Executive Summary

It is commonly believed that there is an inverse relationship between manufacturer and retailer profitability, i.e., any gains for retailers come at the expense of manufacturers.  In this research we advance the notion that this is not necessarily the case.  In particular, we propose that retailers can impact manufacturer profitability in two ways: directly through the exercise of bargaining power to negotiate lower wholesale prices and higher trade allowances and indirectly by affecting the intensity of price competition among manufacturers.  The latter effect has been commonly ignored in the literature to date despite its potential importance. For example, while the growing concentration in the retail sector may have afforded retailers more bargaining power, it may have also led manufacturers to collude and increase prices in order to build a counteracting power to retailers and make up for lost margins.  If so, manufacturer profitability does not suffer although retailers gain influence in the channel.

This research provides a general framework to analyze both the direct and the indirect effects of the retail environment on the pricing behavior and profitability of manufacturers.  We show that changes in the retail environment can influence manufacturer profitability even if there is no shift in power within the distribution channel by affecting the intensity of price competition among them.  The empirical findings confirm that these indirect effects are not to be neglected as they are of comparable magnitude to factors such as advertising and promotions. 

The starting point for our analysis is the development of a demand-and-supply model, where both consumers' decisions and the strategic interactions between manufacturers and retailers are considered explicitly.  This approach allows us to derive a measure of the intensity of competition between manufacturers, which is calibrated from the data.  We relate this measure to a number of factors that characterize the retail environment such as size of the retailer, its assortment depth, share of store brands, and category expertise.

Our approach is illustrated using data for the ground coffee category in Germany. The data set includes sales, price, and promotions in the four largest key accounts (retail chains) in Germany. Because manufacturers interact with these key accounts and not with the individual stores where their products are sold to the consumers, we conduct the analysis at the key account level.  

The empirical analysis shows that in the German market for ground coffee the retail environment affects manufacturer profitability in a significant way. Specifically, we find that larger size of the retailers and higher service quality lead to more intense competition among manufacturers, while a large private label share is associated with less aggressive manufacturer pricing behavior. 

The implications of our findings are twofold: (1) Empirical work, which is aimed at identifying what drives manufacturers profitability should seek to include relevant retail characteristics in the model; and (2) Managers should not only focus on the strategic interactions with retailers as a main determinant of their margins but also think about the impact that retailers can have on their profitability indirectly by affecting the competitive intensity in the marketplace. For example, a manufacturer considering entry into a new market should not only take into account its competitors actions but also the specifics of the retail environment in this market. 

In sum, the approach we advance in this research aids in separating out the direct and indirect effects of demand, cost and retail factors on prices and profits and in this way helps managers make better decisions about where to target their efforts.