During the past few years, private label goods have enjoyed steady growth in an increasing number of food and non-food categories. Many suppliers outside the ranks of the first-tier branders have exploited this growth to achieve significant volumes. Conversely, the share and price premium of traditional brand leaders has been eroded. Many of them are now faced, as Exhibit 1 suggests, with a crucial strategic issue: should they—or should they not—begin to produce private label products themselves for their large trade clients?

However pressing now, this issue can only intensify during the next few years. Leading producers of fast-moving consumer products will be unable to avoid it; they will have to make a choice. How can they best weigh up all the facets of the question? And how can they look beyond short-term considerations of marginal cost and marginal volume, reject simplistic gaming behavior ("if we don't do it, our competitors will"), and make a reliable decision based on a long-term vision of product category evolution?

Here, we lay out an approach, based on a McKinsey study of private label experience in Europe, that may help brand leaders frame the private label dilemma as it applies to their individual businesses. Because the choice is so complex and depends on so many different factors, the right decision will vary from situation to situation. In a future article, we will describe a tested, step-by-step process for actually making that choice. In this first discussion, however, we concentrate on getting it into proper focus—and on making clear the key factors on which it depends.

A strategy in gray

Whenever a brand leader faces the private label issue, there are strong arguments in favor of going ahead:

• Private label represents a large (and usually growing) market segment
• Economies of scale at each step in the business system (manufacturing capacity, distribution, merchandising, and so on) justify the search for additional volume
• Supplying private label will improve relationships with a powerful organized trade
• Control over technology and raw materials reduces the risk
• There is a clear consumer segmentation between branded and unbranded goods that supports providing private label
• Private label helps to eliminate small, local competitors Private label offers an opportunity to compete on price against other branded products
• Private label increases share of shelf space—a critical factor in motivating impulse purchases.
• But there are also strong arguments against:
• Market share growth through private label supply always happens at the expense of profitability, as price sensitivity rises and margins fall
• Disclosing cost information to the trade—usually essential for a private label supplier—can threaten a firm's branded products
• In order to displace existing private label suppliers, new entrants have to undercut current prices, and thus risk starting a price war—in an environment where trade loyalty offers little protection
• In young, growing markets, it is the brand leaders, not the private label suppliers, that influence whether the market will develop toward branded or commodity goods
• Private label is inconsistent with a leader's global brand and product strategy—it raises questions about quality standards, dilutes management attention, and affects consumers' perception of the main branded business.

The private label decision is not a simple either/or choice; no single, generic private label strategy exists. There are many nuances and many variations

Faced with these arguments, manufacturers commonly take a "black or white" approach. Either they never produce private label, or they always do. As Exhibit 2 suggests, however, the private label decision is not a simple either/or choice; no single, generic private label strategy exists. There are many nuances and many variations. The strategic ground is neither black nor white, but gray.

Understanding private label

Evidence suggests that private label will continue to grow. To date, it has achieved a significant level of penetration in some countries, but remains marginal in others (Exhibit 3).

As both the grocery trade and consumers become more sophisticated, private label's market share in these countries is likely to reach those in the United Kingdom and Germany (Exhibit 4).

Even in countries where private label has already achieved a respectable level of penetration, further growth is likely. The dynamics of market development follow a reasonably predictable course. Exhibit 5 and Exhibit 6 describe this general pattern of evolution.

Today, different product markets in different countries are, obviously, at different stages of evolutionary development. But they are all moving in the same general direction—driven, in part, by the self-interest of retailers, which view private label as a strong contributor to profitability, as measured in terms of return on sales (Exhibit 7).

Nevertheless, as Exhibit 8 indicates, the level of penetration by private label will continue to vary by country and product category. This reflects underlying variations in both consumer perception and the behavior of leading branders.

Variations in consumer perception reflect an underlying segmentation of consumer attitudes toward private label purchases

These variations in consumer perception reflect, in turn, an underlying segmentation of consumer attitudes toward private label purchases (Exhibit 9 and Exhibit 10).

And, as Exhibit 11 and Exhibit 12 illustrate, this pervasive segmentation of attitude implies that some product categories offer considerably more potential for private label than others.

From the manufacturer's viewpoint, similarly, some product categories are intrinsically more attractive candidates for private label than others. For example, categories with higher levels of product innovation tend to have a lower level of private label penetration (Exhibit 13).

So, in general, do categories that require significant investments in brand support (Exhibit 14).

Where such investments lead to unusually high prices for branded goods, penetration of private label is likely to be higher, since—as Exhibit 15 and Exhibit 16 indicate—price differentials are often the basis of private label's appeal.

In summary, then, there is a reasonably common set of factors that explains why some categories and countries have higher levels of private label penetration than others (Exhibit 17).

Although some of these factors are difficult for the manufacturers of fast-moving branded foods to affect, others lie well within their—and especially a brand leader's—range of control (Exhibit 18).

For individual retailers, private label's appeal will depend on what it might contribute to—and how it might "fit" with—their distinctive strategies (Exhibit 19).

Such strategies are shaped by differences not only in the objectives of individual retailers, but also in manufacturers' behavior, consumer perception, and the extent of trade development in each country. Within their different strategies, retailers continue to search for the best way to manage private label marketing. Four common approaches can be distinguished, as Exhibit 20 indicates.

Basic beliefs

Whatever their ultimate resolution of the private label dilemma, leading producers of branded goods should approach the decision with this simple set of experience-based beliefs in mind:

• For new entrants, private label may be the only way to gain access to a new market; for followers or marginal players, the sole means of survival in the face of increasing competition and trade pressure. For most leaders, however, private label is a real threat to market share and profitability in the medium and long term. Some limited opportunity may exist, but only in specific situations where:
  • The branded segment is securely protected both from competitors and from cannibalization by private label
  • New needs emerge that cannot be satisfied via existing leading brands
  • There are high entry barriers.
• Private label is not a new segment; it does not create innovative products that generate new users and new occasions of consumption. Rather, it represents a "me-too" brand or set of brands that grow only at the expense of others. Total market volume may well increase in the short term, but on a longer view the risks are real. Though the threat of cannibalization is greater for followers and marginal players, it can also be significant for a leader's branded business, causing:
  • Deterioration of relative price position
  • Decrease in share of shelf space
  • Growth in both the number and the weighted distribution of competitors' private label products.
• Private label development is likely to lower overall category profitability, especially for leading manufacturers. In fact, the marginal profits from private label usually do not compensate for the losses from declining sales, lower unit prices, and reduced margins in the branded business.