Pricing and Revenue management

This version: July 2016. This note has been prepared by Professor Utpal Dholakia to facilitate class discussion. 1

MGMT 682 ● Pricing Strategies Professor Utpal Dholakia Class notes Trade Promotions In many ways, trade promotions are the icebergs of the pricing world. They are largely invisible to consumers but are vast in scale and significance to manufacturers, retailers, and other channel members. A 2010 study by Kantar Retail reported that in the consumer packaged goods industry alone, annual spending on trade promotions exceeded $175 billion, amounting to more than half of all spending on price promotions by CPG manufacturers, and representing more than 16% of annual sales. Another older study conducted by Buzzell, Quelch and Salmon in 1990, estimated that 25% of salesperson time and about 30% of brand manager time is spent in designing, implementing, and overseeing trade promotions in CPG companies like Procter & Gamble. It is likely that these values have only increased since then. What are Trade Promotions? Trade promotions can be broadly defined as all price incentives, whether short-term and long- term, offered to downstream channel members by manufacturers. The most common form of trade promotions works as follows. The manufacturer offers the retailer (or another channel member) with specific products or bundles of products from its line at a lower price. There are usually certain stipulations attached to the offer such as minimum purchase quantity, a certain dollar amount and purchase within a specified time period. In a different version of a trade promotion, the manufacturer may offer a monetary incentive to the channel member to perform certain specific brand-building activities on its behalf. In exchange for providing these incentives, the manufacturer gains new customers, often from currently unserved segments and also increases its sales to existing customers, rewarding them at the same time. Through these outcomes, the manufacturer strengthens its visibility within that retail channel relative to competitors and potentially earns higher revenue. The retailer also benefits from participating in this arrangement. First, it sees direct margin increases flowing directly to its bottom-line from the promotional transactions. Second, by passing on some or all of the discounts obtained from the manufacturer to its end-consumers (say, shoppers in its stores), the retailer can gain significant increased traffic, higher inventory turnover, and greater sales during the promotion’s duration. If the trade promotion is exclusive to the retailer, it could even steal market share from its competitors. The discounted price may allow the retailer to claim price leadership, leading to more sales in other, unrelated product categories. Trade promotions fall into two broad varieties: (1) short-term sales incentives such as off-invoice cash discounts, free shipping, mark down allowances, and quantity discounts, and (2) longer-term brand-building incentives which include joint advertising (also sometimes referred to as “cooperative advertising”), market development, and in-store displays.

This version: July 2016. This note has been prepared by Professor Utpal Dholakia to facilitate class discussion. 2

We will consider each of these promotions in more detail but first, we begin with a short history lesson. Historical perspective on trade promotions Marketing historians have observed that trade promotions have evolved as a result of serendipity rather than deliberate design. Going back to the Nixon administration (late 60s -early 70s), economic conditions warranted a price freeze to help manage inflation in the retail sector. Prior to the effective start date of the price freeze, the CPG manufacturers initiated a significant price increase to protect the inevitable escalation of costs (e.g., material costs) that would occur during this period. One unintended consequence of this across-the-board prospective price increase was the birth of trade promotions in the CPG industry. To maintain their retail prices to the end- consumers, CPG companies dealt back the difference between the old price (before the price increase) and new price. Thus, something that started as a clever approach to get around price controls instituted by the Nixon administration has evolved to over a mammoth $175 billion industry (in the United States alone) by 2010. Although now in its maturity, in the early stages of the trade promotion life cycle, retailers began to create merchandising opportunities at a nominal cost that revolved around retail price reductions and in-store displays. The leading CPG manufacturers of the period (companies such as General Foods, P&G, and Lever Brothers) aggressively supported such merchandising opportunities because they realized significant increases in sales when their products were being promoted in stores. Consumers were much more responsive to merchandising tactics than they are today! Not surprisingly, the CPG stalwarts were amenable to open their purse strings and promote to the trade. This escalation of trade promotion spending by CPG manufacturers was a win-win scenario for both parties. Further supporting the rise, tracking trade promotion expenditures was relatively simple in the pre-computer era. The way it worked was as follows: A flat dollar rate per case was used to build a fund around which the manufacturer and retailer planned their promotion activity. The brand managers at the CPG manufacturers simply tracked these accruals internally against their P&Ls. As time progressed, by the late 70’s and throughout the 80’s, retailers had become very creative in developing new types of merchandising vehicles with separate costs associated with each one. Weekly newspaper inserts promoting specific products, television and radio programs, in-store sampling programs, and slotting fees for new products were all included in part of the merchandising mix during this time. Each new program (obviously) came with its own incremental cost and over time, resulted in a substantial increase in the trade promotion spending of manufacturers. At the same time, as consumers became more sophisticated, the efficacy of some of these programs started to vane. The addition of all these promotional programs also marked the start of the combination of off-invoice and bill-back allowances. The off-invoice allowance was designed to maintain an everyday or promotional retail price point. This allowance, like the initial rate per case allowance, was relatively easy to track and manage.

This version: July 2016. This note has been prepared by Professor Utpal Dholakia to facilitate class discussion. 3

Over time, retailers realized that they would get these off-invoice allowances even if they did not perform all of the required merchandising and other stated requirements to “earn” the allowance. As this happened, manufacturers began to look for ways to put more pressure on retailers to perform for these trade promotion allowances. “Bill-backs” had been around for many years, typically being used for indirect customers that pulled product from a wholesaler or distributor. Manufacturers realized that they could also have more leverage with their direct-ship customers if they layered on additional bill-back incentives. These bill-backs would not be automatically paid to the retailers. Retailers would have to submit paperwork, proving that they performed the necessary tasks to qualify for the trade promotion allowances. Only if the paper work was submitted would the retailer get a check from the manufacturer, resulting in the movement towards pay-for-performance trade allowances (at least in theory). This brief history is helpful in understanding the current state of trade promotions. From a serendipitous start, trade promotions have become the centerpiece of price promotions in the CPG industry. Next, we consider the different types of incentives involved in trade promotions in more detail. Short-term incentives Short-term price incentives given by manufacturers to channel members “off-invoice”1 comprise the most common form of trade promotion. A specific example of such a trade promotion is the “bracket allowance” whereby the manufacturer provides discounted prices when shipment volumes reach certain revenue levels or brackets. For example, if 1 to 25 items are purchased during the promotional period, the cost is $4.50 each. If 26 to 50 items are purchased, the cost is $4.25, and so on. The nature of the quantity discounts offered can take many other forms. Despite their widespread popularity, certain characteristics of short-term trade promotions are important. Forward Buying. Short-term trade promotions are particularly prone to being abused by channel members who often buy more quantity than they can sell to take advantage of the discounted price. This common practice is referred to as “forward buying ” among marketing and supply chain managers. These forward-buy stocks, which consist of merchandise purchased at discounted prices in addition to quantities needed to sell at lower prices or to sell through retailer advertising or end displays during the deal period, are held by channel members for later sale, usually at regular prices. In this case they simply pocket the savings themselves when the item is sold. Another common occurrence is that the channel member will continue to sell discounted products for far longer than stipulated by the manufacturer – which can erode the manufacturer’s brand image. The call to eliminate forward buying has led to the creation and advocacy of a new type of trade promotion, the “scan back,” which has become increasingly popular among manufacturers. With a scan back, the retailer receives promotion money only when it sells the product to the final consumer (tracked by scanner data during the promotion period), not when it buys the product. 1 “Off-invoice” refers to the manufacturer practice of giving retailers a certain amount off each unit of product they purchase and deducting the amount directly from the invoice.

This version: July 2016. This note has been prepared by Professor Utpal Dholakia to facilitate class discussion. 4

This approach effectively prevents any forward buying, because if the retailer buys extra inventory that it cannot sell during the promotion period, it loses promotion money. Recommendations of the scan back scheme promote it as a panacea for trade promotion ills. Another suggestion for improving the practice of forward buying involves instituting a system of virtual forward buying, whereby trade promotion deliveries occur in a staggered manner, which minimizes capital and storage costs. This method can lead to greater efficiency for both the manufacturer and the retailer, while keeping intact the practice of forward buying Pass-Through. Finally, it is worth noting that with few exceptions, the channel member retains autonomy in deciding whether and how much of the discount to pass on to the end-customer. For instance, a national retailer may receive a 10% discount to buy a certain line of tennis rackets from a manufacturer, but may decide whether to keep this benefit, pass some of it (e.g., 5%) or all of it (10%) to customers in its stores. The amount of discount passed on to the end-customers by channel members is referred to as “pass-through”. One recent study conducted by Supermarket News found that for food and beverage products, on average, retailers used 19% of the funds received from manufacturers to cover their costs of running the promotion, 16% went to their bottom line, and 66% of the funds were passed on to shoppers. Diversion. Upon receiving the discounted product from the manufacturer, channel members may sell some of the discounted excess inventory to other retailers at a smaller discount, which is referred to as “diverting”. Diverting goods can also occur from regions in which manufacturers offer especially deep discounts to higher priced areas when different deals are offered in different areas. Examples of this process include: (1) transfer from one division of a multiregional or national retailer or wholesaler to another division, (2) sale and direct shipment from one distributor to another, and (3) consignment through “diverters” -- companies who make such transfers their core business. Increased Price Sensitivity. Another argument made by many experts is that offering short-term incentives encourages retailers to come to expect such promotions thereby creating a vicious cycle of strategic buying during promotions and slackened buying before and after the promotional period, along with increased price sensitivity, ultimately eroding the product’s brand value. Short-term trade promotions also force manufacturers to conform their marketing tactical programs to retailers’ calendars since many competing manufacturers may vie to win a space on the retailer’s promotional calendar. As a simple example, a grocer cannot run in-store price promotions for General Mills, Kellogg’s and Kashi cereals at the same time. Increased Retailer Costs. Interestingly, in addition to impacting profitability positively, both forward-buying and diverting also add to channel members’ costs substantially. Forward buying inflates inventories and boosts interest expense, storage charges and insurance costs. It also often means additional transportation and handling expenses because forward-bought stocks are almost always kept separate from the “regular” inventories. Diverting produces trans-shipment and double-handling expenses for channel members. In one rigorous study conducted at CVS in 2003, the authors (Ailawadi, Harlam, Cesar, and Trounce 2005) found that trade promotions provided a gross increase in sales of 45% on average and also resulted in an additional 16% sales of other products in the store. Despite this sales

This version: July 2016. This note has been prepared by Professor Utpal Dholakia to facilitate class discussion. 5

increase, they found that more than 50% of promotions were not profitable for CVS (relative to not offering the promotion) because the lower promotional margin did not sufficiently offset the incremental sales. Second, they also found substantial variation in net profit impact across product categories and concluded that “eliminating promotions chainwide in 15 of the worst performing categories will decrease sales by about $7.8 million but will improve profit by approximately $52.6 million.” Forward buying also affects manufacturers in negative ways. It is one important cause of fluctuations in its shipments to channel members, generating uncertainty about demand and limiting ability to forecast sales accurately. To counter these issues, many manufacturers maintain excess production capacity and carry safety stocks of finished goods. Among large CPG manufacturers, the incremental costs related to forward buying range from 1% to 2% of their costs of goods sold. Longer-term incentives Longer-term incentives usually cover a longer period of time running into months or years and are based on the manufacturer’s brand building objectives rather than its sales objectives. Examples of long-term incentives include “Co-op advertising” in which a manufacturer provides incentive to retailers where they will share the cost of a retailer advertisement that features their product (note that in most cases, they will retain little or no control over the actual creative execution of the ad, which is generated by the retailer); and “Market development funds” in which a lump sum of money is allocated to push a particular product in a given market or geographical area; Even though manufacturers benefit from longer-term brand-building incentives, many retailers are less inclined to participate in such programs for the following reasons: (1) Long-term brand-building incentives usually do not offer any immediate financial gains to

the retailer. (2) In most mature product categories (think any CPG category like peanut butter, mayonnaise,

etc.), brand-building incentives usually do not increase category growth; rather they shift sales from one brand to another. So it is not clear that the retailer benefits from any sales growth. This issue is compounded by the fact that competing manufacturers (General Mills and Kellogg’s, for instance) will simply run such promotions consecutively, passing sales increases back and forth with corresponding sales decreases to the other brand.

(3) Because trade promotions have become so popular in recent years, retailer (and even other

channel members) can only accept a limited number of offers because they have limited financial ability and display space available. Therefore, retailers are careful in choosing manufacturers they most want to partner with in brand-building activities. Often, national brands win out and smaller, regional, or newer brands get left behind in these trade promotion wars.

(4) Some retailers derive as much as 30 to 40 percent of their overall profitability from trade

promotions, so they are not inclined to forgo short-term financial gains.

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In conclusion, it is important to understand that spending on trade promotions depends primarily on the product’s brand strength. When the product’s brand is strong, fewer and shallower trade promotions may suffice. Consider Dial/ Purex vs. P&G/Tide in the soap category. Dial’s line of detergent products called Purex do not have strong brand preference in the market place; Dial must therefore put more money into trade promotions to move their products. In contrast, Tide has strong brand equity and a base of loyal customers and will need relatively fewer trade promotion spending. Thus, from a marketing perspective, spending on trade promotions is a double-edged sword for most manufacturers. In today’s business environment, they are an integral part of the marketing mix. Yet, they result in negative consequences and hinder one primary objective which is to increase brand strength and shift the focus of the end-consumer away from the product’s price to its intangible and emotional benefits. Slotting allowances or slotting fees Suppliers pay distributors slotting allowances for product placement on store shelves. Sometimes they are requested by distributors, and sometimes they are offered by suppliers. Although common, these allowances are neither uniformly requested nor offered. Well-tested, innovative products can and do reach consumers without slotting allowances. Many supermarkets waive such allowances for minority vendors and for suppliers in their communities. The most common allowances are for new products — so-called new product introduction allowances. These may also cover premium product placements, such as on eye-level shelves or special displays; the cost to have products remain on shelves — pay-to-stay allowances; or the cost to retailers if a product fails. Although a form of trade promotion, the impact of these slotting fees does not apply to mature products. One study reported that slotting fees vary from $1.4–2 million for a national-level introduction of a single stockkeeping unit (SKU). I Although the term has broadened in scope over the years, the term “slotting” originally referred to slots or spaces for pallets in warehouses that had to be created when products were added to the line stocked by distributors. In 2003, the Federal Trade Commission (FTC) conducted a study on the use of slotting fees. There were several interesting findings:

• The food companies surveyed reported that they paid slotting fees for 80% to 90% of all new food product introductions.

• The slotting fee associated with one product in a chain of stores in one metropolitan area varied from $2,313 to $21,768.

• If a food company wanted to roll a new product out nationwide, it would need a slotting fee allowance of between $1 million and $2 million.

The main reason for slotting fees is to cover the considerable costs to introduce a product, to remove the item that previously occupied the shelf space and to recover some of the investment in the likely event that the new product fails. Depending on how a new product is defined, the failure rate ranges up to 80 percent per year. Suppliers do not place products in supermarkets on

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consignment, as they do in many other industries. Supermarkets pay for products and assume the risk that consumers will buy them. When a new product fails, the cost includes the dollars lost from the item that had to be dropped to make room for the new product. There are two main schools of thoughts regarding slotting fees. The first school of thought, the “efficiency school,” states that slotting fees actually increase efficiency in the system by: 1. Providing a signaling mechanism for manufacturers to advertise product quality. This

argument is similar to the argument advanced for advertising, which reportedly acts as a signaling mechanism that enables consumers to determine product quality.

2. Sharing risks between the retailer and the manufacturer . Because of information

asymmetry, the retailer likely knows less than the manufacturer about the probability of success of the product. Therefore, it suffers a disproportionate amount of risk for a product introduction. Slotting fees help maintain the balance by shifting the risk from the retailer to the manufacturer.

3. Aiding in the efficient allocation of shelf space. In any retailer environment, the demand

for shelf space is always greater than the supply; when retailers carry huge numbers of SKUs (average of more than 30,000), new products can enter only if they displace an existing product. Therefore, slotting allowances help the retailer make efficient use of its shelf space. As a corollary, slotting allowances help totally new products attain shelf space, whereas normally, they would have been rejected because they were untested in terms of marketplace performance.

4. Increasing competition and thus reducing total retail prices. The efficiency school of thought largely is favored by retailers that want slotting fees to continue. The other school of thought, called “market power,” argues that slotting fees actually are harmful and damage competition and overall consumer behavior by: 1. Allowing retailers to use their market power to demand and obtain fees. Retailers thus can

demand more fees from smaller manufacturers. 2. Undermining channel relationships, because manufacturers become bitter about being made

to pay fees to get their products to the market. 3. Providing a mechanism for price discrimination. When different manufacturers must pay

differential fees, the costs increase disproportionately. 4. Introducing unfair competition for certain manufacturers that cannot pay the slotting fees and

thus just quit the market. 5. Harming the consumer, because the fees ultimately are passed on to consumers in the form of

higher list prices.

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Sources and Useful References 1. Ailawadi, K., J. Cesar, B. Harlam, and David Trounce. "Quantifying and Improving

Promotion Profitability at CVS." Marketing Science 26, no. 4 (2007): 566-575.

2. Ailawadi, Kusum (2001), “The retail power-performance conundrum: What have we learned?” Journal of Retailing, 77, 299-318.

3. Bell, David and Xavier Dreze (2002), “Changing the channel: A better way to do trade promotions, Sloan Management Review.

4. FTC Staff Study (2003), “Slotting allowances in the retail grocery industry: Selected case studies in five product categories,” Available online at: http://www.ftc.gov/reports/use- slotting-allowances-retail-grocery-industry

5. Poddar, Amit, and Naveen Donthu. "What Do We Know about Trade Promotions? Contributions, Limitations, and Further Research." Journal of Promotion Management 17, no. 2 (2011): 183-206.

6. Poddar, Amit, Naveen Donthu and Atul Parvatiyar (2013), “Drivers of trade promotion deceptiveness: The role of relationship and trade promotion satisfaction,” Journal of Marketing Theory and Practice, 21(1), 45-56.

7. Supermarket News (2012), “Data Points”, August 6.