Private-Label Products in the Manufacturer-Retailer Power Balance

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by Tuck Communications   Aug 19, 2010

The economy is in a major downturn, and supermarket prices for products ranging from milk and eggs to shampoo and laundry detergent are up 20 to 70 percent compared to a year ago. Just the kind of environment in which consumers tend to shift from national brands to significantly lower priced private labels, and at a time when private labels are already seeing a worldwide surge in availability and market share. According to the Private Label Manufacturers Association, private labels accounted for one of every five items sold in U.S. supermarkets, drugstore chains, and mass merchandisers in 2007.

Private labels are viewed as a major factor in the balance of power between packaged-goods manufacturers and retailers. Some say they signal the demise of the brand. At the very least, conventional wisdom is that they are a potent and profitable weapon for retailers because they offer higher profit margins, provide leverage to negotiate better deals from brand manufacturers, and build consumer loyalty to retailers’ stores. I’ve put this conventional wisdom to the test in my research and find that a healthy dose of caution is in order for retailers and that doomsday predictions are overstated for smart brands.

Is it true that private labels provide higher retail margins? As a percentage of retail price, absolutely! They had better, given that private-label suppliers have no brand equity and therefore supply at wholesale prices well below those of well-known brands.

But retailers also sell private labels at prices 20 to 40 percent below national brands and with good reason—research shows that even when consumers perceive private-label items to be physically identical to national brands, they are willing to pay 20 to 25 percent less for private labels. In dollar terms, this price differential makes the private-label margin advantage much smaller. Add private-label marketing costs, for which retailers themselves must foot the bill, and the advantage may all but disappear. Indeed, we have documented many cases in which a retailer’s net “penny profit” from private labels is lower than that from national brands.

This is not about to get better, as retailers try to improve the quality—both actual and perceived—of their private-label products and spend more on ingredients, as well as on packaging and advertising. These improvements, together with a growing emphasis on “premium” private labels, will keep the cost advantage of private labels from improving. On the other hand, intense competition from other retailers’ private labels and from national-brand manufacturers working hard to close the price gap will maintain or even intensify pricing pressure. So retailers who are expanding their private-label line solely because of the lure of higher margins had better beware.

What about negotiating leverage? I have analyzed the margins earned by some major U.S. retail chains on a large number of grocery, health, beauty, and general household products, and I find that in categories where they have strong private-label market share, the retail chains’ margins on national brands are significantly higher. Retail gross margins average 20 percent in categories in the bottom quartile of private-label share and 25 percent in the top quartile. And this is after econometrically controlling for the fact that retailers are more likely to push their private label in high-margin categories. So it does seem that retailers can negotiate better wholesale prices and allowances from brand manufacturers in categories where their private label is strong.

And how about the hope that private labels may help retailers differentiate their offering from competitors’ and make customers more loyal to their stores? My colleagues and I have studied the relationship between the amount a consumer spends at a given retailer’s stores and the percentage of that spending that is devoted to private-label purchases. For major retail supermarket and drugstore chains located in the U.S. and in the Netherlands, positioned on value or on service, we consistently find that consumers who buy little or no private-label products from a retailer spend only a small share of their wallet with that retailer, whereas those who buy some private-label items from the retailer spend significantly more. But we also consistently find that consumers who buy a lot of private-label items from a retailer have significantly lower share of wallet at the retailer compared with midlevel private-label buyers. In other words, the effect of private-label share on store loyalty is in the shape of an inverted U.

Why is this? Consumers who don’t trust a retailer enough to buy any of its private-label products clearly have less loyalty than those who selectively buy some private-label products from the retailer, presumably because they like the quality of those specific products. On the other hand, consumers who buy the retailer’s private-label items across many product categories are drawn more to the savings than to a particular private label, and savings-conscious consumers engage in more price searches and cherry-pick the best deals across multiple stores.

We can’t be sure of where the “inversion point” is in the effect of private-label share on store loyalty; it will depend on the positioning of the retailer and the quality image of its private label. But our analysis so far suggests that any beneficial effects of private-label share on loyalty are pretty much gone at around the 35 percent mark.
What does all of this mean for manufacturers and retailers? Manufacturers certainly cannot ignore private labels, especially not in economically tight times and as retailers continue to close the quality gap and introduce more “premium” private labels. Weak brands are falling by the wayside, but strong consumer pull generated by manufacturers of innovative, competitively priced brands can keep them in good stead, particularly if they demonstrate—with hard consumer data—the ability of their brands to attract a retailer’s most profitable customers.

Retailers do have strong potential leverage in private labels. But margin advantages may be illusory unless retailers have sufficient economies of scale to contain costs and fine-tune their pricing to make the differential with national brands “just right.” Harnessing the power of private labels to build loyalty requires a high-quality, well-differentiated private-label program, and even then, it’s all about achieving balance with national brands—there are negative, not just diminishing, returns to pushing private labels too far.

Originally appeared in the Fall 2008 issue of Tuck Today.