Monday, September 17, 2012

Dieter Brandes on pricing & planning at ALDI


Dieter Brandes was, over many years, a top manager at Aldi, Germany´s biggest and most successful supermarket retailer. He has written several bestselling books on leadership and management at Aldi, "consistently simple management" and better ways of controlling a business. Mr. Brandes is now a freelance consultant. Aldi, the company Mr. Brandes derives most of his advice from, has never used a budget and can be considered one of the most successful retail companies in the world. The company´s results have been outstanding, over decades.

Here's a discussion I had with him over E-mail , the document went back and for so it might be a bit difficult to read. Questions are welcome.

Dear Mr. Brandes,
Thank your for your time just now on the telephone.

A few years ago I contacted you via E-mail and asked you how ALDI calculates it’s selling prices.

Brandes „ Selling prices at ALDI are never based on a calculation.

Your answer was roughly: „ALDI has a 2 step method: First determine the lowest possible selling price. Then step two, see if you can lower the price even more.“

Brandes: „A third or actual first step is beating the direct competition’s price, because it looks good, to go as deep as possible compared to them, preferably 50% lower or even more.

That’s well put, but not a very clear guideline. Exactly how do you calculate what „as deep as possible „ is ? It has to add up. As you wrote "Marketprices just can’t be ignored. There are many retailers who in the past have used incorrect methods, calculations and ineffective cost allocations which have led them to price themselves out of the market and as a consequence out of business.“ (Dieter Brandes, Konsequent Einfach: Die ALDI Erfolgsstory, p. 156).

The normal non-food planning and evaluation method, which is based on the company achieving a gross margin % target, is in my opion, an example of an incorrect method and cost allocation. The founder of IKEA, Ingvar Kamprad, also described the limitations of the usual retail planning method: "Our pricing policy is fundamental. The stumbling block is when we price ourselves out of the market. Our economists constantly go on that we must keep our “total gross profit margin” to a certain percentage. I say to the economists, “What the hell is ‘percentage’ anyhow? ...after having been the subject of endless bickering for over a decade, in this respect we are beginning to wake up with a vengeance. That pleases me enormously."

Brandes: “Aldi has something like that - a rough guideline that results in a total gross profit margin, today roughly 15%, but this has absolutely nothing to do with the margin percentage of individual items. Sugar and milk are always very low.

But isn’t the “total gross margin” the average of the individual article. Isn’t that a link ?

Brandes: “ That’s correct. The total is that of the whole company and can be found in the “income statement”. Simply remember the following ( here in abbreviated form): You operate a particular business with a specific business model. In retail the major determining factor is your range. If that is clear, then you buy the right items that fit your business model as cheaply as possible and sell them at a price that matches your business model. This all happens on an existing space, which you cannot change. So what is the problem with margins, etc? I do not understand it. And that goes for food and textiles as well as for a car salesman.

Let me try to explain the problem of using a gross margin % target.

Existing retail planning methods using a sales and an average gross margin percentage target constantly lead to suboptimal decision making by buyers and merchandisers.

Brandes: “I recommend the following: do not see this margin percentage as a target, but as the actual current margin percentage of the last month or last year. At that margin we have made a good profit. If we could maintain this margin at the current level that would be good. We have the current buying prices and selling prices and a carefully chosen product mix with resulting sales. In practice, this is a relatively stable situation and changes are small. Perhaps there are more changes in the fashion sector, where the latest rage, seasons and buying in lots may play a role.

For example; a company has a gross margin target of 40% and costs are 35% of turnover.

Brandes: “In my opinion, this 35% is only the sum of costs on my income statement. It has (in principle) no other meaning or use in planning for individual items. When I would be generating 40% gross profit, I’d end up with a profit of 5%. That would be very good for a supermarket.

If a certain product sells better than expected and has a margin of 30% this has to be compensated to reach the 40% gross margin target.

Brandes: “NO. If this product sells very well - or sales are achieved in addition to ordinary sales, then the total sales revenue increases as well as the absolute margin in dollars. The gross margin percentage will dip slightly, and most probably the selling (SGA) costs as a percentage of sales will decline. So maybe 39% gross margin and 34% costs.

The decision might be to raise the price, to promote other products with margins above 40%, or to even stop selling the product.

Brandes: "Stop selling 'because the product makes a good turnover??? Increase the price only to meet a "target margin percentage" of 40%? That just can not be serious, can it ?”

The underlying assumption when using an average gross margin target is that products sold at a lower margin percentage than the average cost as a percentage of sales are not profitable.

But products with low gross margins can be very profitable if their selling price is higher and/or number of units sold is higher than comparable products.

Brandes: “All this has nothing to do with "comparable products" to make or with the level of "selling prices".
Products with below average gross margin percentages often increase the store's net profit margin (ie. Bottom line profit).

Brandes:” This can be true.
The costs are mainly the amount of space used and handling time for a certain product, not a fixed percentage of the selling price.

Brandes: “This is correct in principle. But in practice one can forget the costs of space and handling. It makes no sense to calculate and allocate these costs for all 10,000 products. If someone really wants to do some sums, then I suggest marginal costing and revenue.

Retail planning should be based on gross margin income in $ (per sq. meter) without an average gross margin % target.

Brandes: “Completely agree, especially if you’d please also omit the sq. meters.

Below I give a simple example of two identical stores that both sell 1 type of coat.
Joseph’s store sell’s coats with a low gross margin percentage and makes a profit. Voss’s store sells expensive coats with a gross margin percentage and is losing money. If you were to put the income statements of the stores together, than you would conclude (using the standard gross margin % paradigm) that Voss’s coats were somehow profitable.
Brandes: „We shall soon see, whether that is true.

This is followed by a simple method which will measure the coats actual contribution to bottom line profit.
Brandes: „Never contribution to profit, but only the contribution to the total margin in euros.

My question is, how would an ALDI buyer / merchandiser view this ? Which calculation would he or she make to QUANTIFY which coat contributes to the bottom line profit and which might be adjusted in price. How would you yourself decide which articles with a low gross margin percentage are profitable and which articles with a high gross margin % are loss makers?

Brandes: ”Such considerations are never employed. Also, it does not matter what an article contributes. The only question is: what must be in the range and what price should I set, so that it is highly interesting for the customers.”

See the following article

An unconventional idea and the unconventional management accounting behind it.

From the book Vier Generaties Snekerkring : "The year 1906...every clothing store in Amsterdam, including C&A, was targeting just 4% of the population. The remaining 96 per cent could not afford to buy from them. If you could include those 96% in your target group, you could cut your profit mark-up dramatically.

Even with a much lower margin, the far greater volume of sales would still boost the
bottom-line profit!

So it happened that C&A started offering coats of reasonable quality for no more than six guilders. ... It was a knock-out success. From day one the coats flew out the window.

Joseph was making a lot of money in his store. He even drove his nextdoor neighbour Voss out of business. The two stores, that were equally big, merged. When the profit and loss
statements were consolidated it suddenly seemed like the coats sold by Voss were more
profitable and the coats sold by Joseph were making a loss !

Brandes: ”That is wrong. Because it's always about Volume x Margin in euros. At the end we do need money, not margin in percentages. Otherwise I would only sell a single item for a margin of 99% - and selling just one unit would be enough.

I agree with you. Other retailers make the mistake of focussing on high margin %’s and GMROII. “Mr. Hastings tells of taking a store tour in Kmart in 2003. Senior executives were talking about margin and expenses. It turns out that “notions”(zippers, buttons, sewing materials) and curtain hook hangers were the highest margin items in the store… Mr. Lampert’s philosophy was to maximize the inventory value of those peg hooks.) ” and while working at C&A as a shoebuyer, I was given a list of the “most profitable” articles in my assortiment, it was just sorted by gross margin percentage starting with the highest, they were €5,- flipflops with a 90% margin, while we had sold just as many shoes at € 120,- with a margin of 45% in less time. Even at IKEA many managers made the same mistake of assuming that a high gross margin percentage always means that it is the most profitable product.

Brandes: “You are absolutely right. Nevertheless, I don’t care about the margins!! I have decided that flipflops are part of my range just as different shoes in different price ranges and qualities. After that I purchase the assortment and set the right price - and the margins like 90% and 45% are the result.(see above).

With the ALDI calculation, Volume x Margin in euros, you find that pairs of designers jeans with a price of € 100,- and a margin of € 20,- with 5 pairs sold, contribute more to the total margin than polyester pants for € 10,- with a margin of €5,- of which 10 pairs are sold.

Brandes:. "Right. But both are in my inventory. One cannot say that we won’t sell polyester pants, because the absolute margin is low (but 50%). Or, we don’t sell designer jeans, because the gross margin percentage is only 20%. Playing around with these numbers is not worthwhile."

A retailer might say: ”It costs us 35% to sell an item in our store at this location and with our present staff levels, the designer jeans aren’t making us money, the polyester pants with their higher margins are profitable.”

Brandes:”Such a retailer cannot survive in the market. They couldn’t run any kind of business, because they do not understand even the basic 1 x 1 of business administration - or to put in another way, no reasonable ordinary person or businessman would think such nonsense, except probably for someone who didn’t pay attention at Harvard and was subsequently deformed by McKinsey.

Back to the story of Joseph and Voss’s coats:

When considered by conventional retail accounting where the profit mark-up percentage has to be higher than the percentage of costs, new management might have made the wrong decisions for the future.

Let's look at Joseph's numbers:

C&A store selling Josef's black coats
$6,- selling price per coat
-$4,-buying price per coat
--------------------------
$2,- margin or $2/$6 = 33,3% profit margin
50 000 coats sold in one year
$100 000,- gross profit ($2, x 50 000)
-$50 000,- store rent
-$25 000,- labor and staff costs
---------------
$25 000,- bottom line profit

Voss was making a loss with his more expensive coats with a higher profit markup. Let's consider his profit & loss statement.

Voss's store selling expensive coats
$12,- selling price per coat
-$6,- buying price
-------------------
$6,- margin or $6/$12= 50% profit margin
10 000 coats sold in one year
$60 000,- gross profit ($6, x 10 000)
-$50 000,- store rent
-$20 000,- labor and staff costs
---------------
-$10 000,- bottom line LOSS

Consolidated store profit & loss

$ 420 000,- Total sales
-$260 000,- Buying price
-------------------------
$160 000,- Margin, 38% gross profit ($160 000/$420 000,-)
-$100 000,- Rent
-$ 45 000,- Labor and staff costs, 35% selling costs ($ 145 000/$ 420 000,-
--------------------------
$ 15 000,- Bottom line profit

Stores plan their average gross margin % based on their past performance, goals and
expectations for the period ahead.
If a store in a certain year had a gross margin percentage of 38% of sales and the selling costs of running the store were 35% of sales, the net margin would be 3,5%.

For most companies this would be unacceptable, a consultant might be called in and a decision might be made to increase the gross margin percentage from 38% to 40% of sales.

The product mix contains 2 products:
Joseph's coats with a profit mark-up of 33,3% and Voss's coats with a profit mark-up of 50%.

Which coat is contributing more to the store's profits ?

Brandes: “This is my answer. Cost allocations are "inadmissible". How do you actually want to do this with 10,000 articles?
You wrote:“It’s always about Volume x Margin in euros.” that’s easy to calculate for 10.000 articles, not the cost allocation but the contribution to the total profit margin.

Brandes: „Yes, the profit contribution can be measured, if you would really find that necessary. Why? Because it's fun? Therefore, my recommendation: do not employ people in staff positions and close down the controlling department.


With a simple addition you can calculate the following for 10 000 or 200 000 articles (SKU’s) in a store.

(Units sold x Margin in euros) / Stock = Income per unit in stock

Or expressed in another formula
$Margin x TOS = Income per unit in stock
$Margin=selling price - buying price
TOS = Turn Over Speed = units sold per year / average stock

Brandes: “I can understand the formulas. But I do not see why I need the TOS. I have a separate goal for my buyers, they must reach the lowest possible inventory while satisfying demand. Low storage costs will be a result. This has little to do with sales and margins.

But if you have 1 000 units of one article in stock and 15 000 of another article, you should be selling selling more of the second article.
Brandes: “Yes, but only if everything must be sold (sellout). On the other hand, if there is a constant resupply of a certain kind of sock it isn’t relevant. You should only be interested in whether the stocks have been well planned.

ALDI's method of comparing articles: contribution margin based calculation
Brandes: Below it is quite clear that Joseph contributes 62.50% to earnings and Voss only 37,50%. At this point, you should stop calculating. This is the final result, the only one we need. The key remains your choice of store concept: low-cost or luxury provider, or both.


Item_________Margin as % of total sales_______Contribution to margin

Joseph's coats____23,81%_______________________62,50%

Voss's coats______14,29%_______________________37,50%

Total_____________38,10%_______________________100,00%


That’s clear, but it only works because both coats are using the same amount of space (ie. have the same number of units in stock).
Brandes: „It’s always right , depending on the store concept.. And furthermore, are both companies one trick ponies , only selling one style of coat ?

Remember Joseph's coats are marked up at 33,3% and the store's costs are 35% of sales, while Voss's coats are marked up at 50%. It looks like Joseph's coats are loss leaders, because the margin is lower than the cost of selling. If you were part of the buying merchandising team how could you help increase the gross margin percentage ? What would happen if a buyer suggested replacing Voss's coats by more even more expensive coats with a profit mark-up of 25%?

Joseph realized there was no link between an article's gross profit markup percentage and it's bottom line contribution (boost).

He calculated how you can cut your profit mark-up dramatically and even with a much lower margin, still boost the bottom-line profit !

His management accounting system (similar to GMROS) was based on allocating costs not as a percentage of sales but by coats in stock.

Brandes: “This is where the calculation should be stopped, because it is illogical. You should think of using contribution margin-based pricing, but go no further. What is the contribution of each article (units sold x margin in euros) to the general expenses (rent, etc.). I haven’t even looked at your method described below, I won’t take it into consideration. Buyers must also forget the costs of the store. They don’t have anything to do with the contribution of a coat.

In the calculation below, I have at your request gotten rid of the cost allocation, it doesn’t change the conclusions.

For every coat in stock you could calculate the BOTTOM LINE CONTRIBUTION. Income.

Income per coat = $Margin x TOS
$Margin=selling price - buying price
TOS = Turn Over Speed = units sold per year / average stock

Both stores were the same size and could present 1 000 coats on the shopfloor.

The consolidated store thus presented 2 000 coats, 1 000 of Joseph's and 1 000 of Voss's.

Income per coat = $margin x TOS
Joseph's coats = ($6-$4) x 50 000/1 000 = $2 x 50 = $ 100,- /coat/year

Voss's coats = $12-$6 x 10 000/1 000 = $6 x 10 = $ 60,- / coat/year

Total bottom line contribution = SUM of CONTRIBUTIONS ($ 100 x 1 000 coats) + ( $60 x 1 000) = $ 160 000,-

When Joseph (and later generations of Brenninkmeijers) used Income BOTTOM LINE CONTRIBUTION calculations, they could make the right decisions and leave the competition who listened to consultants in the dust.

Consider for example the buyer who suggested stocking expensive coats at a 25% profit
markup, eventhough last years costs were 35% of sales.

The buyer suggested selling coats for $ 24,- which had been bought for $ 18,-. (The competition sold similar coats at a 50% profit markup for $ 36,-).

What would happen if they replaced Voss's coats with these more expensive but lower margin "Keurklas" coats.

Income per coat = $margin x TOS = ($margin x Units sold) / Stock

How fast do I have to sell the "Keurklas" coats to beat the Voss coat's contribution?
TOS = Income per coat / $margin

The $margin is $24-$18=$6
TOS (Turn Over Speed) = $ 60 (Voss) / $ 6,- = 10 turns per year needed to add more contribution than Voss's coats.

Joseph decides to order a few of the coats and sell them as a test. They sell at a TOS of 15.

Contribution Income = $margin x TOS = ($6 x 15) = $90,- euros per coat per year

He replaces the 1000 Voss coats in stock (50% profit markup) with 1000 Keurklas coats (25% profit markup).

Bottom line profit = SUM of BOTTOM LINE CONTRIBUTIONS ($ 100 x 1 000 coats) + (+$90 x 1000) = $ 190 000,-

--------------------------------
Profit and loss statement Joseph + Keurklas coats

$ 660 000,- Total sales
-$470 000,- Buying price
-------------------------
$ 190 000,- Margin, 29% gross profit ($190 000/660 000)
-$100 000,- Rent
-$ 45 000,- Labor and staff costs, 22% selling costs ($ 145 000/$ 660 000,-)
--------------------------
$ 45 000,- Bottom line profit, 7% margin ! ($45 000,-/$660 000,-)


E-mail: ajbrenninkmeijer (a) cs.com

2 comments:

Anonymous said...

Aren't you forgetting some direct costing factors?

In my opinion your costs to sell each item is similar for both articles (think of banking costs, packaging costs, etc. which adds up the total cost for selling an(y) item).

Alderd

Ansgar John said...

Alderd,
Thanks for your comment. I am not sure I understand it.
First off: I am leaving out the costs in future. Dieter Brandes was right about that.
Second: Your costs per coat go down dramatically if you sell more, because they use less space. If you sell it in a day it costs 30 times less rent than if it takes up space in the store for a month. (Not to mention financing.)