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Volume 16, Number 2
February 2010

Behind the label

Should a product be branded by the manufacturer or the retailer? Shih-Fen Chen’s research gives the answer.

Go into a drugstore for a headache remedy, and the pharmacist might direct you to a store brand medication. It costs less than Tylenol, your pharmacist might say, but has the same active ingredients.

Many retailers put private labels or store names on products made by manufacturers who have their own brands. This is referred to as “private branding,” and is a growing practice. Why would a manufacturer who enjoys strong consumer loyalty give up its right to brand a product? And why would a retailer create its own unknown brand, when it can benefit from the reputation of the manufacturer?

Ivey Professor Shih-Fen Chen studies the allocation of branding rights between parties who work together to deliver a product to consumers. In a recent study he looked at the growing trend to private labels and asked the question: who should brand the product, the manufacturer or the retailer?

Researchers examining this trend have offered various theories. One theory explains private branding as an adversarial process in which the retailer grabs more market power from the manufacturer. Another suggests that the manufacturer uses private branding as a way of market segmentation.

Chen rejects both theories. The power explanation may have some validity in the short term, he believes, but creates conflict and reduces efficiencies over time. It also doesn’t explain why large manufacturers sometimes supply products under private labels to small retailers. The segmentation theory also breaks down under scrutiny. Many manufacturers have multiple brands, and can easily introduce a secondary brand targeted at a different market segment.

When Chen looked closely at the practice he came up with a unique theory. “Private branding can be an effective way to limit conflict between the manufacturer and retailer, and reduce the transaction cost between the two parties,” he says.

Retailers often play a key role in marketing a product to the consumer, either through advertising or in-store promotion. When a retailer markets a product under the manufacturer’s brand, the reputation of the manufacturer may gain or lose. If a promotion is successful, the manufacturer might abuse its newly gained reputation by raising the wholesale price, putting the retailer’s investment in jeopardy. But if the retailer over-promotes a product with excessive price cuts, the brand image of the manufacturer might suffer. As a result, the manufacturer has to monitor the operation of the retailer. In both cases, the two parties must incur extra transaction costs to deal with each other. “Private branding becomes a solution to this problem.” says Chen.

Chen’s theory is illustrated by the example of a drug store. Many over-the-counter drugs are sold under private labels, but prescription drugs are usually sold under the manufacturer’s brand. Chen’s theory explains why. When a consumer fills a prescription, the doctor decides what drug to buy and the store pharmacist cannot influence the purchase decision. But when it comes to over-the-counter drugs, consumers often take the advice of the store pharmacist. As a result the maker of a prescription drug needs to appeal to the doctor only, whereas the maker of an over-the-counter drug must monitor store operations. “The retailer has a lot of power to affect the success or failure of an over-the-counter drug,” says Chen. “That’s why we see so many private labels in over-the-counter drugs, but not in prescription drugs.”

Chen tested his theory in a recent study about to be published in Strategic Management Journal. He gathered data from a 2,000-store U.S. retail chain, with 70 percent of its sales coming from 40 private labels. His findings were clear: the retail chain invested more in the advertising and promotion of privately branded products than those branded by the manufacturer. “The empirical data fit my theory beautifully,” he says.

Chen’s research has important implications for managers. Many manufacturers resist the idea of private branding. But resistance to a private label can lead to conflict with the retailer if the product depends on retail advertising and promotion. “Private branding is not a practice used by retailers to grab more market power, but one that enhances the collective efficiency of the two parties,” he says.

For retailers, there is a danger in trying to extend private labels to as many products as possible. While private branding saves on transaction costs, the practice may in some cases reduce the incentive of manufacturers to optimize the quality of the product.

Chen proposes a simple test to decide who is best to brand a product. If the retailer contributes more to the success of the product than the manufacturer, the branding rights should go to the retailer. But if the manufacturer contributes more to the success of the product, the branding rights should go to the manufacturer. “Branding rights should be assigned in a way that aligns the incentives of the parties,” he says. “This reduces the transaction cost and enhances efficiencies for the benefit of the consumer.”

 

Professor Chen's Homepage