Babson College - New Product Introductions, Slotting Allowances, and Retailer Discretion

Retailers are frequently confronted with large numbers of introductions in a wide variety of categories. For instance, in 1999, about 10,000 new products were introduced in the food category. While there is some variation in how retailers embrace these introductions, one practice, namely that of slotting allowances, has been steadily on the rise. These allowances are the controversial fees charged by retailers to allow shelf space for new products. These fees are usually quite high, and the trade press reveals that retailers use several methods for determining the magnitude of slotting allowances. Interestingly, the bulk of the retailers seem to fall into one of two groups: The first group asks a 'uniform" fee for any introduction, while the second group bases its fee on a product-by-product or a "brand-by-brand" basis.

This paper studies whether there are any strategic advantages to either of these methods. From a retailer's perspective, both offer some advantages. In the uniform case, the retailer doesn't 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 this, retailers can benefit from knowing when it is worthwhile to tailor the contract.

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 arc otherwise selling similar products. Such inequity can be eliminated if the retailer confines herself to asking a uniform clotting allowance from any introduction in that product category. 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.

In this article, we employ a mathematical model to characterize an optimal slotting fee contract and use it to identity the conditions under which the brand-by-brand method is preferred over the uniform method. In order to isolate the strategic benefits and costs of the two methods, in this analysis, we partial out the operational costs of implementing the two systems. Also, note that analytical research on slotting allowances is reported both in the economics and the marketing literatures. The main concern of extant literature is to understand the role of slotting allowances m a channel context. Consequently, the focus is on questions such as: "Why do these tees arise'?" And "when are they better or worse than other practices (e.g., resole price maintenance)?" In contrast, we assume that slotting fees are employed in the interaction between channel members, and characterize the preferred method of setting slotting fees.

Marketing texts suggest that the success of a new product depends, among other things, on some underlying characteristics, such ac texture, color, or quality of the product and how well it matches with consumer needs. In addition, success may be affected by the strength of the manufacturer's promotional program directed inwards consumers. The combined effect of underlying characteristics and the promotional program's strength can be thought of as "market attraction" and new products may be ordered along a continuum of attractiveness.

In some instances, such as a line extension, the retailer may assess the attractiveness of an introduction perfectly. In other instances, though, compared to the retailer, the manufacturer is better informed about his product along with the strength of the promotional plan. This information asymmetry plays an important role in the retailer's choice between the brand by-brand and uniform methods.

Next, whether or not the retailer knows the actual attractiveness of a new product neither the retailer nor the supplier can predict whether a given introduction will definitely be a success. This is because some products that seem unattractive may be successful, while others that seem attractive may fail. This uncertainty plays a central role in the retailer's choice of method.

Since any introduction can be a success, some may argue that the retailer should be inclined to carry any introduction. But, the retailer has to protect himself against product failure too. In this context, the brand-by-brand approach allows the retailer to tailor the slotting fee contract so that different types of introductions are treated according to their level of market attraction. This works well when the retailer can assess the attractiveness of the introduction.

However, when the retailer is asymmetrically informed, the optimal contract under the brand-by-brand scheme ensures that the more attractive products receive 'preferential treatment'. The inability to extract the entire surplus from such products may be regarded as an opportunity cost for the retailer. The retailer has the option to curb such costs by asking a uniformly high fee from all introductions. One consequence of this option is that some less attractive brands may not obtain shelf-space. Since some of these brands could become successes, the retailer will also forgo the opportunity to benefit from them. This represents the principal tradeoff in selecting between the brand-by-brand and the uniform methods.

This analysis reveals that three factors are important to consider: One is the information available to the retailer about the attractiveness of the product. The second is the base rate of (highly) attractive introductions in the market. And the third is the relative magnitudes of the various parameters such as market size and the degree of competition between the new and incumbent products. The paper explicitly identifies the conditions favoring one method of setting slotting allowances over the other. It also provides some anecdotal empirical evidence to support the analysis. In order to highlight the main issues, the paper conducts its analysis in the context of a simple mathematical model. Several directions for further work are also identified.

In summary, the method of determining slotting fees is important from a variety of perspectives, including those of retailers, manufacturers, public-policy makers, and marketing academics. The appropriate method depends on several issues, some of which are discussed in this research.

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