Trade Spend Tradeoffs
By Geoff Cutler, Managing Director – The Professional Assignments Group
www.pag.com.au

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All over the world trade spend levels are increasing.  The details sometimes vary by country, but the challenge is the same: how to stay ahead of the game.  If trade spend goes up, without an equal lift in sales, naturally bottom line profit will fall.  For many FMCG companies, trading terms are pretty much locked in.  The amount to be spent is known, and cannot be avoided.  Others are more fortunate, and have insisted on some flexibility in respect of some aspect of trade spend, typically case discounts.

Let’s take a worst-case scenario, assume no flexibility, in other words, let’s assume terms of 15% have been agreed, and this includes case discounts of 10%. Does this mean that it makes no difference how this money is allocated? It certainly does not, although there are many in the industry who keep on saying precisely that.

In order to prove my point, I need to introduce two concepts – effectiveness and efficiency.  If your trade spend is budgeted at 15% to sales, any promotion that consumes less, can be considered efficient.  However, it does follow that if you have locked in this 15%, you will have to have an equal number of inefficient promotions, or promotions that cost more on average. 

To use a concrete example.  Assume the percentage of all sales, which are to be sold on promotion, is 50% (this is a critical KPI).  If we have agreed to 15% as the percentage on all sales, that means we can spend 30% on all promoted sales.   Note here the 15% does not include any costs like on-going trade rebates or off-invoice discounts.  The 15% is PROMOTIONAL TRADE SPEND.  This figure of 30% becomes the benchmark for average costs on a promotion.  If too many promotions exceed this figure, and we still sell 50% on promotion, the 15% average figure will be exceeded.  If we meet the target volume that is budgeted, one can assume the company will meet target profit. 

However, if we end up with 16% to sales revenue, it is guaranteed that the target profit will drop by that 1% to sales, and someone will be very unhappy.  The argument that spending 16% will increase overall sales, and hence profit, is tenuous in the least.  Firstly financial gurus use % in their analysis, so if you report a profit margin of 6% instead of the expected 7%, there will be hell to pay, even if the absolute figure is up.  Secondly, it is by no means certain that increasing spend from 15% to 16% will actually raise the absolute level of profit. This is something we will look at next. However, the really important question is: “Can we beat the 7% profit margin while still delivering 15% to sales as a trade spend cost?”  To answer this we need the second dimension – effectiveness.

Effectiveness considers the cost of delivering the extra, or incremental, sales that the promotion is expected to deliver. Thus, if we plan a promotion, and it costs 30% to sales, it can be expected to deliver some additional volume.  The key question is how much real additional volume.  With the advent of retail scan data, it is possible to determine the base retail sales, and the real increment on a product line.  While this is the starting point, it is not the end.  We also need to discover if, in running this promotion, other products have declined.  If so, the incremental gain must be reduced to accommodate the switching loss.  This last issue is not easy to determine without careful review of scan data, and often folks just look at the gross incrementality.  This is not wise, as switching your own brands will effectively wipe out any real gain that you may have on promotion.

To quote a real example.  Assume we run a promotion, at a 25% discount and also incur a fixed charge that approximates 5% of sales.  So, we ship 120,000 cases at $25 each, giving revenue of $3m.  The total trade spend cost is $900,000.  Assume the gross incremental volume is 75,000 cases.  On this basis, the cost of the incremental business is $12.00 per case.  If this product has a gross margin of 60%, we will be ahead, by $3.00 per case, or $360,000.  However, we have not looked at how much volume was switched!  But Blind Freddy can see that picking products that switch competitor brands is the only way to deliver any incremental profit.  If we discover that 50% of the sales are switched, the arithmetic becomes an incremental cost of $24.00 per case, and this promotion is not worth running.  In fact, running it actually destroys your planned profit %.

The next question you might ask is, do sales switch to the extent of 50%?  This has been answered in a number of research studies, and it has been found that 80% of all promotional sales of grocery products are switched.  This does vary significantly by category, but that means some are worse!  So, if you gain incremental sales on a promotion, the gain will primarily come from other products, which will decline.  The key is: don’t switch your own products!

Finally, our own research has indicated something quite interesting.  Effectiveness and efficiency are largely independent.  If they are plotted in a matrix, this is a typical result:

 This is real data, and shows many promotions with a cost of effectiveness greater than 100%.  In other words, as much was spent on the promotion as the incremental revenue, and sometimes more than twice as much.  The lines on this graph make up a four-box decision matrix.  This is shown below in the BEST model:

There are a number of implications in this BEST model.  A promotion that is low in efficiency can be run, but obviously with less frequency than another promotion that has a higher efficiency.  It is also possible for an individual retailer to charge far more than their stores are able to deliver, thus causing all their promotions to be lower in efficiency and lower in effectiveness than for other retailers. 

One can also identify products, which are Terrible, irrespective of where they are run, or what promotional vehicles, or price points are used.  Economical are products which carry trade spend costs easily – often being high volume lines, but which do not respond significantly to price promotions.  They can be combined with a few Ballistic.  These are products which are expensive to promote generally, as they are low volume lines, but which show significant increases in sales.

Superb are often all too few – particularly as retailers drive up trade spend costs.  The only challenge to Superb is to ensure any trade promotions in this area do not destroy the brand.  In our trade dominated promotional environment, account managers need to be carefully directed, as their primary goal is to drive volume and control trade spend.  If marketing do not set strict guidelines, who can blame sales for over-promoting products that perform.

Hidden in this four-box matrix is the fact that all promotions that fall into Superb and Ballistic deliver positive contribution from the incremental sales. All those that fall into Economic or Terrible deliver negative incremental contribution. 

You can construct a promotional programme that, at least in theory, will have all promotions in S/B or all in E/T.  In the former case you will deliver an awful lot more contribution than the latter.  Yet in both cases, the 15% trade spend cost is achieved by having these promotions average around the vertical boundary of 30%.  Which is quite independent of the horizontal axis of incremental profit. 

If you can structure your promotional programme to limit switching of your own brands, and focus on the lowest cost of real incremental sales/highest incremental contribution, you will be able to increase bottom line profit while maintaining agreed levels of trade spend.  But do not lose sight of the need to control average trade spend costs, as this will completely destroy the bottom line, if it gets out of control.  In fact one really should in an ideal world seek that level of average trade spend that optimises the bottom line.  We wish it were so simple.

The BEST model is the intellectual property of the Professional Assignments Group Pty Ltd.

For further information contact Geoff Cutler at The Professional Assignments Group.

Email: Geoff.Cutler@pag.com.au
Or visit: www.pag.com.au

Date article published: 28/11/2002