Slotting allowances and new product introductions

Abstract

Slotting allowances - lump sum transfers from manufacturers to retailers for carrying new products -have become an important part of promotional agreements over the past decade. Hardly known before the mid-1980s, they now represent a significant cost to launching a new entry in a wide range of product categories. Despite being commonplace, slotting allowances have remained extremely controversial both with manufacturers and retailers. The controversy, in part, follows from a poor understanding of the role that slotting allowances actually play in new product introductions. We attempt to clarify the purpose slotting allowances serve by relating the payment of a slotting allowance to the retailer's cost structure and informational asymmetries within a channel. We consider a manufacturer introducing a new product into a retail channel. The retailer is independent of the manufacturer and only accepts the product if he expects to recover a positive fixed cost at the terms of trade offered by the manufacturer. Following acceptance, the retailer exerts merchandising effort and sets the retail price. We show that if the manufacturer and the retailer are equally informed of the product's demand, the terms of trade never include a slotting allowance. High retail costs are compensated through a lower wholesale price. Similarly, if the manufacturer is better informed of the product's demand, she prefers to convey that information through the wholesale price alone. That is, a high wholesale price, not a slotting allowance, is the manufacturer's preferred signaling instrument. Signaling with the wholesale price alone fails, however, when the retailer has high fixed costs. To convey information and assure retailer participation, the terms of trade must include a positive slotting allowance. A slotting allowance thus serves two purposes in launching a product: passing information down to the retailer and shifting costs up to the manufacturer. We show that the manufacturer prefers paying a slotting allowance to undertaking purely wasteful advertising. A principal virtue of a slotting allowance, then, is keeping money within the channel. Our work is novel along two important dimensions. First, others (e.g., Chu 1992) have assumed that slotting fees arise as manufacturers respond to retailer demands. Here, the manufacturer willingly offers an allowance. As a consequence, slotting allowances do not represent a windfall for the retailer; he merely breaks even on a product for which a slotting allowance is paid. Second, we tie the payment of a slotting allowance to the retailer's fixed cost and the overall terms of trade. This allows us to consider a number of comparative statics with interesting implications. For example, a retailer may receive a slotting allowance for some categories and not for others if his costs differ across categories. A "slotted" product is offered at a lower wholesale price which results in greater retailer effort than for a product on which no allowance is paid. Over a range of fixed costs, greater retailer effort should be correlated with a higher slotting allowance. Finally, for a specific functional form, we show that slotting allowances become more common (in the sense that they are paid over a greater range of retailer costs) as the retailer has greater merchandising ability.