Don't hire an expert in manufacturing to tell you how to retail.

MANUFACTURING BIAS

Problem with your plumbing?  Hiring the world’s best carpenter won’t help.

Ansgar John Brenninkmeijer, February 2015

Executive summary   

1.      The Pricing Advantage: McKinsey manufacturing thinking

2.      Operational leverage in retail: Karel van Eerd of Jumbo Supermarkets

3.      Lower margins beat higher margins even if you are smaller: Sam Walton, Walmart

4.      C&A’s 1906 breakthrough

Profit optimization for merchants is not the same as in production. It requires a different approach and that applies to best value retailers in particular.

If you decrease your price, you will sell more units. In manufacturing clothing and Fast Moving Consumer Goods, the goods move through production at a fixed speed which is unaffected by price. In retail the speed at which you sell changes depending on price. It's literally a different dynamic.

In manufacturing, it pays to increase your selling price. In retailing, it pays to decrease your selling price and C&A history has proved that.

In manufacturing, the pricing lever works better than the volume lever. McKinsey & Co experts explain this and the underlying manufacturing math in the book, The Price Advantage.

In retailing however, the volume lever works better than the pricing lever. You profit from operational leverage. A manufacturer might need a second plant to increase volume, a retailer won’t need a second store to sell more units, he will sell them faster. You can decrease your cost per unit by almost half if you double your volume in existing stores..

Investor Warren Buffett understands how different levers drive different kinds of businesses. That is why he bought shares of Proctor & Gamble which buys soap ingredients and manufactures Tide to sell at a high price, while Buffett simultaneously owns $4,5 billion of Walmart stock which sells Tide to customers for the lowest price. Two different cost structures. P&G does carpentry, Walmart plumbing.

A consultant with a background in manufacturing will inevitably bring along his tool kit (Objectives, Goals, Strategies and Measures) based on the economics of manufacturing even if his client is a retailer. He will tell a retailer to increase gross margins percentages.

If you have a hammer, everything looks like a nail, even if it is a porcelain sink.  

1. MANUFACTURING BIAS, an introduction

When I asked Prof. Steef van de Velde, Dean of the Rotterdam School of Management, whether I could quote him as supporting my work in: counting cash, because you cannot bring percentages to the bank, he replied: “Sure, the numbers add up.The interesting question is: Which cognitive biases are preventing people from understanding low gross margin, high net margin retail?”

In other words: What prevents people, more intelligent than you, from understanding and agreeing with what you are saying, even if you are right?

To give an example, Ingvar Kamprad, founder of IKEA, was faced with his own experts who disagreed with him on many assortment decisions. He wrote in 1998: “Our economists constantly go on that we must keep our "total gross profit margin" to a certain percentage. I say to these experts, "What the hell is 'percentage' anyhow?".

IKEA’s experts are not the only ones with a puzzling view on high volume retail. A group of very intelligent people whose perspective on retail business is at the center of this paper, is McKinsey & Co. They are very competent people with IQ’s off the charts, who seem to have a bias which prevents them from understanding the economics of a store like IKEA or ALDI. I believe the McKinsey approach suffers from a manufacturing bias. When I asked a room full of McKinsey retail consultants: How does a retailer with lower gross margins, make more money than a retailer with higher gross margins?, the only thing they could come up with is that scale allows a larger retailer to have lower buying prices, which isn’t an answer to the question.

But they can… and there are plenty of examples. Just this February 2015 Wholefoods organic supermarkets announced that: “After cutting prices in a bid to shake its reputation for expensive groceries, the company on Wednesday posted first-quarter sales that rose 10 percent. And even while selling its wares for less, Whole Foods still managed to produce profit that topped analysts’ estimates. “This quarter shows they can lower prices and not kill their margins,” . (Bloomberg)

 An excerpt of the first chapter of “The Pricing Advantage” a book written by three McKinsey partners can be found below, followed by the outlines of a McKinsey inspired strategic business plan. After that, operational leverage, the very different thinking and math behind low gross margin retailing is laid out in detail by Karel van Eerd, founder of Jumbo Supermarkets. Finally Sam Walton explains, in his own words how a mental block -similar to McKinsey’s- at larger retailers allowed Walmart to flourish.

2. MANUFACTURING THINKING: MCKINSEY’S THE PRICING ADVANTAGE

Source: “The Price Advantage” Baker, Marn, Zawada, Copyright McKinsey 2010, John Wiley & Sons, Hoboken, New Jersey (Bold font by AJB)

“What’s your advantage? What capabilities distinguish your company most from your peers, allow your business to perform better than your competitors, provide the foundation for superior returns to their shareholders? Is it a cost advantage – do you purchase better and manufacture more efficiently than your competition? Is it a distribution advantage – are your products sold through the best wholesalers, retailers, and locations in your markets? Is it a technology advantage or an innovation advantage? Or is yours a brand advantage or a capital structure advantage or a service advantage?

For all of the advantages that businesses pursue, there is one powerful advantage that is accessible to virtually every business, but actually pursued by too few – and ultimately achieved by even fewer. That advantage is the price advantage.

Setting prices for goods and services is one of the most fundamental management disciplines. (…) very few companies price well. For a host of reasons, few ever develop anything resembling a superior, business-wide, core capability in pricing. In other words, few companies build pricing into the distinctive business advantage it can be.

In this book, we discuss the details of creating and sustaining the price advantage, where pricing excellence generates superior returns to shareholders and enables a company to invest in sustaining its advantages in other areas. But first, let us look at why getting pricing right is so important, and why so few companies realize this advantage.

THE POWER OF 1 PERCENT

(…) pricing right is the fastest and most effective way to grow profits. (…) The average income statement of the S&P Global 1200 (an aggregation of 1200 large, publicly held companies from around the world), shows just how quickly the right price can create profit. (…)

Starting with price indexed to 100, we see that fixed costs (items like overhead, property and depreciation that do not vary when volumes changes) amount to an indexed average of 20,5% of price. Variable costs (expenses like labor and materials that shift in tandem with volume) account for 68,0 percent. This leaves an average return on sales (ROS) of 11,5 percent. (AJB: this paper will show how -contrary to McKinsey’s theory- in retail, fixed costs per unit sold drop when the volume increases. Furthermore, it should be known that the Global 1200 -heavily weighted towards financial & other services and manufacturing- are not a representative group of companies for the retail industry which operates on a different dynamic. But first we continue exploring the McKinsey approach.)

(..) given these Global 1200 economics, what happens if you improve your price by 1 percent? Price will rise from 100 to 101. Assuming volume remains constant, then variable costs will remain constant as well – as will fixed costs. Operating profit, however, rises from 11,5 percent to 12,5 percent, a relative increase of 8,7 percent.

The clear message is that very small improvements in price translate into huge increases in operating profit. When you talk about creating a pricing advantage, you may have to recalibrate your thinking about how large a price increase needs to be to have a meaningful impact. Pricing initiatives that increase average prices by only a quarter or half percent are important because they bring disproportionate increases in operating profit. A 1 or 2 percent price improvement is a major victory with significant profit implications. Find 3 percent – and many companies can, once they start looking – and operating profit can jump by more than 25 percent, if your cost structure is similar to the Global 1200 average.

(…) pricing is far and away the most powerful profit lever that a company can influence (…)

Variable cost is the second most significant one (…) However, most companies have already wrung a lot of variable costs in recent years through purchasing and supply management initiatives, labor productivity improvements, and other measures. As a result, continued improvement in variable cost structure has become increasingly difficult.

Fixed cost decreases have an even smaller effect on operating profit. (…)

The low impact of volume increases on operating profit can be a real surprise to many managers.  A 1 percent increase in unit sales volume only increases operating profit by 2,8 percent, if per unit prices and costs remain constant. This is less than a third of the impact of a 1 percent improvement in pricing. But which lever gets the majority of attention and energy from marketing and sales people? The volume lever, despite its much smaller impact on profit – a fraction of what pricing delivers.

Unfortunately, the pricing lever is a double edged sword. No lever can increase profits more quickly than raising price a percentage point or two, but at the same time nothing will drop profits through the floor faster than letting price slip down a percentage or two. If your average price drops just a single percentage point, then, assuming your economics are similar to the Global 1200 average, your operating profits decrease by that same 8,7 percent.

THE PRICE / VOLUME TRADEOFF

This inevitably leads us to the age-old question of the price/volume/profit tradeoff: If I lower my price, can I increase volume enough to generate more operating profit? That tradeoff does not work. If a business takes steps that effectively reduce average prices by 5 percent, how much of a volume increase would be necessary to break even on an operating profit basis?

With economics similar to the Global 1200 average, a 5 percent price decrease would require an 18,5 percent volume increase just to break even, much less increase operating profits. Such an increase is highly unlikely. For a 5 percent drop in price to generate a 18,5 percent volume rise would require a price elasticity of -3,7 (…) every percentage point price drop would have to drive up volume by 3,7 percent. Our experience shows price elasticities commonly reaching a maximum of -1,7 or -1,8. On rare occasions, usually for consumer items purchased on impulse, it might be as high as -2,5. (AJB: impulse purchases such as fashion?) In the real world, -3,7 price elasticity is extremely rare.

            As this example shows, the basic arithmetic of decreasing price and increasing volume to increase profits just does not add up. (…) the point to remember is that profits are extremely sensitive to even minute changes in prices. Each percentage point of price represents a precious nugget of profit that should be held tight to the chest and never given up without a hard fight.

(AJB: Here is the only mention of best value retailers in the book:) Discount retailers such as Walmart, Home Depot, and Costco are growing larger and accounting for ever-increasing shares of volume in their markets. These giants use their market power to extract lower prices from consumer goods suppliers.

A STRATEGIC BUSINESS PLAN INSPIRED BY MCKINSEY

Clear trade-offs: 1) Sales 2) Margin 3) Overheads

Five objectives of a strategic business plan:

1.    Sales:  Stabilize same store sales, set foundation for topline growth. Sell more online.

2.    Gross margin: Clarify gross margin ambition and levers. Increase GM percentage.

3.    Investments: Buy fancy shelves to convince customers to pay more for the same products.

4.    Organization: Add more checks and balances to buying and planning processes.

5.    Net Profit: Invest in nicer shelves and more consultants to help improve processes.

2. OPERATIONAL LEVERAGE: KAREL VAN EERD, JUMBO SUPERMARKETS

Karel van Eerd, describes the economics of retail operational leverage in his Jumbo stores, which are similar to those discovered at C&A 90 years earlier (see chapter 4). Jumbo is the fastest growing retailer in the Netherlands. They went from a small chain of supermarkets in the 1990’s to the number 2 position in the market today. Along the way experts, with similar biases as McKinsey’s, kept telling Van Eerd that what he was doing was impossible. An excerpt from Van Eerd’s biography is reproduced below.

Source: "Mijn naam is Karel van Eerd en ik bewijs dat ik het wel kan.” (My name is Karel van Eerd and I prove that I can do it.) The vision of the founder of Jumbo Supermarkets. 2011, Retail Thinkers, The Book Shelf, Amsterdam (translation AJB)

"In 1992 I saw declining sales after the summer break. I did not know what the reason was. No one could tell me. Afterwards, I realized that we had priced ourselves out of the market. We had stealthily raised prices. People who are responsible for your margins will tend to do that.

In 1995, Jumbo had 35 stores, but it was not until 1996 that we had a good to great breakthrough, based on a new Jumbo formula. Despite our competitive price positioning, we didn’t manage to gain market share by winning over customers from Albert Heijn and C1000, which were also located in the same towns. An extensive market research project we carried out, was a major breakthrough. The result was a list of the greatest shopping annoyances; things which clients resented and were irritated by in existing supermarkets. We took the time to really think this through.

Our response was a list of seven promises to the customer, that we were going to put into practice; Seven Daily Certainties: "Euros cheaper, is the first one. Jumbo guarantees the lowest price, no article is available for a lower price elsewhere. A second certainty; fresh is really fresh. Products with a sell by date of today or tomorrow can be taken home for free. And a third, for all your shopping needs. Whoever misses a product on the shelf that isn’t currently part of the assortment, gets a guarantee that it will available within two weeks. The first full service discounter came into being. It had never been seen before: the lowest price, combined with a very wide range and perfect service That is what we introduced as the unique Jumbo formula. When we started in 1996, the experts and competitors called it a kamikaze behavior. But if you do the same thing we did, many people will come into your stores. This reduces the cost per unit. A Jumbo store, on average has twice as much traffic  (visitors) as an average supermarket.

At the first Jumbo new style in Den Bosch, I had calculated that if we sold 500 000 guilders per store (per week) that would drive the fixed costs down by half. To achieve that we had to reorganize the store and invest. Fixed costs include a lot of interest and depreciation, but nevertheless they decreased from 10 to 5 percent. Those were five full percentage points no one had considered. But anyone doing the right math could figure it out. The supermarket world was and is gross margin percentage driven. Following our acquisition of the failing Super de Boer chain, that has become even clearer to me. Super de Boer’s demise was based on the assumption:"Sales cannot go up, we must focus on the gross margin percentage." But sales may indeed go up. It is a game that you have to master. You walk on a narrow ledge, and it gets more interesting. Jumbo’s present growth and success, is due to that reasoning. With a wider range, you incur more costs. And by lowering your prices you do have a much lower margin, in percentage. That means you will lose if sales don’t increase as part of the equation. You have to stay sharp and pay more attention to what you are doing.

“But anyone doing the right math could figure it out.”

An average store has a hundred employees. In order to achieve the required turnover, you need five or six key people. They are the heart of the store, plus a team of thirty others. Everything else and the sales increase can be managed with flexible labor based on hourly contracts. It comes down to this: the fewer full-timers you need to generate a dollar of sales, the lower your labor expenses. In the first Jumbo new style in Den Bosch our wage costs expressed as a percent of sales declined from 10 percent to 6.5 percent. There is a variable cost, but that does not increase as quickly as your sales. A one percent (gross) margin increase, isn’t easy. But with the focus on increasing revenue we quickly get full percentage points of (net profit margin) thrown in our lap.

Profit is no more than Sales x Gross Margin percentage minus operating expenses. ... Today we have a lot of sales, much higher than anyone else. I always want more and more customers in the store. If you will manage to get that traffic, the costs expressed in terms of percentage will decrease. Then you become stronger than the competition. Profit is nothing more than the result of a calculation.

3. LOWER MARGINS BEAT HIGHER MARGINS EVEN IF YOU ARE SMALLER: SAM WALTON

After being diagnosed with cancer, Walmart founder, Sam Walton put his story into writing. As he put it: “It’s a story about entrepreneurship, and risk, and hard work, and knowing where you want to go and being willing to do what it takes to get there. And it’s a story about believing in your idea even when maybe some other folks don’t, and sticking to your guns.”

In the following excerpt, he tells an anecdote about selling soap detergent and the anchoring bias existing competitors had to their conventional 45 percent gross margins, which allowed the newcomer Walmart to prosper.

Source: “Made in America: My Story”, by Sam Walton with John Huey, 1992, Bantam Books, New York

"Phil Green ran what became one of the most famous item promotions in our history. We sent him down to open store number 52 in Hot Springs, Arkansas – the first store we had ever opened in a town that already had a Kmart. Phil got there and decided Kmart had been getting away with some pretty high prices in the absence of any discounting competition. So he worked up a detergent promotion that turned into the world’s largest display ever of Tide, or maybe Cheer – some detergent. He worked out a deal to get about $1.00 off a case if he would buy some absolutely ridiculous amount of detergent, something like 3,500 cases of the giant-sized box. Then he ran it as an ad promotion for, say, $1.99 a box, off from the usual $3.97. Well all of us in the Bentonville office saw how much he’d bought, we really thought old Phil had gone completely over the dam. This was an unbelievable amount of soap. It made a pyramid of detergent boxes that ran twelve to eighteen cases high – all the way up to the ceiling, and it was 75 or 100 feet long, which took up a whole aisle across the back of the store, and then it was about 12 feet wide so you could hardly get past it. I think a lot of companies would have fired Phil for that one, but we always felt we had to try some of this crazy stuff."

Green recalled: “Mr. Sam usually let me do whatever I wanted on these promotions because he figured I wasn’t going to screw it up, but on this one he came down and said, “Why did you buy so much? You can’t sell all of this!”  But the thing was so big it made the news, and everybody came to look at it, and it was all gone in a week.”

“we always felt we had to try some of this crazy stuff”

Walton: “As we moved along in the seventies, we had definitely become an effective retail entity, and we had set the stage for the even more phenomenal growth that was going to follow. It’s amazing that our competition didn’t catch on to us quicker and try harder to stop us. Whenever we put a Wal-Mart store into town, customers would just flock to us from variety stores. It didn’t take those stores long to figure out that if they were going to stay in business against this thing Wal-Mart had created, they were going to have to go into it themselves. And most of them did eventually convert to 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 onto to their old variety store concepts too long. They were so accustomed to getting their 45 percent markup, they never let go. It was hard for them to take a blouse they had been selling for $8.00 and sell it for $5.00, and only make 30 percent. With our low costs, our low expense structures, and our low prices, we were ending an era in the heartland. We shut the door on variety store thinking. “

4. A VISIONARY SPARK OF ENTREPRENEURSHIP AT C&A IN 1906:

THE LOW GROSS MARGIN, HIGH NET MARGIN PERCENTAGE BREAKTHROUGH

C&A’s story is remarkably similar to that of Jumbo and Walmart, but the breakthrough came about decades earlier. C&A worked much like other retailers from 1841 until 1906 when it tried to “sell more clothing at higher margins”. The founders, Clemens & August Brenninkmeijer, like other retailers, believed that gross margin percentage was the simplest but most important measurement of profitability. The old rule of thumb was: “You must manage the merchandise mix to maintain the margin above the minimum breakeven percentage.” C&A was successful but not very different from the competition; its bottom line results were good but not great.

Rolling a snowball downhill after 1906, Best Value and the switch to Gross Margin Dollars per Square meter.

1906 can considered to be the actual start of C&A, that year saw a major innovation take place in the business which has had a great impact on people’s thinking within all C&A companies to this very day. In 1906 a visionary spark of entrepreneurship occurred at C&A in Amsterdam, which made the preceding period seem like an uphill battle and the following years comparable to rolling an increasingly large snowball downhill.

 At the time C&A was selling mostly women’s coats, they were bought for around 7 or 8 guilders and sold for 15, resulting in a gross margin of roughly 50%.  Store operating expenses were around 45% and net profit 5%.

Based on simple market research (Bernard) Joseph, Clemens’s son, calculated that he could sell many more coats at 6 guilders instead of 15. He convinced suppliers to change the design and materials of some coats, so he could buy a trial series at 5 instead of the normal price of 7 or 8 guilders. From day one the coats bought at 5 and sold at 6 guilders flew out of the store. As these new coats were selling at a gross margin percentage of less than 20%, the average gross margin percentage in his store dropped dramatically while at the same time expenses, especially staff costs, were increasing. There was such a surge of demand that staff at the store seemed likely to be overwhelmed.  Joseph had to send a telegram to his cousin Georg in Leeuwarden: “Please send sales assistants.” Georg, who was maintaining his margin at 50%, didn’t pull any punches in his reply: “If one tries something new, one should be properly prepared.” But in the end some sales assistants were sent from Leeuwarden to help out in Amsterdam for a while. 

As far as Georg was concerned, what his younger cousin was doing didn’t make any sense. In Amsterdam, on the other hand they had figured out that they could cut their profit mark-up dramatically and even with a much lower gross margin, the far greater volume of sales would still boost the bottom-line profit!  In Leeuwarden, Georg continued to do business the tried and tested way until his retirement in 1917. Georg was stuck in the paradigm that uses gross margin percentages to calculate assortment profitability.

Joseph ignored the gross margin percentages and based his assortment decisions solely on how much money, gross margin dollars, he was making per coat in stock.  He could sell 10-15 times as many coats with a 1 guilder margin as coats with a 7-8 guilder margin.  As a result of shifting the assortment to coats where he was earning a Profit per Piece of 10-15 guilders per coat in stock per year instead of 7-8 guilders, Joseph’s bottom line profit tripled. His Amsterdam store made a profit in 1910 of 83 434 guilders while Georg’s store, running at double the gross margin percentage earned only 27 288 guilders.  By still not adopting the gross margin dollar calculations instead of gross margin percentage maintenance, Georg incurred a substantial Opportunity Cost over the years.  

This figure is an historic chart of C&A’s total profit before and after 1906.

( Please note that Joseph was the first to sell coats at such low prices. Today there might be more demand for high quality coats sold at amazing value. The important thing is to understand the math and be able to recognize which styles are the most profitable at any time regardless of their gross margin percentage.)

At C&A after 1906 managers ignored academic theory and switched to counting cash, as described below.

The Best Value snowball effect

Eventually all the C&A stores switched to gross margin dollar calculations for making assortment and space-tradeoffs. Around 1920 a decision was made to fix the gross margin at a maximum of 25% and offer the very Best Value in the market. Not just at the 6 guilder price point but also for higher price point, high quality clothing. This led to what the Brenninkmeijers referred to as the snowball effect; higher store traffic combined with even higher conversion rates, as people start to blindly trust your prices, leads to a steady increase in sales. Operational leverage (expenses such as rent are fixed) means profits increase faster than sales. This is like a snowball that at first needs a push, but as it rolls downhill it picks up speed. It gets bigger in size and constantly increases in energy.

The new rule of thumb:

“If you’re making more money, you’re making more money regardless of gross  margin percentage”

Replaced the conventional rule of thumb

“You must manage the merchandise mix to maintain the gross margin percentage above the minimum breakeven percentage.”

In the following decades when new articles such as nylons and fur coats were added to the C&A assortment, the mix between the selling price, buying price, turnoverspeed and density were set so that the every article’s gross margin dollars/m² was optimized while still offering Best Value (the highest quality/price ratio).

Conclusion

The two Brenninkmeijer brothers at the threshold of the multinational company that C&A is today, represent the questions that many retailers today, facing declining sales, are asking themselves. Can we lower our margins? Will lower prices increase our sales enough? 

Trust ‘the right math’ and build on the different dynamic that is retail when an ever increasing number of successful retailers admit that lowering their prices has increased results? We can increase sales, lower costs and “take more money to the bank”.

Even today, more than a hundred years after Joseph’s bargain coats, retailers, academics and consultants are as astonished to see -first hand- the result of a shift towards emphasis on cash flow as opposed to gross margin percentages. Many still believe that a store needs to maintain its average gross margin percentage above last year’s expense percentage to remain profitable. Shifting emphasis to low gross margin but higher profit in dollars per year styles is equivalent to a kamikaze action as far as they are concerned.

Comments, questions or E-mails welcome: ajbrenninkmeijer@gmail.com