Short-Term Discounting: Trade Promotions in a Supply

Manufacturers use trade promotions to offer a discounted price to retailers and set a time period over which the discount is effective. For example, a manufacturer of canned soup may offer a price discount of 10 percent for the shipping period December 15 to January 25. For all pur­chases within the specified time horizon, retailers get a 10 percent discount. In some cases, the manufacturer may require specific actions from the retailer, such as displays, advertising, promo­tion, and so on, to qualify for the trade promotion. Trade promotions are quite common in the consumer packaged-goods industry, with manufacturers promoting different products at differ­ent times of the year.

The goal of trade promotions is to influence retailers to act in a way that helps the manu­facturer achieve its objectives. The following are a few of the key goals (from the manufacturer’s perspective) of a trade promotion (see Blattberg and Neslin [1990] for more details):

1. Induce retailers to use price discounts, displays, or advertising to spur sales.
2. Shift inventory from the manufacturer to the retailer and the customer.
3. Defend a brand against competition.

Although these may be the manufacturer’s objectives, it is not clear that they are always achieved as the result of a trade promotion. Our goal in this section is to investigate the impact of a trade promotion on the behavior of the retailer and the performance of the entire supply chain. The key to understanding this impact is to focus on how a retailer reacts to a trade promotion that a manufacturer offers. In response to a trade promotion, the retailer has the following options:

1. Pass through some or all of the promotion to customers to spur sales.
2. Pass through very little of the promotion to customers but purchase in greater quantity dur­ing the promotion period to exploit the temporary reduction in price.

The first action lowers the price of the product for the end customer, leading to increased pur­chases and, thus, increased sales for the entire supply chain. The second action does not increase purchases by the customer, but increases the amount purchased and held at the retailer. As a result, the cycle inventory and flow time within the supply chain increase.

A forward buy occurs when a retailer purchases in the promotional period for sales in future periods. A forward buy helps reduce the retailer’s future cost of goods for product sold after the promotion ends. Although a forward buy is often the retailer’s appropriate response to a price promotion, it can decrease supply chain profits because it results in higher demand vari­ability, with a resulting increase in inventory and flow times within the supply chain.

Our objective in this section is to understand a retailer’s optimal response when faced with a trade promotion. We identify the factors affecting the forward buy and quantify the size of a forward buy by the retailer. We also identify factors that influence the amount of the promotion that a retailer passes on to the customer.

We first illustrate the impact of a trade promotion on forward buying behavior of the retailer. Consider a Cub Foods supermarket selling chicken noodle soup manufactured by the Campbell Soup Company. Customer demand for chicken noodle soup is D cans per year. Campbell charges $C per can. Cub Foods incurs a holding cost of h (per dollar of inventory held for a year). Using the EOQ formula (Equation 11.5), Cub Foods normally orders in the following lot sizes:

Campbell announces that it is offering a discount of $d per can for the coming four-week period. Cub Foods must decide how much to order at the discounted price compared with the lot size of Q* that it normally orders. Let Q^d be the lot size ordered at the discounted price.

The costs the retailer must consider when making this decision are material cost, holding cost, and order cost. Increasing the lot size Q^d lowers the material cost for Cub Foods because it purchases more cans (for sale now and in the future) at the discounted price. Increasing the lot size Q^d increases the holding cost because inventories increase. Increasing the lot size Q^d lowers the order cost for Cub Foods because some orders that would otherwise have been placed are now not necessary. Cub Foods’ goal is to make the trade-off that minimizes the total cost.

The inventory pattern when a lot size of Q^d is followed by lot sizes of QQ is shown in Figure 11-5. The objective is to identify Q that minimizes the total cost (material cost + ordering cost + holding cost) over the time interval during which the quantity Q^d (ordered during the promotion period) is consumed.

The precise analysis in this case is complex, so we present a result that holds under some restrictions (see Silver, Pyke, and Petersen [1998] for a more detailed discussion). The first key assumption is that the discount is offered once, with no future discounts. The second key assump­tion is that the retailer takes no action (such as passing on part of the trade promotion) to influ­ence customer demand. The customer demand thus remains unchanged. The third key assumption is that we analyze a period over which the demand is an integer multiple of Q* With these assumptions, the optimal order quantity at the discounted price is given by

In practice, retailers are often aware of the timing of the next promotion. If the demand until the next anticipated trade promotion is Q₁, it is optimal for the retailer to order min{Q^d, Q₁} Observe that the quantity Q^d ordered as a result of the promotion is larger than the regular order quantity Q*. The forward buy in this case is given by

Forward buy = Q^d – Q*

Even for relatively small discounts, the order size increases by a large quantity, as illustrated in Example 11-11 (see spreadsheet Chapter11-examples11-12).

EXAMPLE 11-11 Impact of Trade Promotions on Lot Sizes

DO is a retailer that sells Vitaherb, a popular vitamin diet supplement. Demand for Vitaherb is120,000 bottles per year. The manufacturer currently charges $3 for each bottle, and DO incurs a holding cost of 20 percent. DO currently orders in lots of Q* = 6,325 bottles. The manufacturer has offered a discount of $0.15 for all bottles purchased by retailers over the coming month. How many bottles of Vitaherb should DO order given the promotion?

Analysis:

In the absence of any promotion, DO orders in lot sizes of Q* = 6,325 bottles. Given a monthly demand of D = 10,000 bottles, DO normally orders every 0.6325 months. In the absence of the trade promotion we have the following:

Cycle inventory at DO = Q*/2 = 6,325/2 = 3,162.50 bottles

Average flow time = Q*/2D = 6,325/(2D) = 0.3162 months

The optimal lot size during the promotion is obtained using Equation 11.15 and is given by

During the promotion, DO should place an order for a lot size of 38,236. In other words, DO places an order for 3.8236 months’ worth of demand. In the presence of the trade promotion we have

Cycle inventory at DO = Q^d /2 = 38,236/ 2 = 19,118 bottles

Average flow time = Q^d/(2D) = 38,236/(20,000) = 1.9118 months

In this case, the forward buy is given by

Forward buy = Q^d – Q* = 38,236 – 6,325 = 31,911 bottles

As a result of this forward buy, DO will not place any order for the next 3.8236 months (without a forward buy, DO would have placed another 31,912/6,325 = 5.05 orders for 6,325 bottles each during this period). Observe that a 5 percent discount causes the lot size to increase by more than 500 percent.

As the example illustrates, forward buying as a result of trade promotions leads to a sig­nificant increase in the quantity ordered by the retailer. The large order is then followed by a period of small orders to compensate for the inventory built up at the retailer. The fluctuation in orders as a result of trade promotions is one of the major contributors to the bullwhip effect dis­cussed in Chapter 10. The retailer can justify the forward buying during a trade promotion because it decreases its total cost. In contrast, the manufacturer can justify this action only as a competitive necessity (to counter a competitor’s promotion) or if it has either inadvertently built up a lot of excess inventory or the forward buy allows the manufacturer to smooth demand by shifting it from peak- to low-demand periods. In practice, manufacturers often build up inventory in anticipation of planned promotions. During the trade promotion, this inventory shifts to the retailer, primarily as a forward buy. If the forward buy during trade promotions is a significant fraction of total sales, manufacturers end up reducing the revenues they earn from sales because most of the product is sold at a discount. The increase in inventory and the decrease in revenues often lead to a reduction in manufacturer as well as total supply chain profits as a result of trade promotions (see Blattberg and Neslin [1990] for more details).

Now, let us consider the extent to which the retailer may find it optimal to pass through some of the discount to the end customer to spur sales. As Example 11-12 shows, it is not optimal for the retailer to pass through the entire discount to the customer. In other words, it is optimal for the retailer to capture part of the promotion and pass through only part of it to the customer.

EXAMPLE 11-12 How Much of a Discount Should the Retailer Pass Through?

Assume that DO faces a demand curve for Vitaherb of 300,000 — 60,000p. The normal price charged by the manufacturer to the retailer is C_R = $3 per bottle. Ignoring all inventory-related costs, evaluate the optimal response of DO to a discount of $0.15 per unit.

Analysis:

The profits for DO, the retailer, are given as follows:

Prof_R = (300,000 – 60,000p) p – (300,000 – 60,000p)C_R

The retailer prices to maximize profits, and the optimal retail price is obtained by setting the first derivative of retailer profits with respect to p to 0. This implies that

300,000 – 120,000p + 60,000 C_R = 0

or

p = (300,000 + 60,000 C_R)/120,000                                             (11.17)

Substituting C_R = $3 into Equation 11.17, we obtain a retail price of p = $4. As a result, the customer demand at the retailer in the absence of the promotion is

D_r = 30,000 – 60,000 p = 60,000

During the promotion, the manufacturer offers a discount of $0.15, resulting in a price to the retailer of C_R = $2.85. Substituting into Equation 11.17, the optimal price set by DO is

p = (300,000 + 60,000 X 2.85)/120,000 = $3.925

Observe that the retailer’s optimal response is to pass through only $0.075 of the $0.15 discount to the customer. The retailer does not pass through the entire discount. At the discounted price, DO experiences a demand of

D_r = 300,000 – 60,000 p = 64,500

This represents an increase of 7.5 percent in demand relative to the base case. It is optimal here for DO to pass on half the trade promotion discount to the customers. This action results in a 7.5 percent increase in customer demand.

From Examples 11-11 and 11-12, observe that the increase in customer demand resulting from a trade promotion (7.5 percent of demand in Example 11-12) is small relative to the increased purchase by the retailer due to forward buying (500 percent from Example 11-11). The impact of the increase in customer demand may be further dampened by customer behavior. For many products, such as detergent and toothpaste, most of the increase in customer purchases is a forward buy by the customer; customers are unlikely to start brushing their teeth more frequently simply because they have purchased a lot of toothpaste. For such products, a trade promotion does not truly increase demand.

Manufacturers have always struggled with the fact that retailers pass along only a small fraction of a trade discount to the customer. In a study conducted by Kurt Salmon and Associates (1993), almost a quarter of all distributor inventories in the dry-grocery supply chain could be attributed to forward buying.

Our previous discussion supports the claim that trade promotions generally increase cycle inventory in a supply chain and hurt performance. This realization has led many firms, including the world’s largest retailer, Walmart, and several manufacturers, such as P&G, to adopt “everyday low pricing” (EDLP). Here, the price is fixed over time and no short-term discounts are offered. This eliminates any incentive for forward buying. As a result, all stages of the supply chain pur­chase in quantities that match demand.

In general, the discount passed through by the retailer to the consumer is influenced by the retailer deal elasticity, which is the increase in retail sales per unit discount in price. The higher the deal elasticity, the more of the discount the retailer is likely to pass through to the consumer. Thus, trade promotions by the manufacturer may make sense for products with a high deal elas­ticity that ensures high pass-through by the retailer, and high holding costs that ensure low for­ward buying. Blattberg and Neslin (1990) identify paper goods as products with high deal elasticity and holding cost. They also identify trade promotions as being more effective with strong brands relative to weak brands.

Trade promotions may also make sense as a competitive response. In a category such as cola, some customers are loyal to their brand, whereas others switch depending on the brand being offered at the lowest price. Consider a situation in which one of the competitors—say, Pepsi—offers retailers a trade promotion. Retailers increase their purchases of Pepsi and pass through some of the discount to the customer. Price-sensitive customers increase their purchase of Pepsi. If a competitor such as Coca-Cola does not respond, it loses some market share in the form of price-sensitive customers. A case can be made that a trade promotion by Coca-Cola is justified in such a setting as a competitive response. Observe that with both competitors offering trade promotions, there is no real increase in demand for either unless customer consumption grows. Inventory in the supply chain, however, does increase for both brands. This is, then, a situation in which trade promotions are a competitive necessity, but they increase supply chain inventory, leading to reduced profits for all competitors.

Trade promotions should be designed so retailers limit their forward buying and pass along more of the discount to end customers. The manufacturer’s objective is to increase market share and sales without allowing the retailer to forward buy significant amounts. This outcome can be achieved by offering discounts to the retailer that are based on actual sales to customers rather than the amount purchased by the retailer. The discount price thus applies to items sold to cus­tomers (sell-through) during the promotion, not the quantity purchased by the retailer (sell-in). This eliminates all incentive for forward buying.

Given the information technology in place, many manufacturers today offer scanner-based promotions by which the retailer receives credit for the promotion discount for every unit sold. Another option is to limit the allocation to a retailer based on past sales. This is also an effort to limit the amount that the retailer can forward buy. It is unlikely, however, that retailers will accept such schemes for weak brands.

Source: Chopra Sunil, Meindl Peter (2014), Supply Chain Management: Strategy, Planning, and Operation, Pearson; 6th edition.