Monday, September 17, 2012

Shifting paradigms or Framing bias & Removing average gross margin %'s from retail planning.

Is a retail store a place where goods are bought then sold, or is it a selling factory or logistics company ?

Trading paradigm/framework question:

Consider a store with two types of pants, 20 of each were put into the store last week, designers jeans with a price of € 100,- and a margin of 20% of which 5 pairs were sold, and polyester pants for € 10,- with a margin of 50% of which 10 pairs were sold.
GMROII (gross margin return on inventroy investment) is much higher for the polyester pants than for the jeans. Store costs last year were 35% at this location and with our present staff levels. I can order another 20 pants, but have to choose either the jeans or the polyester pants, which should I choose to improve my Return On Investment ?

The same question posed from a logistics paradigm/framework:

Customers pay me to buy pants and bring them to the store for them to pickup. Last week I brought 20 pairs of 2 types to the store. For designer jeans 5 customers paid me $ 20, per pair for this service, for the same service 10 polyester pants customers paid me $5,- per pair. I can order another 20 pairs but have to choose between the two types of pants, which should I choose to maximize my profit ?

If you see a store as a place where a collection of items that has been bought, is sold, then it seems logical to focus on gross profit margins expressed in percentages. For example, in a clothing store if you have a fixed budget to buy articles for the season, then articles sold at the end of the season with the highest margin % have made the best use of your buying budget.

The same is true of a poor street vendor selling fruit who has a limited amount of money to buy fruit for the next day's sales.

Eddie Lampert is used to trading on Wallstreet. He is now running Kmart and Sears from a buying and selling paradigm. If you buy stocks, bonds etc. then gross margin percentage profit (in a certain time period) is your most important resultant.

Some of the most successful retail formula's are however now managed as selling factories not as street vendors. Below we consider a clothing store, IKEA, Wal-Mart and ALDI.

In the past managers always worked for at least 6 weeks in the store's own clothing manufacturing factories. The stores themselves were managed as selling factories. In the manufacturing factories the focus was on optimizing machine use, in the stores the focus was on meters instead of machines. The profit per sq. meter (aka GMROS) should be as high as possible. The markup was fixed at 25% (considerably lower than competitors) and attention was focussed on managing stock turns (=turnover speed). Stock turns were managed per price point within commodities. For example trousers with an average price of 10,- would have to reach a stock turn target 5 times higher than trousers priced at 50,- to achieve the same profit per sq. meter. Smaller articles that took up less space could have lower stock turn targets than larger items at the same price point to achieve the same profits per sq. meter.

As one entrepreneur said to his son when explaining merchandise planning:"Meters are the Alpha and Omega."

"IKEA is a production-orientated retailing company." It works very closely with the factories trying to lower costs. It also owns it own furniture factories (Swedwood). So when Ingvar Kamprad decided to sell hot dogs at IKEA, he didn't do that based on the percentage profit margin on hot dogs, but by approaching the hot dog selling process much the same way as the manufacturing process: "The target he set was that two people at the counter would be able to sell three hundred hot dogs an hour. A number of trials were carried out, and the best working position as well as the most functional fittings were tested."

Using wages per hour, rents, energy costs they calculated the profit per day on hot dogs. Just as you would in a factory calculate the profits when making an IKEA bookcase.

Ingvar Kamprad also did the same type of calculations for the sale of what is now called the ÄLMHULT mug. They retail for €0,25. Huge amounts of them are sold straight off the pallet. There is little handling involved, and the dollar margin per square meter is above average. In other words Ingvar had "proven" that they were profitable.

But the textbook planning method for retail is based on the old buying and selling paradigm. The mugs have a low percentage gross margin and were at first moved into the furthest corners of the store by managers trying to improve their gross margin percentages.

As Ingvar puts it: "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?”

Ingvar wrote in 1998 "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."

When I worked at IKEA from 2001 to 2004, methods had been developed to get department managers focussed on sales instead of gross margin percentages, but the underlying planning system and IKEA's own textbooks had not been changed.

The question is, what will happen after Ingvar leaves the company ?

Wal-Mart according to Peter Drucker has changed the paradigm of retailing from the buying and selling of goods to moving them.

Sam Walton in his autobiography described the paradigm shift as shifting from "variety store thinking" or "concepts" to discounting. "It's amazing that our competitors didn't catch on to us quicker and try harder to stop us. Whenever we put a Wal-Mart store into a town, customers would just flock to us from the variety stores...most of them did eventually convert to discounting. Kuhn's Big K became a discount chain. Sterling launched it's Magic Mart discount chain. And Duckwall went into discounting.
Now most of these guys already had distribution centers and systems in place, while we had to build one from scratch. So on paper we really didn't stand a chance. What happened was that they didn't really commit to discounting. They held on to their variety store concepts too long. They were so accustomed to getting their 45% markup, they never let go. It was hard for them to take a blouse they'd been selling for $ 8,-, and sell it for $ 5,-, and only make 30 percent...we were ending an era in the heartland. We shut the door on variety store thinking."

Wal-Mart over time lowered their average margins further from 30% to around 20% percent, to the companies asking 45% it just didn't make sense. Their reporting systems couldn't show them a profit on individual articles that had a less than average percentage margin.

Walton himself on the other hand, wrote about a Wal-Mart store manager selling 200 lawnmowers for $ 200,- that he had bought for $ 175,- as an example of excellent retailing. They were sold in days from the parking lot without even having been brought into the store. In my opinion the fact that the margin was 12% while the average Wal-Mart markup at the time was 30% didn't deter Walton from mentioning it in his book, because it was obvious to him that this article had increased the store's bottom line profit. The store earned $200-$175 * 200 = $ 5000,- extra margin with minimum extra costs. Competitors who were locked into the variety store way of thinking (paradigm) saw something completely different. They would look at the sale of lawn mowers for a 12% margin, consider the fact that Wal-Mart's store costs were 26% of sales and the obvious conclusion (viewed through the old paradigm) was that Wal-Mart had lost money by selling them.

Calculate the stores results from this real life example without the sale of these lawn mowers (see page 4 of the store simulation document). The average gross margin percentage would have been higher, but the bottom line profit would have been half as much.

ALDI : Dieter Brandes, former CEO of Aldi Nord wrote :"Marktpreise können nun einmal nicht ignoriert werden. Schon manches Unternehmen hat sich mit falschen Kalkulationen und unzweckmässigen Kostenrechnungen aus dem Markt >>herausgerechnet<<." (Konsequent Einfach, p. 156).

In the blog post below is a framework of documents dealing with adjusting retailing accounting to the new paradigm by removing average gross margin % targets from retailing planning and evaluation.

Comments, input, help with writing to better express this concept, etc. are more than welcome.

E-mail me: ajbrenninkmeijer (a)

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