Outsourcing in Place: Should a Retailer Sell its Store-Brand Factory?

Abstract

Several major grocery chains in the US own factories that produce some of their store-brand products. Historically, these store-brand products have been the low-price, lower-quality alternatives to higher-priced national brands, but the quality and consumer acceptance of store brands have increased markedly in recent years. While demand for store-brand products is higher, managing the associated factories can be costly for retailers, leading some to consider selling the factories to third parties.We study the impact of selling a retailer's existing capacity-limited factory to a third party when a store-brand product competes with a similar national-brand product. We examine the equilibrium dynamics between two external suppliers and show how the outcome changes with respect to prices, capacity limitations, the distribution of profits, and the sequencing of pricing decisions. Among other things, we show that, surprisingly, the national brand's equilibrium wholesale price may fall when the factory is sold. We also show that the retailer may be strictly better off if he sells the factory, with these benefits being above and beyond any savings in fixed ownership and operating costs. Taken together, these results imply that when the store-brand factory has tight capacity, the adverse effects due to double marginalization on the store-brand product from selling the factory to a third party may be partially or fully offset by a reduction in the national brand's wholesale price.