When consumer goods manufacturers set out to improve their efficiency, they usually start with marketing and production. Trade spending—the payments they make to retailers in hopes of encouraging promotion—is almost always overlooked. Yet for improving the profitability of a consumer goods manufacturer, this is among the most important levers, up there with pricing, media spending, production costs, and distribution. Indeed, McKinsey has found that proper management of trade spending can increase a company’s return on sales by two percentage points.

In consumer goods, "trade spending" means all of a manufacturer’s cash payments to grocery retailers beyond "terms and conditions," such as bonuses, discounts, and advertising allowances. One example of trade spending is the central-warehouse discount; another is the second-placement fee. In all, these payments account for up to 30 percent of the costs of a typical consumer goods manufacturer (Exhibit 1).

Such is the power of retailers that an absolute reduction in trade spending is hardly realistic. Competition for limited shelf space is intensifying, particularly in center-city grocery outlets with 600 to 800 square meters of selling space. More intense pressure from private labels is also weakening the position of manufacturers. In addition, more and more of them are turning away from media spending for product launches and toward trade-related activities (such as free sampling) that often raise trade spending.

These higher levels of trade spending have shifted profits from manufacturers to retailers: in 1992, consumer goods producers in the United Kingdom collected about 48 percent of the total industry profit pool; by 1997, their share had fallen to 44 percent. During that period, the retailers’ share grew to 49 percent, from 42 percent. The same trend can be observed in the rest of Europe.

In many cases, only about half of the total payment a manufacturer makes to grocery retailers earns something definite, such as shelf space, in return. The rest of these payments are hidden price concessions. Although most manufacturers know this, the retailers’ power compels them to pay up. But the high degree of variation among individual accounts in the structure of trade spending shows that manufacturers can at least increase the part of it that adds value for them (Exhibit 2).

To do so, however, a manufacturer must ascertain the profitability of each account by instituting a system of account-specific profit-and-loss statements. Many consumer goods manufacturers don’t use them at all; others don’t use them sufficiently; and still others don’t perform complete calculations for them. Yet the detailed knowledge of accounts they can provide reveals the effectiveness of individual profit levers (for instance, the promotion mix) and indicates which are most likely to increase the part of trade spending that adds value for manufacturers instead of serving as a disguised price concession.

In fact, price concessions don’t always suit the best interests of either manufacturers or retailers. The additional sales volume that a whisky manufacturer, for example, generated by increasing the level of the price concessions it gave retailers to 30 percent, from 10 percent, was minimal. Both sides would have benefited more from a different use of those funds.

Agreements on prices and promotional spending are worthwhile alternatives. Manufacturers entering into the former should insist that price concessions benefit consumers instead of vanishing into the retailer’s coffers. As for promotion, the impact of different measures on sales volumes varies considerably, so a separate P&L statement is needed to verify that the terms of such agreements are being honored.

Price agreements and promotional spending tend to be more effective when they are tailored to an account’s specifics. Moreover, it is possible to achieve higher profits in the short term, but they are not likely to be sustained without long-term investments to build skills in sales and key-account management.