Modelling the Effectiveness and Profitability of Trade Promotions Author(s): Robert C.

Blattberg and Alan Evin Source: Marketing Science, Vol. 6, No. 2 (Spring, 1987), pp. 124-146 Published by: INFORMS Stable URL: http://www.jstor.org/stable/183683 . Accessed: 02/08/2011 17:48
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MARKETING SCIENCE Vol. 6, No. 2, Spring 1987 Printed in U.S.A.

MODELLING THE EFFECTIVENESS AND PROFITABILITY OF TRADE PROMOTIONS

ROBERT C. BLATTBERG AND ALAN LEVIN

of University Chicago Interactive Data Corporation

Trade promotions have become an increasingly important element of the marketing mix. Yet, there is very little research describing how to measure the profitability and effectiveness of trade promotions. This paper describes how retailers behave when trade promotions are offered. Then, a model is developed to capture the two key components of the process: the consumer and the retailer. An example is given showing how to apply the model to actual manufacturer and retail sales data. Then estimates of the profitability for different items in a product category are calculated. Many research questions are raised in this paper which can serve as future directions for research. Why are trade promotions generally unprofitable? How can scanner data improve the estimates given? How do different types of trade promotions affect the retailer and ultimately the consumer? Which brands and items should be trade promoted? (Modelling; Trade Promotion; Scanner Data)

1. Introduction Brand managers devote substantial dollar resources to trade promotions and, in many companies, trade promotion budgets are much greater than advertising budgets. Yet, there have been very few models developed to measure the profitability and sales effects of trade promotions. The purpose of this article is to present a model which assists management in understanding and measuring the effects of trade promotions. The specific uses of the model presented are: (1) to evaluate individual promotions, (2) to identify the best trade promotions for each size and in each geographical area, (3) to evaluate future promotional plans, and (4) to develop trade promotion tactics. The model developed is applied to a data set using Nielsen consumer sales data (bi-monthly) and company shipment data. The consumer sales data used have many imitations which are discussed later. However, the general modelling approach can be applied to scan data such as Nielsen's Scan Track. The model can actually be applied more easily to these data than the data described in the paper since more accurate consumer promotions and weekly sales data are available from Scan Track. Before continuing, it is useful to define a trade promotion. Trade promotions are special incentive programs offered by the manufacturer to their distribution channel members. They take many forms, including direct price discounts and free case offers.
124 0732-2399/87/0602/0124$01.25
Copyright ? 1987, The Institute of Management Sciences/Operations Research Society of America

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Channel members are then expected to "push" the product through the pipeline by offering financial and merchandising incentives. Ultimately, the goal is to get the retailer to offer the consumer a price discount and, in many situations, merchandise the product through displays and newspaper advertising. In certain situations the manufacturer will require the retailer to sign a compliance agreement which will make the retailer guarantee some form of price reduction to the consumer or merchandising activity on the proposed item. Most of the studies of promotional activity have concentrated on consumer response to deals. Kuehn and Rohloff(1967) and Frank and Massy (1965) have attempted to measure the sales effect of price-off and other types of promotions. Webster (1965), Montgomery (1971) and Blattberg et al. (1981) have attempted to measure the characteristics of the deal buyer. None of these studies considers how channel members respond to trade deals. Goodman and Moody (1970) developed a system to measure the effect of trade promotions on sales of the manufacturer. Their system incorporated the buying behavior of other members of the channel. They postulated that the main factors affecting sales were trend and seasonality. When trade promotions occurred, the other channel members varied the quantity purchased, either to build inventories at lower costs or reduce inventories in anticipation of trade promotions. Their model was theoretical with no empirical validation. Brown (1973), using a similar concept, offered a methodology to attempt to estimate the dealer's inventory during a deal and the trough after a deal caused by the trade selling inventories bought during the dealing period. The problem with the methodology developed by Goodman and Moody and by Brown is that it attempts to measure consumer purchasing indirectly. They do not attempt to estimate the size of trade inventories, a crucial factor in determining the effect of the promotion. Abrahim and Lodish (1987) use a similar approach to Brown in estimating the effects of alternative promotions. They use a time series model in which managers and consultants analyze the manufacturer's shipments in order to measure the effect of a promotion. Through different statistical procedures they create a baseline forecast of what sales would be without promotions and then the difference in the baseline and actual shipments is a measure of the effect of an individual promotion. They thus allow each promotion, even of the same type, to vary in its effect on shipments and profits. The major problem with Brown's and Ibrahim and Lodish's models is the possible lack of robustness in predicting future promotional effects. By relying heavily on modeling residuals and allowing differing effects of identical types of promotions, it becomes very difficult to generalize the results to future time periods. However, according to their published articles, they have excellent success in analyzing promotional effectiveness. Chevalier and Curhan (1976), using a survey, describe how trade promotions affect retailer promotion activity. While not formally modelling the relationship between retailer promotions and trade promotions, they show that retailers promote only a limited number of items for which they accept trade promotion allowances. Further, slow moving items are unlikely to be displayed and substantial financial inducements are required to obtain retail price cuts. Most importantly, they question whether trade promotions are profitable to the manufacturer. The study conducted by Chevalier and Curhan is an excellent starting point for this article. Many of the issues they discuss such as "forward buying" (retailers loading their inventories) and the effectiveness of different types of trade promotions will be the basis of the model developed in this paper. The primary conclusions they draw will be consistent with the findings in this paper. The model outlined in this article will combine consumer sales, factory shipments

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and estimated pipeline inventories to evaluate the sales effect and profitability of trade promotion activity. In addition to developing a theoretical model, actual consumer sales and shipment data are used to estimate the model's parameters and test its accuracy. The model described in this paper is general in form. It has been applied to different data sets such as SAMI as well as Nielsen bi-monthly store audit data which are used to estimate the consumer sales equation in this paper. The model can be used with scanner data which are currently becoming available from sources such as Nielsen. As better consumer sales and promotional data become available, the model described in the paper can be applied with some minor modifications to these new data sources. The remainder of the article is divided into seven sections. ?2 describes the model theory and structure; ?3 describes the data utilized and the estimation procedures; and ?4 the results. ?5 explains how the model is used to evaluate promotions. ?6 demonstrates the model's forecasting capabilities. ?7 discusses the uses of the model; and ?8 offers some concluding comments. 2. The Model 2A. Introduction Most consumer packaged goods are distributed through a two- or three-step channel. The two-step channel results from the manufacturer shipping to a retailer (Step 1) who sells to the consumer (Step 2). More complex systems exist in which manufacturers ship to wholesalers (or distributors) who sell to retailers who then sell to consumers. The model was developed to represent a two- or three-step distribution system mathematically. Below, the theory of the model will be described, specific hypotheses generated and equations derived. 2B. Model Theory Figure 1 shows the relationship between the model's components. It begins with promotions influencing shipments. When a trade promotion is offered (such as an off-invoice discount) the wholesaler or retailer increases his orders from the manufacturer.' This increase in orders occurs for two reasons. First, the retailer will "forward buy" and hold inventory in order to take advantage of the special incentives being offered. Second, since the goal of the trade promotion is to increase retail promotions and merchandising activities, it is expected that retailers will increase their inventories in anticipation of increased consumer sales from their retail promotions.2 If trade promotions can generate consumer sales they will ultimately increase longrun manufacturer shipments. In general, if consumer sales do not increase, trade promotions merely increase short-run pipeline inventories which are run down after the deal, resulting in a post promotion sales trough. The result is that the retailer buys at a reduced price from the manufacturer without sales increasing to compensate for the reduced price. In this case trade promotions become unprofitable.3
Trade promotions are defined as inducements offered to the intermediaries in the channel of distribution resulting in special activities supplied by these intermediaries. The most common types of trade promotions are bill-backs, allowances, off-invoice allowances and free goods. 2 Retailer promotions and merchandising activities take the form of short-term price reductions (deals). 3 In some circumstances, inventory savings to the manufacturer may mean a trade promotion is profitable even though it did not increase consumer pass through. If the retailer or other channel members have lower carrying costs than the manufacturer, it may be profitable to trade promote even without increased consumer sales. Another way to think of trade promotions is that the manufacturer is giving a quantity discount to certain members of the "trade". The advantage of these discounts has been documented by Lal and Staelin (1984) and Dolan (1986).

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FIGURE1.

Factors in addition to trade promotions are often included in the models, such as advertising, price changes, trend, category seasonality and any other variables considered important in the product category. Competition is an important factor in modeling sales and shipments but it is very difficult to include for several reasons. First, there are rarely data collected about competitor's trade promotion activity. Second, even if data were collected historically, one would need to forecast competitors' behavior in order to use it normatively. Third, it is necessary to design competitive game models, including competitors' activities, to understand how their actions might affect the firm's activities. Primarily because of the lack of available data, but also for the other reasons mentioned, competitive activity will not be included in the model. The effect of eliminating competition in the model primarily influences the effect of trade deals on retailers' promotions. Retailers will buy less from a specific trade deal offered by the manufacturer because a competitive trade deal was offered. The effect will be greater variation in shipments when a given trade deal type is offered. This will increase the standard error of the residual. However, if this residual is uncorrelated with the independent variable, the estimates will be unbiased but have a wider standard error. It is impossible to know whether the residual is correlated and hence will be assumed, as in most marketing models, to be independent of competitive activity. 2C. Forward Buying Because "forward buying" by the retailer is a crucial factor in determining the profitability of a trade promotion, it is useful to show why it exists. Figure 2 gives a plot of the shipment history of a firm for a specific product in a market (the solid line). One sees the peaks and valleys and the rather erratic nature of the shipment plot. The circles indicate trade promotions which occurred during the

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80.000

60.000

..-

---0---0

UNIT SHIPMENTS ADJ UNIT SALES PROMOTION PERIOD

2. FIGURE Nielsen Adjusted Sales vs. Factory Shipments Product X-Market 1.

period.4 The plot demonstrates that there are usually troughs after a trade promotion ends, because channel members forward buy during the promotion and then run down their inventories after the promotion ends. Figure 2 also shows consumer sales (Nielsen)-the dotted line-for the same product in the same market. One sees that consumer sales have much less variability than shipments because the retailer is buying for inventory with much less being passed on to the consumer. The result is large swings in shipments resulting in retailer's stockpiling. Because Nielsen estimates of consumer sales are smoothed, they result in less fluctuations than may be occurring in a given retailer when a promotion occurs. However, in any market retailer promotions are not simultaneous. Thus, some of this "smoothing" over a two-month period is due to different retailers' running one week promotions. Many products also do not have sizeable consumer sales increases when a retail promotion is run. To see this, suppose 50% of the stores promote the trade dealt brand for one week in the bi-month (8 week) period. Sales in these stores increase 100% for the week. Over 8 weeks, this is a 12.5%increase in sales multiplied by 50% or a 6.25% sales increase. A sales increase of 200% would cause sales to increase only 12.5% over the bi-month period if 50% of retailers promote. If 4-week sales data were used (SAMI) a larger spike would occur but the general conclusions that retailers are heavily stockpiling would not change.
4 This product is heavily trade promoted as are most grocery, drug, and health and beauty products. Trade deals occur in over 70% of the periods. Yet, the regular price is not the trade deal price and retailer actions are based on the difference between regular price and the trade dealt price. The reason is that the trade deal lasts for a fixed period of time and therefore the retailer must forward buy (inventory) in order to receive the lower price. A long-term price reduction would result in different retailer buying behavior.

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The reason the retailer stockpiles can be explained by an EOQ inventory model. The retailer evaluates three main costs: (1) product cost, (2) inventory carrying costs, and (3) set up costs. For most retailers (1) and (2) dominate. If there is a temporary price reductioh, the retailer purchases up to the point where the savings from the promotion are less than the additional holding costs associated with keeping the product in inventory. Because the retailer is buying more than the quantity sold when a promotion occurs, after the promotion ends the retailer will order much less than the quantity being sold. The result is a trough after a deal which is evident in Figure 2. From this explanation one also sees the conditions for a profitable promotion: Most of the incremental units sold by the manufacturer during the promotion period must also be incremental units sold by the retailer. If the retailer does not pass the promotion through to the consumer, then the channel members are only buying at reduced costs which results in a lower implicit selling revenue to the manufacturer without long-run increased units sold to compensate for the reduced price. Model Hypotheses Based on the above conclusion, it can be said that retailers use some form of inventory model to determine how much to purchase on a given deal.5 This helps to explain several of the empirical findings just described and results in the following hypotheses. First, retailers will "forward buy" when trade promotions are offered if the savings from the promotion exceed the holding costs. The "forward buying" will cause a trough after the deal. Second, the response to a promotion will be lower at the beginning of the promotion than at the end of the promotion assuming that the retailer can reorder. The lower sales results from the retailer only buying enough to get through the deal and then forward buying at the end of the deal. Thus, retailer inventory behavior can explain the higher sales at the end of a promotion and the trough in the sales following a deal. In any model of shipments, it is important to capture this inventory effect. For the consumer sales equation, the retailers anticipate their promotions and buy inventories to cover both forward buying and expected sales during the promotion. Thus, inventories can serve as a surrogate for retailer promotions. Based on the conclusions drawn above, the following hypotheses were generated. Shipment Hypotheses. 1. Inventories inversely affect shipments. 2. Trade promotions increase shipments. Consumer Promotion Hypotheses. 1. Retailers build inventories in anticipation of offering consumer promotions. These hypotheses will be used to develop a model structure. 2E. Model Structure In developing the model there were four equations initially postulated: (1) manufacturer's shipments, (2) retailer promotions, (3) consumer sales, and (4) inventories. The following general model is postulated. Shipmentst = fi(inventoryt_l, trade promotionst, other factorst), Retailer Promotionst = f2(trade promotionst, inventories-t_), Consumer Salest = f3(trade promotionst, retailer promotionst_l, other factorst, other factorst_l), (2.2c)
Some retailers (e.g. warehouse stores) may buy from deal to deal. This would not cause a trough after the deal but cause higher peaks. However, many retailers do forward buy and thus there is generally a trough after a deal.
5

2D.

(2.2a) (2.2b)

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Inventoriest = f4(inventoriest_1, shipmentst, consumer salest),

(2.2d)

where t = the time period andfi( ) is a function. For each of these equations, trade promotions refer to the various types of trade promotions used such as off invoice and bill backs. Each different type will be included in the empirically estimated model. 3. The Estimated Model and the Data 3A. The Data

To perform the analysis, data were gathered from a variety of sources. The data were for a three-year period for each major product, and its associated sizes (10 products) and markets (6 markets). Each product size and market combination were analyzed separately. The following data were used to estimate the model: -Factory shipments -Nielsen sales -Manufacturer's price -Trade promotions -Advertising expenditures Because Nielsen data are bimonthly and factory shipments are monthly, it is necessary to decide on the appropriate time period to use. If the time period of a month is chosen, then Nielsen data must be adjusted. Using a month as the time period maximizes the use of data on manufacturer shipments and promotions. Thus, the analysis was performed using one month time periods. A variety of methodologies were discussed to develop monthly Nielsen numbers. It was decided to adjust Nielsen bimonthly sales using linear extrapolation. However, the standard errors and t-statistics may be biased, because the monthly observations are weighted bimonthly data.6 As mentioned earlier, inventory data are considered to be extremely important in the development of the models and for the analysis. The inventory data supplied by Nielsen was insufficient for the analysis because Nielsen inventories represent stock inventories in the store and do not account for other inventories in the system, especially at the warehouse level. Thus, an estimate of pipeline inventories was made. To estimate the pipeline inventories Nielsen monthly consumer sales and manufacturer shipments were used. Since the relationship for inventories in a given period is simply: (3.1) INVt = INVt_ + Shipmentst - Consumer salest, one can estimate inventories if initial inventories Io were available. Because initial inventories were not, a procedure was established to estimate it. Io was chosen so that each period's initial inventory was greater than or equal to zero. Thus, the inventory data used are relative inventory. If Io were available, then actual inventory could be estimated. Because the firm did not collect information about retailer promotional activity, it was necessary to eliminate equation (2.2b) from the set of equations. This required revising equation (2.2c). As a surrogate for retailer promotions, last period's inventories were used. When the retailer promotes, he builds inventories in anticipation. Trade deals were not included because the retailer's promotional periods do not correspond to the manufacturer's promotional periods. The manufacturer may run a promotion for three months and the retailer will promote only one week in the period. Therefore, one
6 The econometric implications of this procedure were not derived. Future research will attempt to evaluate this issue in more detail.

EFFECTIVENESS AND PROFITABILITY OF TRADE PROMOTIONS

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would not be able to use the timing of trade deals to predict retail promotions. This leads to a revised equation: consumer salest = f5(inventories_-1, other factorst). The remainder of this section describes the equations used in the final model. 3B. Shipments Equation The primary variables used to explain shipments were pipeline inventories and different types of trade promotions. Inventories were lagged because ending inventories from the previous period influenced shipments in the present period. Incorporating trade promotions into the model raises several issues. First, the firm offered numerous types of promotions. The major types were off-invoice discounts, sales drive discounts and a special fall premium promotion.7 These promotions were included in the model as separate variables. In addition, the issue arises how to incorporate the value of the trade promotion into the model. To make alternative trade promotions comparable across types and over time, a percentage dollar discount to the channel member was used. This percentage discount was used to represent the magnitude of a promotion.8 Second, the shipments occurring during the trade promotions were not constant. Because the firm allowed a channel member to purchase only once during the promotion, a specific pattern for shipments was observed. A variable was created which indicates the percentage of a trade deal shipped each month. This percentage varied depending on the length of the deal (2 months, 3 months, etc.). For example, suppose a trade deal lasts three months. Then, the percentage of the total shipped on deal in month 1 represented 30%, in month 2-20%, month 3-50%. The percentages were calculated using actual data based only on the shipments during the dealing period. The percentages used for each deal of varying lengths are given below:
Percentage Shipped by Month Length of Trade Deal 2 3 4 1 40% 30 30 2 60% 20 20 3 50 10 4

(3.2)

40

To measure the effect of a deal, a new variable was created which is the product of the trade promotion percentage discount times the percentage shipped each month during the trade deal. This approach is used in the model for off-invoice percentage. The reason an adjustment was made for percentage shipped per month is that retailers do not buy evenly throughout a trade promotion. At the beginning of the promotion they buy to cover their retail promotion and at the end they buy for inventory. Thus, the shape of the response function is not uniform over the period of the trade promotion. Second, a separate end-of-deal variable was developed to capture the carryover effect being caused by orders taken during the promotional period at the discount price but shipped the month after the promotion ended. Daily invoice data were used to determine the length of the carryover effect. Generally, it was found that over 98% of the orders placed during the deal period had been shipped within one month following the
7 Bill backs, free goods, or other commonly used promotions would be entered as separate variables in the model. They would be converted to dollar values and then entered. 8 Because percentages are independent of the absolute magnitude of prices, using a percentage discount adjusts for inflationary change.

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end of the deal. Therefore, a one-period carryover effect should capture this phenomenon. The variable used to define end-of-deal was the percentage trade promotion discount times a dummy variable which is 1 if a promotion just ended and zero otherwise. Third, when manufacturer's case price increases, the retailer is likely to forward buy. Therefore, a price increase is often preceded by an increase in sales. In general, this can be modeled by having a dummy variable for the period prior to the deal times the percentage price increases. Thus, the effect of a price increase leads shipments because the retailer or wholesaler forward buys. Fourth, sales drives were used to push the product from the wholesaler to a retailer. For all units sold by a wholesaler to a retailer, the wholesaler would receive a payment of X% of the wholesale price as a financial incentive from the manufacturer. This type of trade promotion was used to push the wholesalers to load retailers. Fifth, a fall premium was offered to the manufacturer's sales force every September. The purpose of this premium was to have the sales force increase effort on specific products. Because it was difficult to translate the fall premium into a percentage, a dummy variable was used which was 1 when a fall premium was present and zero otherwise. Sixth, trend was modelled using time which was 1 in the first month, 2 in the second month and up to 35 in the last month. It was found that a linear trend adequately fit the shipment data. As was stated earlier, competitive factors were not included in the model because data were not available. Also, seasonality was not included in the shipments equation because an independent sales measure indicating shipment seasonality was not available. Using dummy variables to measure seasonality would have added too many variables to the equation. The final list of variables used for estimation in the model along with expected signs is shown in Table 1. This leads to the shipment equation: shipment, = f(inventory,t_ , off invoice,, end of dealt, sales drive,, pricet_,, fall premium, trendt). (3.3) 3C. Consumer Sales Equation The consumer sales equation had to be reformulated because certain data were not available. While sources exist for retailer promotions (Majers),9 the firm did not subscribe to this service. Since retailer promotions could have a major effect on consumer purchases, alternative variables were needed. Because pipeline inventories depend on retailer promotions one can substitute this variable into the model as a measure of retailer activity. The reason for using pipeline inventories is that high inventory levels would cause the retailer to respond with special promotional activities to reduce the inventory buildup.?0 Thus, whereas high pipeline inventories are expected to reduce manufacturer shipments, they will also cause increased consumer sales due to retailer promotions. The consumer sales equation therefore contained an inventory variable as surrogate for retailer promotions. Determining which consumer marketing activities to include in the consumer sales equation raised similar issues to those outlined in developing the shipments equation. Because it was measured with substantial error, retail price was omitted even though it
9 Majers provides data to measure retailer's promotional activity. 10In the near future Nielsen Scan Track data will make it be possible to measure retail sales and promotions much more accurately. One can then analyze the effect of different manufacturer promotions on retailer promotional activities rather than using inventory as a surrogate.

EFFECTIVENESS AND PROFITABILITY OF TRADE PROMOTIONS TABLE 1

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in ExpectedSigns of Variables FactoryShipmentModel

Variable Used 1. 2. 3. 4. 5. 6. 7. Lagged pipeline inventories % Deal completed X off-invoice % End of deal % Sales drive % Price change % (in t + 1) X dummy variable Fall premium Trend Expected Sign

+ + + +
+

was known to be important. The price measure available was Nielsen's price estimate. A regression was run between manufacturer price and retail price and very low correlations were found. The reason for these low correlations appears to be how Nielsen weights store prices. As additional outlets stock the product or the outlet's market share increases, the Nielsen estimated prices fluctuate. These fluctuations do not represent "true price" changes in the market, merely shifting outlet shares or brand market shares. Thus, using Nielsen prices was extremely difficult. If price is uncorrelated with other factors in the model, then no bias in the coefficient estimates exists. Therefore, omission of price may not cause serious problems in the use of the model. Consumer advertising was incorporated into the model using total advertising dollars and then deflating by an inflation factor for industry advertising costs. Both current and lagged deflated advertising were used, though only lagged advertising was incorporated in the final model. Current advertising entered with the wrong sign. The cause of the wrong sign could not be determined. The other factors included in the equation were seasonality and trend. Seasonality was estimated using Nielsen category sales data not brand or item data. By using category sales data, any item marketing effects would not contaminate the seasonal adjustment. X- 11 was used to estimate the seasonal patterns. Trend was simply a time indicator beginning at 1 and going to 35. A dummy variable was also utilized to remove large residual effects which could not be reasonably accounted for by the other variables. This was only used in a small number of models. The final list of variables used for estimation in the consumer sales model along with expected sign is shown in Table 2. This leads to: Consumer sales = f(inventory,t_, advertising-t_, seasonalityt, trendt). 3D. Inventory Model The inventory model is a straightforwardaccounting relationship: INVt = INVt_1 + Shipmentst - Consumer Salest. (3.4)

(3.5)

The procedure for estimating inventory was given in ?2. 3E. Functional Form The functional form used for the model given in equations (3.3) and (3.4) was to log the dependent variable. The specific choice of this functional form is partly arbitrary because it is difficult to state which functional form is most likely to represent actual behavior. A log model made it easy to combine the two equations into a forecasting system and also to make sure negative sales are not predicted by the model. The next section presents the model estimation procedures and the results of the estimation. Comparisons of actual vs. fitted and forecast accuracy are presented to evaluate the quality of the models.

134

ROBERT C. BLATTBERG AND ALAN LEVIN TABLE 2 Expected Signs of Variables in Consumer Sales Equation Variables Assessed 1. 2. 3. 4. Lagged pipeline inventoriesa Lagged deflated advertising $ Category seasonality Linear trend
a

Expected Sign + + + +

Lagged pipeline inventories are used as a proxy variable for consumer promotions.

4. Model Evaluation This section is divided into two parts. The first gives the estimation results and the second describes the results of the simulation test used to evaluate the model. 4A. Estimation Results

For the product line studied, there were 10 items in each of 6 markets. The 10 items represented line extensions and sizes. Thus, 60 different sets of coefficients were estimated for both the shipments and sales equations. Because there were so many different sets of coefficients estimated, the results are presented in three separate tables. Table 3 gives the actual estimates for the shipments and sales equations for the same item in two separate markets. The overall results are summarized in Tables 4 and 5. The coefficients in the shipment equations in Table 3 show that the lagged inventory variable, indicative of the pipeline inventory in the distribution system, has the correct

TABLE 3 Coefficient Estimates for Two Markets and Sizes SHIPMENTS EQUATION Market I/Size 2 Variable Lagged inventory Trend Off-invoice End of deal Sales drive Price change Fall premium Constant Coefficient -3.29 X 10-5 -5.964 X 10-3 36.9071 3.4142 21.4402 13.5317 0.2029 8.8366 R2 = 0.845 # of obs. - 35 T-Ratio -2.94 -0.72 6.51 0.75 3.27 2.31 1.34 45.32
K2 = 0.611 # of obs. = 35

Market 2/Size 2 Coefficient -4.26 x 10-5 7.24 X 10-3 25.6119 4.2845 3.4890 4.6786 0.2290 8.7882 T-Ratio -3.15 0.88 4.93 0.99 0.55 0.89 1.61 45.54

CONSUMER SALES EQUATION Lagged inventory Seasonality Trend Lagged advertising Constant 3.295 X 10-6 0.0127 -0.0005 0.0005 7.89 2 = 0.446 # ofobs. = 35 2.10 2.69 -2.01 0.33 16.45 = 0.511 # ofobs. = 35 4.880 x 10-7 0.0270 1.737 x 10-3 1.990 x 10-3 6.2365 0.17 4.60 0.92 1.08 10.65

EFFECTIVENESS AND PROFITABILITY OF TRADE PROMOTIONS TABLE 4 Shipments Equation Number of signs Number correct 360 345 Sales Equation 180 155

135

sign and is statistically significant. The promotional variables-off invoice, sales drive and fall premium-also have the correct signs although their effects vary across markets. The off-invoice promotion variable, adjusted for the length of time of the deal, usually had the largest t-ratio in the shipments equation. In the consumer sales equations, lagged inventory, acting as a surrogate for retailer activities, again has the correct sign. However, its significance is typically not as great as in the shipments equation. The lagged advertising variable also had the correct sign, although its significance for this product category was not very high. Tables 4 and 5 give a summary of the coefficient signs and adjusted R-squares. This is a test of the model. One sees that in general the signs are correct, with 345 out of 360 signs correct in the shipments equation, and 155 out of 180 signs correct in the consumer sales equation." Given that the model was not initially designed using these data, this is a strong validation of the model. The adjusted R-squares ranged from 0.23 to 0.95 for the shipments equation and from 0.15 to 0.94 for the consumer sales equation. The average adjusted R-square is 0.66 for the shipments equation and 0.57 for the consumer sales equation. The wider variation in adjusted R-square for the consumer sales equation is due to the use of Nielsen bimonthly data and the omission of some explanatory variables discussed earlier. 4B. Evaluation of the Model: Fitted versus Actual The previous section partially evaluated the model using the number of correct signs for the coefficients and adjusted R-squares. However, these measures do not necessarily indicate how the model will do in predicting future shipments and consumer sales based on future inventory levels. Therefore, a "simulation test" was used. The "simulation" test discussed in this section is a more stringent test of the model than evaluating the residuals because the inventory values are computed from predicted consumer sales and predicted shipments rather than actual consumer sales and shipments. The simulation begins with an initial estimate of inventory in period 1 and then predicts shipments and consumer sales for the next period. Next, the predicted values of
TABLE 5 Frequencies for Adjusted R2 in Models Shipment Equation R2 Number 0-0.20 1 0.20-0.40 6 0.40-0.60 13 Sales Equation 0.60-0.80 27 0.80-1.00 13

A2
Number

0-0.20 7

0.20-0.40 12

0.40-0.60 14

0.60-0.80 17

0.80-1.00 10

" There are 60 equation estimates (6 markets, 10 sizes) for consumer sales and shipments. One coefficient had an ambiguous sign, trend and was not included in the calculation of number of correct signs.

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ROBERT C. BLATTBERG AND ALAN LEVIN

z N a
\

?II

,~~~~~~~~~~~~~~
'

[1

? . It

? a

... ?

?I

I.I

1978

1979
FIGURE 3.

1980

1981

1982

Factory Shipments Model.

consumer sales and shipments are then used to calculate inventory for the next period. The process continues for all the remaining periods. For the simulation to fit the sales and shipment data accurately requires that each period's consumer sales and shipment estimates be reasonably accurate in order to compute the inventory values. If this is not the case, the simulated versus actual data will begin to depart. However, the simulation test is less stringent than a holdout sample because the parameters have been estimated on the data used in the simulations. Later, in ?6, these models will be evaluated by making forecasts and then comparing these forecasts to the actual results. Figure 3 shows actual versus simulated shipments for a specific size in a given market. Figure 4 shows actual versus simulated consumer sales. For the shipments equation certain peaks and valleys are missed, but, in general, the model closely fits actual shipments. For the consumer sales equation, the model does not track as well, but, again, it follows actual consumer sales. The reason the consumer sales equation does not do as well is that Nielsen data are not very accurate measures of true consumer sales. This was emphasized earlier in discussing estimation issues, and it is important to realize that Nielsen data are also estimates smoothed over a two-month period and not sums of actual monthly consumer sales. Based on the simulation test, the model appears to be able to forecast future shipments and consumer sales given initial inventory values.12 This will be important in the next section which describes how the model will be used to evaluate promotions.
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12

EFFECTIVENESS AND PROFITABILITY OF TRADE PROMOTIONS

137

5. Evaluation of Trade Promotions As stated in the introduction, the primary objective of this model is to evaluate sales response and profitability of a trade promotion. The purpose of this section is to describe the methods used for evaluating the effect of a specific promotion on shipments, consumer sales and profits. 5A. Sales and Shipment Response The first issue will be a promotion's effect on sales and shipments. The method used is to simulate the simultaneous equation system with and without the trade promotion. This approach gives the "average" effect of the trade promotion. Actual shipments and consumer sales for the period will not be used because factors other than trade promotions affect them. Figure 5 shows the monthly effect of the promotion. During the first month of the promotion, shipments increase dramatically over what they normally would have been had there not been a promotion. The next few periods of the promotion also show incremental shipments, although less dramatic, due to the nature of the trade deal promotion and the firm's contractual buying limitations. The final peak occurs after the promotion period and shows the carryover effects, i.e., those orders placed at the deal price which were not shipped until the following period. This discrepancy between orders and actual shipments is an important phenomenon which must always be accounted for in the development of the models. The major peak at the end of the promotion period also indicates that distributors are loading their inventories as the deal period is about to expire. The result of this loading is shown by the trough following the deal period. Finally, as time goes on shipments gradually return to normal levels. The dotted line in Figure 5 indicates sales response as a result of the promotion. Two phenomena should be noted. First, consumer sales effects lag shipment effects by at least a few time periods. This should be expected since it takes time for the product to move through the distribution pipeline into the consumer's hands. Second, consumer sales activity is much smoother than shipments. This is due to the lagged effect'of the promotion and retailer stockpiling of the product. Figure 6 demonstrates the incremental effect of a promotion on both shipments and consumer sales over time. As Figure 6 indicates, although shipments may increase significantly during a promotion period, this increase must ultimately be passed through the system, as shown by the dotted sales lines. The entire process generally takes several months before the incremental inventories are passed through the wholesaler and retailer.

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ROBERT C. BLATTBERG AND ALAN LEVIN

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Figure 6 also shows that in the long run, the incremental increase in consumer sales equals the incremental increase in shipments. This occurs because over the long run it is necessary for shipments to equal consumer sales. If the trade promotion does not increase consumer sales, then it merely shifts the timing of the retailer's purchases. This is the key to analyzing the profitability of a trade promotion. In general, the more the retailer passes through to the consumer relative to the quantity shipped on deal, the more profitable the promotion will be. In conjunction with the determination of sales response due to a trade promotion, it is also important to understand the financial implications of running a trade promotion. This issue is discussed below. 5B. Profit Analysis of the Trade Promotion Evaluating the profitability of individual promotions allows the marketing manager to understand the financial effect of a trade promotion. Although one might argue that promotional expenditures may be utilized to gain or retain market share over competitors, an understanding of profitability should make a marketing manager more effective in deciding the types of trade promotions campaigns to use. Analyzing the profitability of a trade promotion requires cost accounting information and the number of units sold at the reduced price. The accounting information is used to determine the cost of goods sold so that the marginal cost of each unit of the product can be measured. The quantity sold at a reduced price during the promotion is required because not all units sold during the promotion period are purchased using promotional allowances. The following procedure was used to assess the profitability of individual promotions: 1. The difference in shipments between running a promotion during a particular period of time and not running that promotion was computed each month, using the models estimated from the historical data (see ?5A). 2. Incremental unit shipments due to a promotion were computed by summing the unit differences created in Step 1 over an extended period of time until the cumulative effect did not change from month to month. 3. Incremental dollar shipments due to a promotion were computed by multiplying the unit differences in Step 1 by that month's price. Next, the dollar differences were summed, giving total incremental promotional dollar shipments.13
13It should be noted that since prices change over time, the incremental dollar shipments would usually not match incremental unit shipments multiplied by the current period's price.

EFFECTIVENESS AND PROFITABILITY OF TRADE PROMOTIONS

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4. Incremental Gross Profit was computed by multiplying the incremental dollar shipments by each period's product gross margin. 5. Deal Cost was computed by multiplying the total promoted shipments sold during the period by the effective discounted dollar price. The total percentage of a month's shipments sold on the trade deal were 80% for months during the promotion and 50% for the month immediately after the deal ended. Thus, the amount sold on trade deal is computed by multiplying total unit shipments sold during the promotion period by 80% plus 50% of the total unit shipments delivered during the month after the promotion to allow for carryover effects. The 80%and 50%factors were utilized as estimates of shipments sold at the promoted price, based upon an analysis of total, regular and special price shipments across products.14 Using the data displayed in Figures 5 and 6 one can compute the profitability of running the trade promotion. Figure 6 shows that incremental sales during the promotion period were 55,000 units and 15,000 for the month following the promotion. The regular sales, not given in the graphs, were approximately 20,000 units per month. Thus during the four months of the promotion (September through December), 80,000 + 55,000 = 135,000 units were sold. In the period after the promotion, 35,000 units were sold. The promotion being analyzed was an 8 %off-invoice promotion. Regular price was $12.00 and so the discount was $1.00. Utilizing the algorithm outlined above, total
14 These percentages are usually obtained from historical promotional information available in most companies. The 80% and 50% were averages across trade deals. Due to random fluctuations a given trade deal might deviate slightly from trade deal to trade deal.

140

ROBERT C. BLATTBERG AND ALAN LEVIN

shipments sold on promotion were equal to 80% of product shipments during the promotion period puls 50% of the product shipments for the period immediately following the end of the promotion period. If the off-invoice allowance is $1.00 per case, then the total cost of the promotion is $1.00 X [(0.8 X 135,000) + (0.5 X 35,000)] = $125,500. The gross margin percentage for this product was 50%or $6.00 per case. From Figure 6 one sees that long-run incremental increase in shipments was 15,000 units. Then, the incremental profit for the additional unit was $90,000. Combining the two calculations of deal costs and incremental profits shows that the deal lost $35,500 in total. Thus, while shipments actually increased approximately 15,000 units, the cost of discounting shipments normally sold was greater than the profit gained from the promotion. For this particular firm, an evaluation of the profitability of their promotional activities across products, markets, promotion types and time was performed and displayed graphically. Examples of these results are shown in Figures 7-10. Each graph shows four bars for each of the product-area-time-promotion types being assessed. The first bar indicates incremental dollar shipments. The second bar shows incremental gross dollar profit. The third bar displays the dollar cost of the promotion and the fourth bar indicates the incremental net dollar profit of the promotion. It should be noted that incremental net dollar profit really represents an opportunity cost, and not a direct profit or loss to the individual product-market being assessed; that is, a loss due to a promotion indicates expenditures which could have been utilized for other activities but instead were spent on a promotion. A profit indicates that the promotion generated enough incremental business to cover the cost of running that promotion. 250.000 200.000 150.000 100.000
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EFFECTIVENESS AND PROFITABILITY OF TRADE PROMOTIONS

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Figure 7 shows an evaluation of a promotion for 4 sizes, aggregated across all markets. It shows that certain sizes "lost" money and others were profitable as a result of this particular promotion. It is comforting to know that not all product promotions result in lost profits. In this case it meant a change in strategy for the firm since the largest selling size was also the greatest "loser" in profits when this promotion was run. Figure 8 shows a comparison of a particular type of promotion for one product-area across time. As Figure 8 indicates, different off-invoice percentages cause different effects depending upon when the promotion is run, how long it is in effect, and how soon after another promotion is run. Figure 9 compares two promotional types for a particular product. As one can see, the off-invoice promotion generates much higher incremental dollar shipments than the sales drive promotion, but at a greater cost. The off-invoice promotion might be more effective in gaining market share, whereas the sales drive might be better in maintaining share while minimizing losses. The analysis of the trade promotions given in Figures 7-10 gives mostly negative results. They show that most trade promotions do not pay out. This result is commonly found by most researchers studying trade promotions.15 There are several reasons: 1. Trade deals probably do not directly pay out, and are used defensively rather than to increase profits. 2. The models do not directly adjust for maintaining distribution through trade dealing.
'1 See, for example, Chevalier and Curhan (1976).

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3. They cannot easily adjust for competitive effects because data are rarely collected for trade promotions of other firms. 4. Sales will decline and profits increase if trade deals are reduced. Most managers appear to be afraid of market share declines. By carefully analyzing trade deals, managers will begin to assess the profits versus risks of changing their trade deal policies. 6. Market Forecasts Using Models One of the best evaluations of the accuracy and reliability of any model developed is to use it under actual conditions to forecast. Utilizing the models developed for the evaluation of trade promotions, forecasts were made and then compared to actual sales and shipments. The results are summarized in Tables 6a and 6b. With regardto the accuracy of the models' monthly forecast, a few key points can be made using the results shown in Tables 6a and 6b. First, carryover effects can cause significant monthly variations. Although the models incorporate a measure of these effects, their variation can deviate significantly from promotion to promotion causing reasonable shifts in actual shipments when compared to those forecasted by the models. Secondly, corporate goals and objectives to achieve planned unit sales volume, regardless of the cost, can also cause problems. For instance, when a firm makes financial plans for the total year, top management may try to shift product shipments reported from December to January to start the next year above plan. Overall, as the tables indicate, the two separate forecasts were accurate. The average

EFFECTIVENESS AND PROFITABILITY OF TRADE PROMOTIONS TABLE 6a Actual vs. Forecast Product I-Market X Actual 81 4 81 5 81 6 81 7 818 81 9 81 10 81 11 81 12 82 1 82 3 824 Total 33135.2 22328.3 74791.9 57437.6 8 1320.2 55376.1 27397.7 47948.5 72004.6 49131.3 92490.8 31801.8 695224.0 Forecast 35900.0 26400.0 79100.0 53600.0 72800.0 52700.0 33500.0 42100.0 80600.0 53400.0 82500.0 35300.0 690300.0 Difference 2764.8 4071.7 4308.1 -3837.6 -8520.2 -2676.1 6102.3 -5848.5 8595.4 4268.7 -9990.8 3498.2 -4924.5 % Difference 8.3 18.2 5.8 -6.7 -10.5 -4.8 22.3 -12.2 11.9 8.7 -10.8 11.0 -0.7

143

absolute error was 11.8% for product 1 and 11.3% for product 2. By grouping time periods together, the forecasting accuracy of the model improves. Utilizing the models on a total product line basis across a twelve month forecasting period, the percentage difference between the actual shipments and the forecast shipments was less than 4 percent. Naturally, from month to month there were variations, but on the average it was found that the models performed well as a forecasting tool. The overall accuracy of various product-area models varied. Generally, the higher the volume sales of the product, the more accurate the model. Smaller products, in terms of unit sales, did not perform as well as the larger products. Since product management is usually much more interested in their high volume sizes than in their flanker sizes, it was felt that the models worked well. A number of other forecasting tests were performed by the organization using different scenarios and different product-area models. The results led to the utilization of

TABLE 6b Product 2-Market X Actual 814 81 5 81 6 81 7 81 8 81 9 81 10 811 81 12 82 1 82 2 82 3 82 4 Total 11453.9 9497.2 24882.6 21236.1 22881.5 19271.8 8029.2 15442.5 21672.9 16556.6 16055.1 26184.0 12720.2 225883.0 Forecast 10300.0 11800.0 29400.0 20500.0 25300.0 15800.0 9000.0 12400.0 20700.0 15400.0 18600.0 29100.0 13000.0 232300.0 Difference -1153.9 2302.8 4517.4 -736.1 2418.5 -3471.8 970.9 -2042.5 -972.9 -1156.6 2544.8 2916.0 279.8 6416.5 % Difference -10.1 24.2 18.2 -3.5 10.6 -18.0 12.1 -13.2 -4.5 -7.0 15.9 11.1 2.2 2.8

144

ROBERT C. BLATTBERG AND ALAN LEVIN

these models in the development of future marketing plans, coupled with management input and experience. 7. Uses of the Model The specific uses of the model presented are: (1) to evaluate individual promotions, (2) to identify the best trade promotions for each size and in each geographical area, (3) to evaluate future promotional plans and (4) to develop trade promotion tactics.16 The model cannot be used to evaluate the effect of eliminating all past promotions or to evaluate new types of promotions. The reason is that the statistical methods utilized cannot go beyond the scope of the data used to fit the model. Therefore, a strategy of eliminating promotions which will affect other variables, such as distribution and competitive reaction, is so extreme that it is not possible for the model to evaluate this strategy. Another use of the model is to design test promotions for selected sizes and areas. On the basis of the results of the model, the firm realized that it is possible to eliminate promotions and to increase profitability. However, to follow that strategy across 10 sizes and 6 areas may reduce the overall profitability of the product. Even though the model indicates certain strategies or tactics that can be followed by the firm, it is much more sensible to design controlled experiments in which promotions are eliminated in 1 or 2 areas with control areas following the "normal" promotional strategy. Then based on the experimental results, the strategy can be implemented gradually in other markets. Therefore, a recommended use of the model is to identify trade dealing tactics and then design experiments to test their effects. The model can be used to track and evaluate the test strategies. This is similar to the adaptive control approach recommended by Little (1966). Using the model developed, the firm found out that most of their promotions were not profitable. This had been suspected by the firm but not documented. The model allowed the firm to analyze correctly the profitability of their trade promotions. As a result of the analysis of the firm's past promotions, the following recommendations were made. 1. More stringent contractual requirements. These might include such areas as requirements for consumer pass through of discounted items, use of count/recount systems so that the promotional allowances were paid only on the units sold to the consumer during the promotional period, and incentives which allow distributors to buy on deal only if they increase their purchases relative to prior periods. 2. Increase consumer promotional spending. These included increased advertising, couponing, and special packaging where increased demand by the consumer would "pull" the product through the system.17 3. Fine tune promotion strategy. Given the current trade promotion program, it was determined that reducing the discounts being offered, shortening the promotion durations and lengthening the time between promotions might be more effective than the current promotional program. Overall, this model allows the firm to evaluate its promotional history. The results of this process can then be used to develop future promotional strategies. In addition, the
The model simulates sales and shipments under different alternative trade deals. It then calculates expected profits. This thus allows the model to be used to evaluate alternative trade deal tactics such as shortening the length of the trade deal. 17 Couponing and special packs were not incorporated in the model but were examples of pull-oriented promotions the firm could use.
16

EFFECTIVENESS AND PROFITABILITY OF TRADE PROMOTIONS

145

model-generated forecasts can be used in product scheduling or development of realistic sales quotas. Regional and national promotional evaluations can also be developed through aggregations of individual product-market simulations. 8. The Model Applied to Scanner Data The model developed in this paper was applied to manufacturer shipment data and Nielsen bi-monthly consumer sales data. In the last year several firms have begun to offer scanner data by retailer in selected U.S. markets. An example is Nielsen's Scan Track data. The availability of scanner sales data will enhance the model currently developed. It will eliminate many of the data problems described in ?3. More importantly it will provide more accurate estimates of the retail promotions that result from trade promotions. It will provide more accurate sales estimates of the effect of these retailer promotions for a brand and the effect on competition. The model as described in this paper can easily be applied to scanner data. The conceptual structure still applies. The major difference will be more accurate estimates of the model's parameters. 9. Summary The purpose of this paper has been to develop a model in which the sales effects and profitability of trade promotions have been evaluated. The model has provided firms with a number of analyses and results that have highlighted many of the problems firms currently have with trade dealing. These include: 1. Lack of consumer pass through of trade deals. 2. Heavy forward buying by retailers, making many trade deals unprofitable. 3. Variability in effectiveness of trade deals across sizes and markets (sales districts). There are, however, many questions not currently answered or understood. Further research is required in a number of important areas of trade dealing. 1. Competitive environment of trade dealing-Can a firm reduce trade deals to increase long-run profitability when competitors do not reduce trade deals? 2. Trade deal effectiveness-When are trade deals effective? In which product categories? Which sizes? Which types of retailers? 3. Data availability-In the next several years scanner data will be available for most large SMSA's. How will the availability of these data change the models currently being used? 4. Nonpackaged goods categories-How can models and analysis of trade promotions be conducted for durable goods and non-packaged goods products such as clothing, electronics, etc.? It is hoped that the model presented in this paper will serve as the beginning of future research in this area. 8
18This paper was received November 1984 and has been with the authors for 3 revisions.

References
Abrahim, Magid, and Leonard Lodish (1987), "PROMOTER: An Automated Promotion Evaluation System," Marketing Science, 6 (Spring), 101-123. Blattberg, Robert C., Gary Eppen and Joshua Lieberman (1981), "A Theoretical and Empirical Evaluation of Price Deals for Consumer Non-durables," Journal of Marketing, 45 (August), 116-129. Brown, Robert G. (1977), "A Model for Measuring the Influence of Promotion on Industry and Consumer Demand," Journal of Marketing Research, 10 (November), 38-0387.

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Chevalier, Michel and Ronald Curhan (1976), "Retailer Promotions as a Function of Trade Promotions: A Descriptive Analysis," Sloan Management Review, 18 (Fall), 19-32. Dolan, Robert J. (1987), "Quantity Discounts: Managerial Issues and Research Opportunities," Marketing Science, 6 (forthcoming). Frank, Ronald E. and William F. Massy (1965), "Market Segmentation and the Effectiveness of a Brands Price and Dealing Policies," Journal of Business, 38 (April), 186-200. Goodman, David A. and Kevin W. Moody (1970), "Determining Optimum Price Promotion Quantities," Journal of Marketing, 34 (October), 31-39. Kuehn, A. A. and A. C. Rohloff (1967), "Consumer Response to Promotions," Promotional Decisions Using Mathematical Models, P. J. Robinson (Ed.), Boston: Allyn and Bacon. Lal, Rajiv and Richard Staelin (1984), "An Approach for Developing an Optimal Quantity Discount Pricing Policy," Management Science, 30 (December), 1524-1539. Little, John D. C. (1966), "A Model of Adaptive Control of Promotional Spending," Operations Research, 14 (November-December), 1075-1097. Montgomery, David B. (1971), "Consumer CharacteristicsAssociated with Dealing: An Empirical Example," Journal of Marketing Research, 8 (February), 118-120. Webster, Frederick E., Jr. (1965), "The Deal Prone Consumer," Journal of Marketing Research, 2 (May), 186-189.