At the margins

Retail is simple, some say. Sell product to people for a profit. But it becomes far from simple when you consider the current conditions. Labour wages? Rising. Cotton prices? Rising. Wheat? That too. Oil? And that. As these costs continue to devour retailers’ already tight margins, where is the profit going to come from?

At the Retail Week Conference in March this year, Debenhams chief executive Rob Templeman said: “Deflation won’t be there anymore. The world has changed.” Last week’s Consumer Prices Index (CPI) issued by the Office for National Statistics crystallised this statement. Inflation rose to a two-and-a-half year high, recording an official annual rate of 4.5%.

“Deflation won’t be there anymore. The world has changed”

Rob Templeman, Debenhams

Cutting it

So how can retailers adapt to this changed world? Earlier this month George Weston, chief executive of Associated British Foods, owner of Primark, announced the value retailer will absorb the soaring cost of cotton and defend its market share rather than hike up its prices. Analysts forecast the decision will cost Primark £20m. Shares in ABF slumped following the news, but Weston insisted he was “determined that Primark will retain its position as a price leader”. It is a brave move, but arguably more important for a fast-fashion retailer whose customer base is devoted to its bargain price tags.

For retailers unable - or unwilling -to absorb a multimillion pound hit, what are the options? The CPI shows that retailers’ prices are creeping up. In January this year, Templeman said that increased commodity prices would result in double-digit price increases for Debenham’s outerwear, which requires more material and time to produce. He anticipated that the retailer’s overall prices would rise by between 4% and 6%.

But price increases are easier to introduce for some retailers than others. Jason Gordon, principal and consultancy Booz & Co, points out that customers at the top end of the spending spectrum behave differently: “They’ll pay big money for the right product.” In the middle market and at value end, the situation needs to be watched very carefully; in the case of a value fashion retailer, prices can only go up so much before the product becomes anything but throwaway fashion.

Gordon also believes it is easier for grocers to increase prices. “We all have to eat and a certain amount of footfall is guaranteed,” he says. “Customers understand that the price of food goes up and down and the price of individual product becomes less important. So long as grocers try to create value, they’re in a good position.”

Nevertheless, whatever the type of retailer, prices “cannot keep going up ad infinitum”, says Gordon. Pricing is only a tiny part of retailers’ battle in countering inflationary pressures, and to maintain their brand values and maximise their chances of maintaining market share retailers need to keep any increases as low as possible. Skilful margin management has never been more vital. There is opportunity within the supply chain to improve efficiency - Templeman says there is greater potential for retailers to exploit direct sourcing. Container fill and shipping methods can also be scrutinised.

But in general, more retailers need to recognise that chasing sales with no margin is pointless. “Retailers need to focus a lot more on percentage margin and cash profit. It’s a lot more like how an entrepreneur would run their business,” says Aidan Bocci, chief executive of consultancy Commercial Advantage. “The whole industry is chasing sales with no margin because everyone is trying to hit last year’s numbers. It’s short-term money. You’re propping things up by delivering numbers that won’t deliver a result.” Gordon agrees: “A lot of retailers will need to be comfortable with a lower like-for-like sales number, and they’ll need to be comfortable with a more profitable piece of a smaller pie.”

Margin management is a skill that Poundland chief executive Jim McCarthy knows well. By virtue of the name of the company, price elasticity is not an option for a single-price retailer. As he says: “We’ve had to manage cost inflation for the last 21 years, and it’s a combination of factors that enable us to do that successfully”. Re-engineering Poundland’s own-brand product is one strategy. It might take a couple of pencils out of a box of 50, for instance. In turn, stocking smaller, lighter product leads to cost-savings on packaging and even transportation, and means more product can be stocked on the shelves.

Manufacturers are altering their product too. Toblerone bars have been downsized from 200g to 170g, helping McCarthy keep the price at £1. Elsewhere, the fashion players are also adapting their product by working with suppliers to make them from lighter fabric with less detail. It only becomes a problem for the consumer if they’ve bought the same product before and can make a direct comparison.

To try and keep customers flocking at a time when retailers are having to put up their prices, many stores are resorting to a heavy use of promotions to create a sense of value. Emmanuel Hembert, principal at global strategy consultancy AT Kearney, says that in the grocery sector the average promotional rate to volume is 40%. In many categories at the moment it’s more than 50%, and in snacks it’s as much as 70% of the volume.

But, he warns: “There is a danger of pushing it too far and getting into a spiral of promotions that you can’t get out of. Once you get consumers used to that, getting them out of the promotional cycle is very difficult.” Bocci agrees it can be a risky approach.

“One of the problems many organisations have is discounting products when they don’t need to. You’re rewarding disloyal customers and crucifying your profitability.”

The promotion plethora is also impacting on supplier relationships. Squeezing suppliers is an obvious way to reduce costs and preserve margin, and yet at the same time strong supplier relationships are critical in the quest to create margin - these are the people who will help retailers look at ways to cut costs in the supply chain and work with them to re-engineer product. Retailers, though, are pushing them further than ever before.

McCarthy says that healthy supplier relationships are absolutely critical in enabling the single-price retailer to maintain its margins amid ongoing inflation. “Some major retailers invoice for lost profit if a product is late or short-delivered. We don’t impose penalties,” he says. “Also, we make quick decisions. Overall, the cost for the supplier to serve us is substantially less and they’re supportive of us.”

John Lewis also recognises the importance of building long-term supplier relationships. “The current climate is definitely challenging for suppliers and retailers,” says head of buying operations Sarah Lewis. “We work together on how we can absorb inflationary pressures and ensure the customer still gets the same quality and value, and look for opportunities to take out unnecessary costs through the development and production process.”

Thinking ahead

Retailers run the risk of planning too late for rises in inflation. Bocci says: “As a leader in a business you need to plan your business around an assumed level of inflation. Every time prices go up, everyone says ‘oh, that’s a surprise’, and by the time they’ve responded to the commodity prices in your business you’ve lost about six or nine months of the year.” Instead, he says retail leaders should plan ahead, rather than react. And even if prices don’t increase, what’s the worst that can happen? The business will be better placed to further create margin and growth.

Many of those retail businesses that struggle are those that start their inflation-battling strategy by looking at cost in the profit and loss. “The smart ones start by looking at the consumer,” says Bocci. Many products were developed at a time when there was abundant consumer cash and huge economic growth. He advises looking closely at what the consumer wants today. “What can we take away from them that they don’t care about?”

“An increase in interest rates would effectively wipe out the entire apparel market from consumers’ wallets”

Emmanuel Hembert, AT Kearney

Waitrose is one retailer that has done a remarkable job of achieving growth in a downturn, and planning ahead has been instrumental in that. In a radio interview last week managing director Mark Price said that before the recession even began in the UK, it was monitoring the US closely. “We knew there would be an oncoming recession and it focused our minds,” he said. It looked at what its consumers would want and introduced its lower priced Essentials range early on. The range has increased its volumes, grown its customer base, and meant that existing customers now put an extra two items in their baskets each visit.

Moreover, Waitrose is proof that by forward planning, it is possible to decrease prices despite inflationary pressures. The growth that has resulted from adapting its product range has enabled the grocer to provide better value for customers. “We made sure prices were sharper, and we’re investing £40m a year at the moment in reducing our prices,” said Price.

There is a dark shadow looming on the horizon that makes planning ahead even more critical. Hembert says: “One thing that hasn’t yet happened to the consumer is the rise in interest rates.” And when that does happen their purchasing power will be severely affected. He points out that the level of mortgage interest repayments in the UK is £57bn. The entire UK apparel retail market is worth £46bn.

“An increase in interest rates would effectively wipe out the entire apparel market from consumers’ wallets,” he says. A potential price war would increase even further the need for close margin management, and retailers need to plan for that now rather than when the time arrives.

As retailers kiss goodbye to a world of deflation, the trading game becomes ever more taxing. But they’re not ones to complain. They wouldn’t be in the business if they didn’t enjoy a challenge.