Wikipedia defines price undercutting as: ‘Price cutting, or undercutting, is a sales technique that reduces the retail prices to a level low enough to eliminate competition‘. It is obvious that price under-cutting happens mostly to boost volume sales. This article is about how undercutting works in the context of Indian FMCG.
Brief Overview of the supply-chain and the trade schemes
As mentioned in earlier posts, the typical distribution line for an FMCG product in your area looks like: Stockist -> Company Distributor -> Wholesaler -> Retailer Or Stockist -> Company Distributor -> Retailer. Typically, the distributor gets a margin of about 6-8% and the retailer gets a margin of 10-15%.
Just like the way the FMCG company brings out various promotions to the end consumer, the company also introduces various trade schemes or trade promotions as incentives for all the partners in the supply-chain. Typically, the incentives are based on the quantity of the volume purchased or the value purchased. There are many different types of incentives such as, but the major ones are:
1. Quantity Purchase Schemes (QPS)
A few examples are below:
a). Buy 25 pieces, get one piece free; 50 pieces, get 5 pieces free; 100 pieces, get 12 pieces free; 200 pieces, get 25 pieces free
b). Buy 25 pieces, get 1% discount; Buy 75 pieces, get 3.5% discount; Buy 150 pieces, Get 7.5% discount
2. Value Purchase Schemes (VPS)
Example: Buy Rs.5000 get 4% discount, Buy Rs.8000 get 7% discount, etc.
So, the formula seems simple: the more somebody buys a particular product the more the discount. Bargaining Power!
But, this is where the problem starts.
Undercutting by the Wholesaler
We shall walk through a common scenario of how undercutting happens. For simplicity of math, lets say, a product has an MRP of Rs.15, and the retailer gets it for Rs.13.50 and the distributor gets it for Rs.12.50. Lets say the wholesaler also is getting at Rs.13 as he typically buys more. So, simply just say the distributor margin is Rs.1, the retailer margin is Rs.1.5 and the wholesaler has a margin of Rs.0.50.
Lets say Mr. Lal Babu is a a very big wholesaler who caters to certain number of retailers locally. When the distributor goes to Mr. Lal Babu he says there is a new scheme. Lets say the scheme is: Buy 75 pieces, get 3.5% discount; Buy 150 pieces, Get 7.5% discount.
So, Mr. Lal Babu decides to buy 150 pieces. So, apart from his actual cost, he gets a bonus 7.5% discount. So, instead of buying the product at Rs.13, Mr. Lal Babu buys it at Rs.12 (7.5% discount over Rs.13). So, now instead of selling it to the retailer at the usual price of Rs.13.5, assume Mr. Lal Babu sells it to the retailer at Rs.12.50, taking his usual margin. The company distributor is selling the same product at Rs.13.5 to the retailer. So, you see what the problem is?
The retailer would be attracted to buy from Mr. Lal Babu as he gets more margin compared to the company distributor. One might think it is only Rs.1, but when they buy a couple of cases, it translates into good savings for the retailer.
Is undercutting only relevant to wholesale?
The answer is No. The philosophy of under-cutting is the same, but it can be done by anybody in the supply chain. So, the salesman himself, in order to reach his target, can make this happen. He makes an invoice against one such large wholesaler Mr. Lal Babu and he passes the benefits to his retailer. But, this is going to be a problem in future for the salesman, as the retailer will get used to these benefits and he stops buying in normal situation. In a way, the brand or the particular product starts to become more driven by the wholesalers.
Various channel partners do under-cutting to boost volumes at his/her own level. Territory Sales Officers who will be in-charge of certain stockists too sometimes bill it against a certain stockist ABC, but he actually sells it to a big wholesaler. The distributor too can have his own share of price undercutting to attract the retailer.
Undercutting is a very common phenomena in the field. Though FMCG companies have various strict mechanisms to curb them, new loopholes are invented continuously to take advantage and undercut. After all, price matters to everybody.