I cut my academic teeth doing work on supply chain contracting. I consequently found a BBC report on pay-to-stay payments interesting (Premier Foods accused over ‘pay and stay’ practice, Dec 5). The subject of the report is Premier Foods, a large UK manufacturer with several food brands. Premier had the chutzpah to effectively ask its suppliers for bags of cash. Here is what the firm’s CEO wrote.
[Chief Executive Gavin Darby] wrote: “We are aiming to work with a smaller number of strategic suppliers in the future that can better support and invest in our growth ideas.”
He added: “We will now require you to make an investment payment to support our growth.
“I understand that this approach may lead to some questions.
“However, it is important that we take the right steps now to support our future growth.”
But when a supplier raised questions in an email about the annual payments, another member of Premier’s staff replied.
“We are looking to obtain an investment payment from our entire supply base and unfortunately those who do not participate will be nominated for de-list.”
You can contemplate the lovely Britishness of “nominated for de-list” while watching this video on the subject.
I should note that Premier Foods has since backed off its demand after the negative press following this report (see here).
Why does this interest me? In part, it is the claim from a spokesman of a small business trade group that this is “not helping the supply chain.” There is a real issue of why a manufacturer would demand such payments upfront. The obvious answer is that they do it because they can. However, that is not completely satisfactory. If the manufacturer can demand a pile of cash, why would it prefer that to a price cut on the goods or services it buys from the supplier? A pile of cash is nice, but on its own it does not affect how the manufacturer prices (more accurately it doesn’t impact prices in a standard economic model). A per unit price cut would increase the manufacturer’s profit on every unit it is already selling plus allow it to cut price and move more product. For example, if the manufacturer is currently selling one thousand units per period, it should prefer a price cut of a dollar per unit to a straight thousand bucks. The price cut should allow it to sell more than a thousand units and thus net more than a thousand dollars.
So are there other explanations? One can tell a story about information here. In fact, I have told that story in a related setting. When supermarkets demand upfront cash from brands looking to launch new products, the payments are known as slotting allowances. In the US, these were hotly debated in the early 90s — debated enough that I was able to publish a paper on the topic. The basic story is that a brand knows whether it is launching a strong or weak product. A brand benefits from the retailer believing it has a strong product because the retailer will put in more promotional effort. Consequently, a claim that a product is a sure winner isn’t credible; when everyone claims to be great, the retailer discounts every claim. That’s where slotting allowances come in. They allow a brand to put its money where its mouth is and convince the retailer that it should support the new product.
The setting with Premier Foods is a little different. Here the downstream (and supposedly) uninformed player is asking for the upfront money as opposed to the upstream, informed player just offering it. In modeling parlance, we are moving from signaling to screening. Turns out that’s also been looked at in the context of slotting allowance. But that model has an important difference from the story discussed above. Specifically, that paper assumes that the brand is the one capable of exerting promotional effort. Hence, the retailer likes the lump sum since a fatter margin gives the brand an incentive to promote the product. So this model doesn’t really cover the Premier Food situation. They are asking for payments from suppliers who do maintenance in their plants. Those suppliers don’t do advertising to drive Premier’s sales. Second, it is not clear why there should be significant information asymmetry. If a firm has been their supplier for ten years, the firm’s capabilities should be fairly clear.
It might just be that Premier Foods prefers certainty. In reality, the benefit of a price cut is variable because sales are random. The pile of cash doesn’t depend on economic conditions while the benefit of a price cut does. Upfront money then offers Premier some insurance. From an economic point of view, this seems inefficient. Premier should be better able to whether swings in the market then its smaller suppliers.
However, there is another possibility. My argument for price cuts depends on part of that cut being passed on to consumers to increase sales. That is not guaranteed to happen since Premier does not sell directly to end consumers. It is dependent on grocery stores passing through a wholesale price cut. If Premier gets a price cut from its suppliers, it may worry that its retailers will simply demand a large reduction is Premier’s prices and take Premier’s gain as their own. Cash upfront may be harder for the retailers to expropriate.
That is the most reasonable explanation I can come up with for Premier Food’s actions. But is it bad for the supply chain? It is certainly bad for the suppliers, but it seems to amount to moving money from one pocket to another. That creates winners and losers but it shouldn’t really change overall supply chain performance.