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Trade Spend: The Consumer Goods $35 Billion "Elephant in the Parlor"

Trade spend exists at the intersection of brand and customer strategies, and every promotion must be linked directly back to these two drivers. However, too often performance and compliance are neither well defined, nor well measured. Studies show it often has a negative ripple effect on the entire supply chain, resulting in substantial indirect costs that are estimated to be $30 billion annually for the U.S. food industry. Here's a perspective on how trade spend can be used to increase profits across the supply chain.

by Peruvembra Ravi and Nicholas Seiersen

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Trade spend was once a brilliant idea to get special placement and/or pricing for manufacturers' consumer goods in mass retail stores, while giving the retailers a way to monetize prime store "real estate". It has grown into a multi-billion dollar monster that is out of control; trade spend is the consumer goods' "elephant in the parlor". Estimated at $26 billion in the United States, it consumes 13 percent of sales, 61 percent of Consumer Product Goods (CPG) manufacturers' marketing dollars, and it is growing faster than sales, making it the second largest expense line, after Cost of Goods Sold (COGS). Manufacturers and retailers agree it is an important issue: trade spend management is inefficient (thought to cost the industry a further $10 billion annually to manage and administer) and the return on trade spend is questionable at best. It also has a negative ripple effect on the entire supply chain, resulting in substantial indirect costs that are estimated to be about $30 billion per year for the U.S. food industry. In addition, trade spend deals involving temporary price reductions are usually unprofitable, and that the level of profitability declines with an increase in the frequency and the magnitude of the price reduction, according to Researchers Blattberg and Levin. Other studies have shown that 85 percent of trade spend deals are unprofitable. These studies do not account for the effect of increased logistics costs; thus, the actual proportion of profitable trade deals is likely to be even lower.

Legal and regulatory changes in the United States are also targeting the obscurity of trade spend deals. Section 404 of the Sarbanes-Oxley Act requires CEOs, CFOs and external auditors to attest to the adequacy of internal controls and systems for financial reporting, including the reporting of trade spend programs. Ruling 01-9 of the Financial Accounting Standards Board in the United States requires all trade spend items to be classified as revenue reductions rather than as COGS expenses, with the exception of payments made for services rendered by another member of the supply chain that satisfy a set of restrictive conditions. Trade spend programs that do not satisfy these conditions could result in a reduction in revenues, thus defeating the very purpose for which these programs were developed.

Given the marketing, logistics and legal complexities associated with trade spend programs, identifying the most effective trade spend strategies is an important determinant of the success or failure of consumer goods manufacturers. To be workable, a trade spend strategy must be successfully "sold" to all members of a supply chain. This article will identify strategies that benefit not merely manufacturers but the entire supply chain.

Trade Spending is rarely examined very closely on a customer-by-customer basis, under the assumption that it is the result of a strategic corporate decision applied equally to all customers, according to a very clearly laid out set of company guidelines and policies. The truth is that although such policies are in place, the execution in the marketplace is rarely uniform across the customer-base. In fact, looking at trade spend only through the aggregated line items of the company's P&L will mask significant proportional cost differences between customers. The underlying cause of trade spending inequality among customers is the multitude of spend buckets that have evolved and been made available to the revenue-motivated sales force competing for the customers' share of business. In reality, this translates into battles between the sales staff in your company to get the lion's share of your trade spend for their customer.

The large number of spending options (see sidebar) is required to achieve different objectives with customers. For example, merchandising and co-op advertising allowances are intended to increase lift through promotional activity; performance spending and listing allowances aim to improve positioning on the customer's shelves. There are also claims and returns meant to decrease the customer's risk in carrying the company's products and distribution allowances to offset the customer's logistics costs. Some trade spend is in place in response to continuing pressures on prices. Bonus or extra goods and deductions give the sales force the flexibility to negotiate on price. Terms of sale also offer flexibility around price to some extent, but are primarily intended to modify the customer's ordering and payment behaviour. Each customer will pressure the organization differently for spending dollars as their preferences and demands are influenced by their unique strategies, policies, systems and even individual personalities.

Policies and guidelines are designed to control how each available trade dollar is spent. However, rarely do policies control total spend with a given customer. With such a wide array of possible ways to claim money from the organization, customers (often with the help of your company's own sales organization) can be very creative at structuring their business relationship to minimise their 'net net' price by bending or breaking the rules governing your trade spend.

What is wrong with Trade Spending and promotions?

Two large issues exist in CPG trade spend today. First, trade investment is not driven by strategy. Trade spend is the intersection of brand and customer strategies, and every promotion must be linked directly back to these two drivers. Second, performance and compliance are neither well defined nor well measured. It is essential for the execution of the promotion that both the manufacturer and the customer understand the goals and the measures.

What is changing in trade spend?

There are three main changes underway in grocery sector:

• Tiered pricing is replacing minimum orders and truckload discounts
• For those manufacturers who have a thorough knowledge of the value of each task in their supply chain, this provides transparency to both parties, and simplifies the process
• For those who don't have such knowledge or control, this can add unwanted complexity to a situation that is already cloudy.
• A balanced scorecard approach is becoming the most effective way to control operations in the extended supply chain. A clear, negotiated set of performance standards provides a transparent fact base for customer negotiations. These standards are critical to ensure performance and, ultimately, the achievement of the desired supply chain efficiencies. Furthermore, a balanced scorecard approach builds and enhances the link between sales and supply chain to ultimately deliver the best value to the customer and consumer. Elements of this scorecard include: clear accountabilities and responsibilities, sources for data and information, timing - not just timing of product through the supply chain but also frequency of reporting, benchmarks and goals, and high visibility internally throughout the organization and externally to customers. It is important to note that a similar scorecard is critical in evaluating the effectiveness of promotions.
• "Dead-net" pricing is looming as the ultimate end state. Both grocery retailers and manufacturers are looking to simplify the trade spend management process. Retailers have been leading the manufacturers toward dead-net pricing for this reason. By eliminating the noise of myriad terms (including legacy terms), dead-net pricing allows both parties to focus on execution, measurement and price. For the retailers, it also facilitates planning, permitting them to set a pricing for the product for the year, eliminating period-to-period fluctuations. From the manufacturers' perspective, dead-net pricing eliminates deals (e.g., annual volume rebates) that do not build incremental sales volume. It forces a thorough investigation into the true value of their investment into the customer and trade.

What are the supply chain/logistics implications of trade promotions? Trade promotions cause a temporary spike in demand, which increases logistics and manufacturing costs during and after the promotion.

• To meet the sudden increase in demand, additional shifts, overtime or subcontractors may be used, or both finished goods and work-in-process inventory may be built-in anticipation of the expected promotional volumes, both at the manufacturer and at its suppliers.
• The manufacturer may be compelled to use expensive modes of transport or uneconomical shipment sizes both inbound to their plants and outbound to the retailers.
• The spike in demand could also result in expedited 'rush orders'. Rush orders could result in lower levels of quality due to hurried inspections and increased worker fatigue. Furthermore, rush orders for one product could result in a premature termination of production runs for other products and incurring the expense of a further setup. This issue propagates down through the suppliers.
• Firms that promote heavily are thus more likely to maintain larger amounts of production capacity (i.e. more plants and/or more equipment) than would be required to produce the market requirements in the absence of trade promotions. If promotions are common across the product line, this excess capacity must also be highly flexible. New products are more difficult to introduce as they compete for manufacturing capacity during these promotions.
• The unnatural boosting of demand introduces further uncertainty in the demand forecast, thus making it more likely that the firm will either buildup excess inventory or suffer shortages and the resultant lost sales and expediting costs, both during and after the promotion. Worse, this greater uncertainty increases the complexity of operations, and drives the need for more sophisticated systems and processes, also more costly.
• The ensuing periods of low levels of demand may result in poor utilization of machine capacities, labor, freight modes, and fixed costs absorption.
• The fluctuations in demand caused by a promotion tend to be amplified as one moves up the supply chain, with first-tier suppliers facing larger fluctuations than manufacturers and second-tier suppliers facing larger fluctuations than first-tier suppliers. Thus the extent of disruption caused by a trade promotion increases as one moves up the supply chain.

How can we make promotions more effective and profitable?

• EDLP (Everyday Low Pricing). During the transition to an EDLP policy, there would be a short-term drop in sales. In many situations, a switch to an EDLP regime may be opposed by retailers who have grown accustomed to making the bulk of their purchases at very low prices during promotions. An effort must be made to persuade retailers that the abolition of trade promotions reduces costs for the entire supply chain, and that this reduction in cost can be shared by various players in the supply chain. It is typically easier for large manufacturers like Procter and Gamble (P&G) to enforce an EDLP policy than it would be for a smaller and less powerful manufacturer. Yet, it might be worthwhile for a manufacturer to give up market share by cutting back on promotions, provided the reduction in market share is accompanied by an increase in profits. In fact, anecdotal evidence from Proctor and Gamble's move to ELDP indicates the years following this move were crowned with the highest profits P&G had earned in 21 years, and two thirds of their category market share also increased. This suggests that this focus may drive greater profitability. Similarly, Unilever's results improved as they radically consolidated the number of worldwide brands.
• If giving up trade promotions is not an acceptable option 'Scan-back' trade promotions may offer an attractive option, where the manufacturer offers a discounted price to the retailer only for the actual number of units sold to the final consumer during the promotion period. This system is also likely to result in opposition from retailers, who are now compelled to completely eliminate the practice of forward buying.
• Another solution is to alter the rewards that drive managers to offer trade promotions, such as making sales commissions and bonuses dependent on cumulative sales over a relatively long period of time rather than over a single quarter, or linking a significant part of the sales force compensation package to the firm's, or the account's, profit instead of to sales revenue, or the number of units sold during a quarter.
• Increased coordination between different functional areas within a firm, and between different levels in a supply chain, would result in better-designed trade promotions. The use of systems like VMI and CFPR would make it less likely that manufacturers and retailers would work at cross-purposes, and would help in the resolution of issues related to forward buying and pass-through. Software products that facilitate supply chain coordination also assist in the design and management of trade promotions. These include specialized trade promotion management products offered by the Synectics Group, Demantra, and other organizations. Trade promotion management components have also been included in more comprehensive supply chain management software products offered by PeopleSoft, Manugistics, and other providers.

While these options are valuable tools in the management of trade promotions, it is important to address the fundamental driving forces that lead to unprofitable trade promotions. Improve coordination across all the supply chain organizations to design better trade promotions and that reduce current logistics and manufacturing costs. It may require revamping incentives and key performance metrics.

The approaches to trade spend management outlined in this article can increase profits for the entire supply chain and can thus be readily "sold" to all functional areas within your firm and to your retail partners. They provide a win-win situation for manufacturers, retailers and customers, with a well-coordinated supply chain offering a wider array of products at lower prices, while increasing profits for manufacturers and retailers and keeping a check on logistics and manufacturing costs.