inventoryCommission to retailer

' Illegal copyingShutout non-tech,customersCost/digital infrastntct.

' Payment issues/ minors

' Compete with otherrecxos. inWeb Site

' Illegal copying' Lower margin due toIntermediary

' Payment issues / minors

Dis intermediated Dlslniermedlated Digital distrlb.infrastructureRevenue loss diie toless ownershipInability to introducenew artists/albums

ArtistPro

Greater visibility/Advt.No Illegal copying

Possibly more sales andcommissions

Direct link to customerHigh margin

Outsourced digital distrib,• Visibility ' more visitors

Con ' Too many intermediaries Music QualityIllegal copiesNot i good channel foradvt. and mktg. music

Music QualityIliegal copyingLower margin

' Illegal copying' Difficult to reach allcustomers/no advt.

' Cost/digitai infrastruct.

' Compete with otherartists on the Web site

' Lower margin' No direct link to customer

' Loss ol sales due toreduced ownership

' Artists cannot reachcuston^crs easily

ficing the packaged CDs some customers favor.• The retail component of this strategy is a useful way

to give customers a music experience and introducethem to new artists.

• This strategy can be phased to evolve as the marketchanges. The first phase of creating customized CDscan evolve into a second phase of Ín-store produc-tion of packaged CDs to minimize in-store inven-tory, and then to a third phase of an inventory-lessstore where customers identify artists, sample music,and create CDs.

• Retail store operations benefit from cost efficienciesinherent in this strategy.

• Record companies can ensure copyright protection.

Record company-customer. This option exploits thepotential of direct digital distribution, bj'passing theretailer and achieving significant cost reduction in dis-tribution and retail operations. Table 1 demonstratesthe entire cost of retail store operations can be elimi-nated, although the Web server operations integral tothis strategy can make a big dent in savings. This strat-egy allows the cost of a CD to be reduced by as muchas 45%, but several issues must be addressed for its suc-cessful implementation. One issue involves copyrightviolations, a major source of concern for record com-panies. Since digital downloading facilitates illegalcopying, record companies are understandably con-cerned about revenue generation from this option.Also, the significant bandwidth requirements maymake this option infeasible tor downloading entire

CDs for a portion of the home Table 2. Comparisonmarket, and may shut out a mar- °' distributionI L 1 1 I strategies,ket segment that lacks internetsavvy. In addition, the overall sales growth may declineif record companies are unable to generate fresh salesfrom new recordings. Thus, record companies may stillneed retail operations and the retailing environment topromote new artists and records, thereby increasing thecosts associated with this strategy. Finally, the teenagemarket segment may be unable to complete onlinepurchases due to lack of access to credit cards or otheronline payment mechanisms.

Record companyAntermediary-customer. This strat-egy eliminares a problem associated with the previousoption: that customers must visit multiple sites to gettheir music. An intermediary could consolidate musicfrom multiple record companies and provide a one-stop shop for the customer. An online retailer likeAmazon.com could generate additional sales revenueby providing extensive search facility and systeminfrastructure to download music. Customers mayfind additional value in other services offered such asunbiased music reviews, community building, andemail alerts.

Artist-customer. As shown in Table 1, this strategyallows for cost savings in every &cet of music indtistryoperations, although the artist will incur the expensesof direct advertising and Web site maintenance. Theelimination of intermediaries creates the most efFicientsupply chain strategy, but severa! issues beyond effi-ciency must be addressed. Record companies play a

92 September 3003/Vo), 46, No 9 COMMUNICATIONS OF THE ACM

EDUCATING THE PUBLIC ON COPYRIGHTS ANDTHE IMPACT OF ILLEGAL COPYING ON THE MUSIC

INDUSTRY IS CRITICAL TO ENSURE THE MUSICINDUSTRY REMAINS HEALTHY, AND INCENTIVES

EXIST FOR ARTISTS TO CREATE NEW MUSIC,

major role in promoting new artists and songs. Whilewell-established artists may he ahle to sell directly tocustomers, newer artists may struggle to reach cus-tomers, as over 30 albums are released monthly. Evenwell-established artists may he unahle to expandbeyond their existing customer hase if advertising chan-nels do not promote their music. Further, the "freemusic" expectancy of customers associated with thisstrategy may create significant risk for artists, since rev-enue streams are not assured. Many artists view thisoption as A promotional channel to establish theirnames before being recruited hy a record company.

Attist-intermediary-customer. In this option, an inter-mediary aggregates the artists' offerings to reduce thesearch burden and information clutter for the customerand also to expand the market reach for the artists.These intermediaries can provide additional value hycreating online communities with similar music inter-ests, and offering services such as online music reviewsand email alerts for new releases and concerts. Thebusiness model is prohlematic if sales do not take off, orextensive advertising hecomes essential to generate rev-enues. As with the record company-intermediary-cus-torner strategy, this strategy is likely to be integratedwith an online retail site (see the figure). Such integra-tion is sustainable as a business model since it providessufficient value to attract customers. Record companiesmay see it as an opportunity to reduce their risk by eval-uating new artists' popularity before signing a contract.

Audio'On-demand (AOD). This option allows cus-tomers to create their own customized playlist offavorite songs and to listen at their convenience from anInternet radio station [1]. A simple suhscription modelcould be used to deliver music to the customer. Thecustomer has complete flexibility to choose as well aschange the playlist during the suhscription period,thereby avoiding getting locked in with a few songs, aswith the ownership model. As with traditional radio

stations, the subscription fees could he partially subsi-dized hy advertising, if customers were willing to listento some advertising. The Internet radio stations cotJdhe owned hy record companies, intermediaries, Inter-net service providers, or traditional radio stations.Record companies, instead of distributing music forownership, may use the audio streaming mode to reachlisteners for a monthly subscription. Since ISPs will hedelivering the music to the customer, they may offer itas an additional service to obtain extra revenues.

Benefits of this strateg)^ include minimizing copy-right violations, since music is streamed without localstorage. For casual listeners, this strategy is an attractivealternative to traditional radio, as they get a customizedplaylist for a nominal tee. Several inarketing and tech-nological issues must be addressed before this approachbecomes feasible. By allowing the customer to choosesongs, tbe record companies lose the valuable radiochannel for promoting new albums. They must findinnovative strategies to introduce new songs withoutexcessive intrusion on customers' music experiences.Another issue to consider is whether a v;ilue propositionexists for customers to switch from free radio broadcastto a paid Internet radio station. The television industryhas some parallels. Although free broadcasts ai'e avail-able, customers are willing to pay a subscription fee fora cable connection, which provides more choices andbetter quality transmission. Similarly, pay-per-viewcoexists with monthly cable subscription service. Thiswould he analogous to Internet radio stations sellingmusic downloads.

The technical issues are more problematic. Thevision of AOD is not yet a reality at the quality and ser-vice levels required hy the customer. For AOD to besuccessRil, music must be delivered on both wirelessand wired mediums, since customers demand the flex-ibility of listening to music while sitting in front of theirdesktop PCs, on the move in a car, or while using a

COMMUNICATIONS OF THE ACM September 200VVol 46, No 9 93

portable player device. An important differencebetween broadcast radio stations and Internet radio sta-tions is the latter requires the radio station to maintaina continuous two-way link with each customer. Thisresults in a significant load on the server and the sup-porting network infrastructure. The availability of sur-plus bandwidth ¡n the fiiture could alleviate thisproblem.

Future of Music DistributionTable 2 provides a summary of the pros and cons ofeach distribution strategy for the stakeholders: cus-tomers, retailers, record companies, and artists. Whileit will be tempting to predict one strategy will prevailover the others, it is more likely that several will coexistin their own niche markets. The relative success of eachstrategy is dependent on many contextual factors.

One factor that will influence the restructuring ofthe industiy is the power dynamic among artists,record companies, retailers, and customers. As men-tioned earlier, the music industry is dominated by ahandfial of major record companies that control thecreation, marketing, and distribution of music, andrecord companies have considerable power over mostartists. The increased customer power derived throughuse of illegal P2P music sites was temporarily reducedby the legal actions taken by record companies to shutdown P2P sites, but many new P2P sites have sprungup, reducing the impact of RlAAs actions. Artists, dueto the threat of copyright violations, have generallysupported the position of the record companies in thedigital distribution debate. Table 2 reveals the positionof the retailer is at risk, since they get disintermediatedin all except the first option. Given the power structurein the industry, it is likely that record companies willinfluence the fiiture distribution strategy by providingincentives or disincentives for customers to use onechannel or the other.

The record company-retailer-customer strategy is theleast disruptive to the supply chain, with minimal riskof copyright violations. Several early attempts at thisstrategy have had mixed restilts. jay Samit at EMIclaims this strategy allows "the smallest mom-and-popshops to have the same inventory as Amazon" [11].While retailers would definitely prefer this option,record companies and artists may view ¡t as an inter-mediate strategy until the technology issues related tocopyrights and communications infrastructure aresorted out. Internet-sawy customers may not favor it.

The record company-customer siïiitQ^ W\\\ be favoredby all stakeholders except the retailer, who is disinter-mediated. But the significant risks related to copyrightinfringement may force record companies and artists,two powcrflil partners in the supply chain, to proceed

cautiously. Slow download times may curtail use of thisoption, especially in countries burdened with poorcommunications infrastructures.

Customers will likely favor the record company-tnter-medimy-customer siïAXQ^, since customers tend to lackfamiliarity with record companies. Record companiesmay find this option useful to broaden their reach, evenat the expense of sharing profit margins with an inter-mediary. We have seen joint partnerships among recordcompanies, which represent a hybrid of the intcrmedi-aiy strategy, and the more direct record company-cus-tomer sivaxc^. For example, Pressplay, a joint venture ofVivendi (Universal) and Sony, ofîers digital musicdownloads. While the record companies' profits andsales are plunging, they are exploring various optionsincluding partnering with technology companies todevelop Internet-based digital distribution. The latestApple ventLire, iTunes, is an example of this strategy[8]. iTunes enables the download of songs at a dollareach, which includes the ability to copy the song to 10additional devices. It remains to be seen whether theinitial success of this venture can be sustained. Theinterest of Microsoft and Hewlett-Packard in thesepartnerships fiirther attests to the economic feasibilityof this option.

MP3.com and others have experimented with thedirect sale of music from artists or through intermedi-aries, with limited success. While some artists considerrecord companies as adversaries, most artists see theirvalue once they recognize the risk involved in directsales, and the extent of marketing and promotionrequired to reach customers. Since the artist-customerand artist-intermediaiy-customer strategies disinterme-diate two powerful supply chain members, record com-panies and retailers, and provide no significant benefitsto other chain members, they are least likely to succeed.

The AOD option has the advantage of reducingcopyright violations, but the technical issues and thesustainability of this business model, especially if sub-scription services are not popular, make it a riskyproposition. A downloading option is currently offeredto address quality issues in audio streaming, but with arestriction on playtitne. MusicNet, backed by threerecord companies (EMI, BMG, and AOL/TimeWarner) offers a subscription service using RealNet-works audio streaming technology. ISPs such as MSNand AOL offer a subscription service to enhance theirInternet offerings by partnering with Pressplay andMusicNet, respectively. Once music is available in adigital form, multiple business models can coexistsimultaneously to provide complete flexibility to thecustomer. In fact, the business model of MusicNet is ahybrid model Incorporating the record company-inter-mediary-customer and AOD strategies, simultaneously

9 4 September 2003/Vol 46, No 9 COMMUNICATIONS OF THE ACM

providing both ownership (although in a proprietaryformat) and listening options.

Management IssuesThe success of any digital distribution strategy depends

on several important issues: copyright protection, com-munications infrastructure, and pricing and paymentstrategies. The copyright protection issue has technicaland sociological components. The International Feder-ation oí- the Phonographic Industrv' (IFPI) estimatesthat the number of burned CDs worldwide is nearingthe number sold in stores, indicating illegal copying isas big as the music industry. Record companies areexperimenting with various copyright protection tech-niques to reduce copyright violations without increas-ing the compliance burden on customers. Newtechnology initiatives, such as registration of every copy,timed expiry, proprietaiy formats, and watermarks andfingerprinting are being tested. Customers' need forflexihility to share music among multiple personaldevices, and the need for an Internet connection toenforce digital rights management, complicate copy-right administration. Record companies will delaylarge-scale digital distribution unless they are confidentcopyright violations risks are significantly reduced. Thesociological component of the copyright issue becomesimportant in this context. Educating the public oncopyrights and the impact of illegal copying on themtisic industry is critical to ensure the music industryremains healthy, and incentives exist for artists to create

new music.Nt) strategy discussed in this article will succeed

without a solid communications infrastructure. Thesuccess of each strategy requires the ability to distrihuteelectronically to users with adequate quality and rea-sonable response time. The quality of audio streamingsuffers if the connection cannot sustain a minimumdata transfer rate. Factors influencing this rate includethe type of connection in the local loop, the backbonebandwidth, and the server capacity. High-bandwidthDSL and aihle modem sei-vices should alleviate some oftbe problems in the last hop. The backbone infrastruc-ture used hy an ISP must be upgraded to supportstreaming traffic, and ISPs may end up charging extrafees to support audio streaming. On the server side, var-ious new technologies such as load balancer, cacheservers, and content delivery networks bave been intro-duced to improve performance.

The pricing strategy plays an important role in thesuccess of digital distribution. Packaged CDs are pricedto distribute risk across many songs. The price per songmust be fixed at a level that will not cannibalize the salesof packaged CDs, hut will provide sufficient returns torecover the cost of album development, as well as the

cost of failures. The price must he sufficiently attractiveto entice customers to switch from free services such asGrokster and KaZaA. Record companies must ensurethere is no revenue loss in disaggregating the albuminto individual songs. One potential worry is the can-nibalization of sales of packaged CDs. This may beavoided by delaying the introduction of single song dig-ital downloads, similar to how the movie industryreleases movies to video three to six months after the-ater release. Also, new online payment methods mustbe developed for the teenage segment to prevent teensfrom growing dependent on illegal file-sharing options.Adult super\'ised debit accounts with use restrictions, ora pre-paid subscription model with a limit on numberof downloads can be used to facilitate payment.

ConclusionThe digitization of music has created opportunities toreengineer the supply chain and improve its efficiency.Five digital distribution strategies were examined in thecontexts of the industry cost strticture and the relativeroles of stakeholders. The major issues related to suc-cessfiil implementation of each of these strategies wereexplored and elucidated. B

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net Tracking Report. I'ew Internet Tracking and Aiiierlaiii Life I'tojcct;www.pewinteriiet.org/re ports, 2001.

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(i. May, B.,and Singer, M. Unchained melody, McKinsey Quarterly I (2001).128-137.

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Street Journal (Nov. 29, 2001), Bl.

G. PRFM PREMKUMAR (prem@iastaie,edu) k the Union Pacific

Professor in Information Systems ar the College of Business, Iowa StateUnivereicy, Ames, lA.

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