New product introductions, slotting allowances, and retailer discretion.(two methods studied for slotting allowances of product introductions)

Ramarao Desiraju [*]

Abstract

Retailers are increasingly demanding slotting allowances for new product introductions. We study two methods of determining the magnitude of such allowances: In the first, the retailer sets the allowance on a "brand-by-brand" basis. In the second, all introductions are asked the same "uniform" allowance. Using a mathematical model, we address the question "which is the preferred method?" This analysis reveals an important tradeoff. While the brand-by-brand method lets the retailer benefit from any successful introduction, the uniform method lets the retailer demand higher allowances. We identify the conditions favoring the use of these methods. [c] 2001 by New York University. All rights reserved.

1. Introduction

"Innovate Or Die" may well have been the slogan embraced by food and health/beauty aids (HBA) companies during the 1990's. This view is reflected in the number of new products introduced yearly; New Product News reports that in 1990, there were 13,244 introductions with 10,301 introductions coming from food categories. And, of the 2,943 total non-food introductions that year, 2,379 were from HBA. In 1999, the comparable figure for the food category was 9,814, with the highest introductions in condiments, candy, bakery foods, dairy products, and beverages. For HBA, too, the introductions of recent years are similar to those of previous years. The evidence is clear: retailers are confronted yearly with large numbers of introductions in a wide variety of categories.

Retailers have reacted to this onslaught of introductions in a variety of ways. Some retail executives, such as Gary Wilber, president and CEO of Drug Emporium, a national chain of 164 discount drug outlets, openly solicit new products indicating new items are "... the lifeblood of the business. We like to have new items in the store before anyone else gets them..." (POPAT News 1989). Other retailers argue that introducing a new product is a "service" they provide the manufacturer, and that certain costs are incurred during the process (Kotite, 1993). Yet, others feel that "manufacturers and vendors rush to get items in and bypass all the things that made their products successful in the past, such as test marketing" (Supermarket Business, 1992).

While there is some variation in how retailers embrace these introductions, one practice, namely that of slotting allowances, has been steadily on the increase throughout the industry. These allowances are the controversial fees charged by retailers to allow shelf space for new products--computerized inventory systems divide shelf space into "slots" hence the term, slotting fees.

The controversy about these fees arises from the fact that retailers and manufacturers do not see them in the same light. An industry study by the 1990 Joint Industry Task Force on new product introductions estimates that on average, manufacturers incur a cost of $222.12 per SKU per store that accepts distribution of an introduction. Of this amount, 64 percent is spent on consumer promotions, trade deals and slotting fees, whereas only 18 percent is spent on R&D. In contrast, the cost incurred by a retailer is merely $13.51 per SKU per store operated [1]. Given these figures, manufacturers argue that there is no direct relationship between the actual cost of adding new products and the magnitude of slotting fees taken by retailers.

Supermarket executives and retail consultants such as Ronald Weber, however, point out that when an increasing number of players are competing for the same market, "retailers feel tremendous pressure to stock products with an acceptable return.. .slotting fees are simply the cost of doing business" (Entrepreneur, July 1993, p. 131). Similarly, John Motley, a Senior VP at the Food Marketing Institute, testified during recent senate hearings that "each year, food retailers spend an average of $956,800 per store on new products that fail."

Irrespective of the justification or the lack of it, the magnitude of these fees is quite high, as shown in Table 1. Note from the table that these fees per item varied anywhere between $2,000 and $20,000 in 1992 and between $3,000 and $40,000 in 1997.

Recent reports from the industry (e.g., Advertising Age, 2000, March 13, p. 75) estimate the total amount spent on slotting fees around $16 billion per year. The magnitude of these allowances and their prevalence in the industry make them an important topic for academic attention and several contributions have been made to the literature (e.g., Shaffer, 1991; Chu, 1992; Sullivan, 1997; Bloom et al., 2000). However, other issues concerning slotting allowances remain unresolved, and this paper studies one such issue.

Consider the results of a survey of supermarket executives (Supermarket Business, 1992) summarized here in Table 2.

The table reveals that retailers use several methods for setting the slotting allowances. A small percentage (3 percent) of retailers have no specific method (i.e., the "It varies" category), while 5 percent determine the slotting allowance purely on the basis of additional costs incurred in carrying the new product (i.e., the "Percentage of cost" category). The remaining retailers have some formal method for determining the magnitude of slotting allowance. Interestingly, the bulk of the retailers fall into two rather equal sized groups. One group has a "uniform" fee for any introduction (i.e., the "Set fee" category), while the other group bases its fee on a product-by-product or a "brand-by-brand" basis (i.e., the "Negotiation" category).

Similar results are evident from a more recent survey of supermarket executives (Supermarket Business, 1997) summarized here in Table 3.

The focus of this paper is on assessing the relative merits of these two methods of setting slotting allowances, uniform or variable fees. The main issues we want to address include: Are there any strategic advantages to either of these methods? Under what conditions is one method more profitable than the other? Can the method of setting slotting allowances also be subject to controversy between manufacturers and retailers?

From a retailer's perspective, both offer some advantages. In the uniform case, the retailer does not need to spend much time tailoring a contract for each new product that approaches the retailer, and this reduces the costs of product evaluation. The brand-by-brand method, on the other hand, provides the flexibility of tailoring the fee to the individual product. Obviously, this procedure will require more time and effort from the management. Given such investment, retailers may benefit from knowing when it is worthwhile to tailor the contract. Further, it will help to know when manufacturer preferences vary from those of the retailer, so that remedial or compensatory actions can be planned and implemented.

From a public policy standpoint, the brand-by-brand method involves considerable discretion upon the part of the retailer. Since the retailer cannot anticipate the actual demand of a manufacturer's product with certainty, it appears inequitable to impose different slotting fees on manufacturers that are otherwise selling similar products. Such inequity can be eliminated if the retailer asks a uniform slotting allowance from any introduction in that product category. Since our interest is in determining whether such discretion is desirable even from the retailer's perspective, public policy makers will better understand the motivations for the two methods.

Finally from a marketing academic perspective, it is interesting to characterize the market settings in which different retail practices are optimal. We do so by mathematically developing an optimal contract and identifying the conditions under which each of the two methods are preferred by the retailer. In our analysis, to isolate the strategic benefits and costs of the two methods, we partial out the operational costs of implementing the two systems. Before developing our model, we review the relevant literature.

The analytical modeling research on slotting allowances is reported both in the economics and the marketing literatures. The main concern of these investigations is to understand the role of slotting allowances in a channel context. Consequently, they focus on questions such as: "Why do these fees arise?" And "when are they better or worse than other practices (e.g., resale price maintenance)?" In contrast, we do not ask here why slotting fees arise; rather, we assume that slotting fees are employed in the interaction between channel members and ask which method of setting slotting fees is preferred. More specifically:

Chu (1992) shows [2] that slotting allowances can help screen lower demand manufacturers from higher demand manufacturers. That is, only the higher demand manufacturers will be willing to pay the huge up-front fees which they hope to recover through the subsequent sale of their product. Contrarily, lower demand manufacturers will be less willing to pay the huge up-front fees since the products are unlikely to recover the money in the market place. Our analysis builds on Chu' s work; we identify and characterize the conditions when such screening is preferred to the brand-by-brand method of determining slotting fees.

In contrast to Chu' s work, where the retailer asks for these fees, Lariviere and Padmanabhan (1997) (LP) show that manufacturers can have an incentive to pay the slotting fees voluntarily. In their analysis, LP characterize the properties of a separating equilibrium in which a high demand manufacturer signals his demand via the voluntary payment of a slotting fee. LP also prove the existence of a pooling equilibrium in which all types of manufacturers pay the same level of slotting allowance. Our brand-by-brand method and the uniform method are similar in spirit to the separating and pooling equilibria in LP's work. There are, however, some important differences that we now note.

First LP's focus was on explaining why slotting fees arise in the context of new product introductions. Therefore, they do not devote much attention to a comparison of the properties of the separating and pooling equilibria. In contrast, the main objective of our paper is to understand the strategic costs and benefits of the two methods of setting allowances. In this sense, we extend LP's research.

In addition, in the above stream of research, it should be noted that the manufacturer knows whether his product has high demand or not. Further, in equilibrium, the retailer carries the products of only the high demand manufacturers. In reality, though, many industry experts indicate that four out of five new products introduced do not make it through their first year. How can this hold if retailers carry only the high demand products? We resolve this important issue in our analysis by assuming that the ultimate demand for the new product is uncertain, even for the manufacturer. This distinction allows us to …