Trade spend effectiveness – It’s easy to get in through the back, but hard to get out through the front

Recently, I attended a conference on investing in food and nutrition companies at the University Club. One of the panelists dropped the statement above. It was catchy so I dwelt on it for a while on the train ride back home. I wanted to share my notes.

Trade spend is a blanket term for all cash or equivalent outlay that companies devote to promote their products at a point of purchase. Examples include price reductions, free product/trial and coupons. Trade spend is supposed to stimulate trial and drive post-promotion volume growth at full profit margin. A simple way to measure ROI for trade spend is:

ROI = (Incremental Volume * Contribution Margin – Promotional Cost) / Promotional Cost

ROI for trade spend is particularly important for small food companies. Due to lack of concrete historical data, buyers often offer shelf space to young companies based on potential e.g., an exciting new super food, a charismatic founder’s story etc. However, buyers usually impose mandatory trade spend on these companies. Spending can be as high as 25% of revenue. Ecstatic entrepreneurs often forget that competitors on the same shelf are also required to invest in promotions. They also forget that promotions are merely a catalyst for future high volume growth at full profit. Numbers ruin a good story. As data accumulates, buyers quietly replace products that don’t meet volume thresholds with new products whose owners have fresh cash to spend on trade.

Before committing to promotions, young companies should focus on a few key things to better position themselves to win.

  • Clear Value Proposition – Companies with a strong value proposition are better able to identify relevant customer segments for their products. They also have clearer frameworks for pricing and value. Additionally, they are better positioned to develop compelling marketing materials that resonate with customers and drive engagement. A strong value proposition also allows companies to test products on different potential customer segments, collect more data and improve their offering.
  • Customer Knowledge – Grocery aisles are chaotic. Products are similar and are perpetually on promotion. Brands that can occupy customers’ mind share prior to a store visit have a higher chance of winning. Data gathering is the driver for customer knowledge. Here’s an example: a tart cherry juice company in our portfolio was initially positioned as a recovery product for high-intensity athletes. However, as we gathered more data, we discovered that baby boomers seeking relief from joint pain were also a major customer segment. We adjusted our strategy accordingly.
  • Tracking and Adjusting – Companies must also develop tactical mechanisms and processes to test, track and measure ROI for different types of trade promotion. Promotions have to match preferences and habits of the customer segment, geography etc. After testing, promotions that don’t generate positive ROI must be dropped.

My initial takeaway from the panelist was that brands that don’t satisfy buyers’ volume thresholds will lose shelf space. A profounder takeaway was that companies without robust strategic and competitive processes to maximize return on trade spend will fail.

Operating leverage – Benefits are for closers, the rest get slaughtered

Back in the day when analysts were still getting paid in investment banking, a friend decided to “invest” in a $80,000 Porsche. His reason was to “use this baby to woo and close on a wife asap then hopefully afford car payments on a dual income.” Those who know me well also know how I sometimes believe that everyone is entitled to my opinion. So, I offered my friend a lesson on operating leverage that I will revisit today.

Operating leverage is the degree to which a business has fixed costs. Let’s consider two companies with $500 of fixed production overhead. Assuming that pricing and contribution margin are held constant, the business with lower revenue will have higher operating leverage. The table below illustrates the concept. As units sold increase, fixed and total cost per unit drop, but dollar savings progressively become smaller.

 Operating leverage chart1

There is a catch. Companies still need to work diligently in order to unlock operating leverage, e.g., through:

  • Revenue growth – My friend’s ultimate goal/revenue was to find a wife so I urged him to go, with his car, to as many dates as possible to maximize the number of potential candidates/units reached/sold (not as comparable really). We also discussed possibly renting out the car during downtime or Ubering on the way to dates. Companies with high fixed costs have to quickly cover them by growing revenue e.g., through finding new customers, applications and/or related revenue streams.
  • Margin expansion – We also considered using non-premium gas for the car and having some dates at cheap restaurants. Companies can increase price and/or decrease cost. However, as we have learned, increasing contribution margin ain’t easy.
  • Capacity utilization – I also suggested that my friend drive his car to as many dates as possible even for candidates that didn’t satisfy his marriage profile, but potentially provided other value e.g., great conversation. Companies call this private label. Unfortunately, private label is often low-margin and might require additional investment in order to meet different customers’ specifications. Furthermore, companies need to unlock additional capacity to accommodate private label orders that are usually lumpy and unplanned.

My friend succeeded in his mission, but in reality, the car turned out to be serious overkill.  Most dates decided on an encore based on substance of the discussion and experience. By the time the car was retrieved from six blocks away, they were too tired to notice. If he hadn’t succeeded quickly enough, his car and rent payments would have sunk him and he would have been forever a sad bachelor.

Some entrepreneurs I speak to tout several benefits of in-house manufacturing, which include; independence from contract manufacturers, flexible production and inventory planning, ability to customize and produce different Skus e.g., seasonal products, branding reasons e.g., supply chain control. In my view, when put into perspective, these benefits often aren’t “must-haves” for smaller companies. Fixed costs hog cash, increase pressure to “grow now”, reduce nimbleness and can generate negative retained earnings. I encourage companies to avoid piling up fixed costs before investigating cheaper (maybe not as convenient) alternatives.