How to apply subsidies

Vouchers (version 2)When designing a new product such as a diarrhoea treatment kit for low income countries, affordability is a key issue.

The best outcome from the product design process is an affordable product that needs no subsidy. However, this is often not achievable as was the case in the trial phase of the ColaLife initiative in Zambia. The cost of production is too high if the product is unaffordable for your customers after the product has gone through the value chain and all the players in that value chain have taken their profit.

Costs of production are likely to be higher at the outset with a new product due, for example, to the lower levels of production at the start. If you are faced with a situation where the ex-factory price of the product is too high, a judgement needs to be made about whether to proceed or not. If you believe that, in the medium term, through economies of scale, the cost of production can be brought down to a level that will be profitable then you should proceed. If this isn’t the case, then the product design needs to be revisited to further reduce costs before proceeding.

If you judge that a higher than optimum cost of production is a short term issue that will be resolved through economies of scale once the volumes increase then you will need to subsidise the product initially to ensure the product is affordable from the outset to your customers.

If a subsidy is to be used then it is absolutely crucial to success where and how this subsidy is applied.

What level subsidy is needed?
Firstly, establish willingness to pay of your target group. Then, work up the value chain towards the manufacturer, plugging in typical mark-ups for a similar product that ‘willing value chain participants’ (retailers, wholesalers, distributors), would expect. Are you left with enough value for a manufacturer to produce a product with a viable ex-factory price? If not, then an initial subsidy may be required.

How to subsidise
Option 1:
The way subsidy is applied is absolutely crucial. A subsidy applied somewhere along the value chain, giving the product free to wholesalers for example, will create a fake value chain which is unlikely to survive when the subsidy is removed. The subsidy must be applied at the ‘top’ of the value chain to reduce the ex-factory price. This ensures that the price points along the value chain are established from the outset and that the subsidy is invisible to everyone except the manufacturer. Once the product is established and volumes increase, the manufacturer will need to work to reduce the costs of production and thereby eliminate the subsidy. The way that we did this in our case is described here: How the ColaLife trial findings have influenced the design of Kit Yamoyo. Applying a subsidy in this way and then eliminating it will not disturb the precious value chain.

To reiterate, never subsidise anywhere along the value chain. A mid-value chain subsidy will create a ‘false’ or distorted value chain which you may not be able to re-establish when the subsidy is removed. For example, if you were to subsidise wholesalers so that they could sell the product more cheaply, or even give it away, the value chain would be changed significantly when the subsidy was taken away and retailers would have to pay more for the product – which they may or may not be willing to do – and they would have to pass these additional costs on to the caregiver which may make the product unaffordable.

The value chain is what ensures caregivers get an affordable product in their shop that they can buy. So it is absolutely crucial. If it is changed when a subsidy is removed it is likely to break and given that it is the value chain that drives the distribution of the product, the product will become unavailable.

Option 2:
A second subsidy option that will not destroy the value chain is the use of vouchers. These can be given to caregivers during an introductory period, to encourage their first purchase, or as part of a marketing drive. The voucher value is normally less than the retail price to encourage some cash contribution from the customer. Using vouchers in this way will actually strengthen the value chain as they increase product demand. Vouchers can also be used to ‘pump-prime’ a newly established value chain.

Who provides the subsidy?
In our case the initial subsidy was provided by the donors supporting the scale-up. If no donors are involved then the subsidy will have to come from the manufacturer and/or their investors.