A wide variety of industries have production lines that produce multiple outputs at the same time. In some cases, these outputs serve different purposes, such as chemical processes, oil refining, and so on. Production outputs can also serve the same basic purpose, where quality levels may differ as a result of quantity being more important than quality. Microprocessors that differ in speed or light emitting diodes that differ in luminescence are two such examples.

With vertically-differentiated products (i.e., the microprocessor and light emitting diode examples), production often follows a spectrum of lower quality to higher quality. In this regard, the manufacturer sorts and classifies the output into grades. Pricing, production, and product-line design are the primary strategic decisions for vertical co-product manufacturers. Additionally, manufacturers often use an indirect channel to sell their products. More specifically, they wholesale co-products to self-interested distributors who then sell them to end consumers.

If a firm decides to adopt an indirect channel strategy, then it is vital that it understands the possible ways in which this might influence its product line and channel profits. Researchers Tao Lu, Ying-Ju Chen, Brian Tomlin, and Yimin Wang explain, “when selling through an indirect channel, the manufacturer needs to take into account the self-interested distributor’s purchasing and retail-pricing strategies in designing its product line, setting wholesale prices, and choosing a production quantity.” Double marginalization in the indirect channel may ultimately have an impact on the product line design. The question is, will the manufacturer offer more or fewer products, and to what extent will the quality of these products change?

To investigate this matter further, the researchers analysed a manufacturer distribution model in which a co-product manufacturer sells its products via a distributor. This involves the manufacturer having the ability to determine its product line, quantity, and wholesale prices to charge the distributor. Next, the model allows the distributor to choose its purchase quantities and retail prices to charge quality-sensitive customers. Additionally, the researches looked into how production quantity and product line design via an indirect channel compares to the optimal quantity and line decisions of a manufacturer when selling directly to end consumers.

“Two key metrics in product line design are the number of products in the line and the difference in qualities between the highest and lowest quality products. We refer to these two metrics as the size and length of the product line respectively”, the researchers explain.

Within this framework, their findings revealed that when selling co-products directly to a distributor, the manufacturer should decrease the size and length of its product line. In terms of an independent product setting, qualities can be adjusted without affecting the quantities made available. However, this not true for co-products, as these quantities are constrained by the output quality distribution and overall quantity produced. More specifically, the manufacturer would be unable to increase the product line length while maintaining the same quantity for each profitable market segment. Hence, in response to the lower profit margin in the indirect channel, a manufacturer should reduce its initial production quantity and increase the quality of its lowest grade, which would decrease the product line length.

“Additionally, we show that there exists a theoretical contract, combining revenue sharing and reverse slotting fees, that can eliminate the indirect channel distortions in both product line design and output quantities”, they add.