Navigating Markups and Cost Pass-through: What Business Leaders Need to Know

Understanding how costs are passed through along the supply chain is critical for business professionals who want to effectively navigate inflationary pressures and pricing strategies. In the working paper “Markups and Cost Pass-through Along the Supply Chain”, members of the D^3 Pricing Lab Santiago E. Alvarez Santiago Ernesto Alvarez-Blaser , Alberto Cavallo Alberto Cavallo , and Paolo Mengano Paolo Mengano , along with Professor Alexander MacKay of the University of Virginia, provide a comprehensive analysis of the relationship between production costs, markups, and pricing strategies along the supply chain. Based on data from a global manufacturer, their research offers valuable insights into how different parts of the supply chain—manufacturers and retailers—adjust their prices in response to cost changes. The findings are relevant to businesses looking to understand pricing behavior in a world where cost shocks and inflation can significantly impact profitability and consumer prices.

Key Insight: Stable Markups Despite Cost Shocks

“In the US, total markups were stable from June 2018 through June 2023, covering the pandemic and the recent inflationary period.” [1]

• Retail prices rose during the inflationary period, yet the main driver of these increases was production cost changes, not markup inflation.
• Manufacturer and retailer markups tend to move in opposite directions. For example, when retail markups increase, manufacturer markups often decline.
• Despite the individual fluctuations in markup levels at different stages of the supply chain, overall markups stayed stable across the board.

For business leaders, this finding underscores the importance of managing production costs effectively while recognizing that markup increases may not always be feasible or sustainable during inflationary periods.

Key Insight: Different Reactions to Cost Shocks

“The manufacturer adjusts prices rapidly, typically achieving complete pass-through within two months for aggregate shocks and instantaneously for product-specific shocks. Retailers, on the other hand, adjust prices more gradually, achieving complete cost pass-through within five months for aggregate shocks and passing through only partially idiosyncratic shocks.” [2]

• Manufacturers typically achieve full cost pass-through within two months for large, aggregate cost shocks.
• Retailers, however, are slower to adjust their prices in response to both aggregate and idiosyncratic cost changes, with full pass-through often taking five to six months.
• Idiosyncratic cost shocks, which affect specific products, tend to be absorbed more by retailers than manufacturers.

Understanding these dynamics is crucial for executives tasked with managing price strategies. They can better predict when cost changes will affect consumer prices and strategize around their competitive pricing accordingly.

Key Insight: Retailers Absorb More Costs for High-Quality Products

“The manufacturer sets higher dollar margins and markups for higher-quality products. Retailers on the other hand apply a uniform dollar margin across all products within a category.” [3]

• Retailers tend to apply the same margin across products, regardless of quality, resulting in lower markups for high-end products.
• Manufacturers increase markups for higher-quality products, capturing more of the value consumers place on these premium items.
• This suggests that pricing strategies should vary depending on product quality, especially when aligning manufacturer and retailer interests.

For business professionals, this insight highlights the importance of understanding how product quality affects pricing decisions along the supply chain and leveraging this understanding to optimize product portfolios.

Key Insight: Retailers Delay Pass-Through of Unexpected Cost Shocks

“The cost pass-through of production costs to retail prices is greater for expected costs relative to unexpected costs.” [4]

• Retailers tend to take longer to pass through unexpected costs, likely due to their desire to avoid sudden price increases for consumers.
• For aggregate costs, expected shocks hit retail prices almost immediately and arrive at full pass-through within two months while unexpected shocks achieve pass-through completion after five months.
• Manufacturers, by contrast, respond more quickly to both types of cost shocks.

This finding is significant for business leaders who must plan for both predictable and unpredictable cost increases. By preparing for a slower response to unexpected costs, businesses can better manage consumer pricing and market expectations.

Key Insight: International Differences in Markup Strategies

“In Canada, similarly to the US, the manufacturer has higher markups, whereas in Mexico and the United Kingdom retailers have larger markups.” [5]

In the US and Canada, manufacturers tend to have higher markups than retailers, while in the UK and Mexico, it’s the converse, retailers show larger markups. These regional differences point to the need for businesses to adapt their strategies depending on market conditions and local supply chain dynamics. For global businesses, understanding regional differences in cost pass-through and markup strategies can provide a competitive edge in managing global supply chains effectively.

Why This Matters

The insights from “Markups and Cost Pass-through Along the Supply Chain” are crucial for business professionals tasked with pricing, cost management, and profitability. By understanding how costs are passed through the supply chain, businesses can make more informed decisions regarding pricing strategies, especially during periods of inflation or cost volatility. The findings also highlight the importance of managing expectations around product quality, regional market dynamics, and the timing of cost shocks. For executives, this knowledge is essential in setting long-term strategies that can balance profitability with competitive pricing, particularly in an environment where cost shocks are increasingly common.

References

[1] Santiago Alvarez, et al., “Markups and Cost Pass-through Along the Supply Chain”, Harvard Business School Working Paper No. 25-009, (August 2024): 1-38, 1.
[2] Alvarez, et al., “Markups and Cost Pass-through Along the Supply Chain”, 2. 
[3] Alvarez, et al., “Markups and Cost Pass-through Along the Supply Chain”, 2.
[4] Alvarez, et al., “Markups and Cost Pass-through Along the Supply Chain”, 2. 
[5] Alvarez, et al., “Markups and Cost Pass-through Along the Supply Chain”, 3.

Meet the Authors

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