Managing Profits in Retail?

I deliberately end the title with a question mark. So how does a retailer make money?

I have been, surprisingly often, asked this question, both by existing and potential retail
entrepreneurs. The existing retailers tell me that they always have cash in the bank, and
assume that they are making money, but don’t know how. The new entrepreneurs ‘see’
the difference between the buying and selling price, and assume that the retail industry is
an ‘easy’ way of making money. This perception is enhanced by the fact that we all read
about retail success stories, count the number of stores a private retailer operates, and use
the number of stores as a surrogate for ‘success,’ and profitability. The retail industry
globally is replete with failures. The retail industry appears attractive because when we
evaluate the industry at any moment of time, we inadvertently end up evaluating the
successes (survivors), and factor out the failures. Reflect upon the changes in the retail
brand names in any of the malls of Dubai over the past five years. Another challenge for
existing retailers managing multiple outlets is to maximize / optimize profitability across
outlets, since returns from each outlet of a multiple outlet chain do differ based upon
contextual conditions like demographics, neighboring retailers, and so on. An outlet in
Sharjah will find it difficult to achieve sales per square foot numbers of a similarly
located store in Dubai.

Profitability or return on capital employed, I use this term interchangeably in the article,
is the basis for which business organizations exist. My experience suggests that it is often
believed that profits are a consequence of many different actions implemented and done
well by different people within the organization, and therefore managing profitability
requires establishing overall profitability goals, and identifying and implementing actions
to achieve the goals. It is not unusual for different functions within an organization (e.g.
buying, logistics, store operations, marketing etc.) to be committed to achieving their
respective goals, and we still fail to achieve organizational goals. We can lose sight of the
fact that often interaction of different organization functions has an impact upon overall
organizational results. Just like synergy is 2+2=5, we can have diseconomies where
2+2=3 e.g. a goal of minimizing logistics cost for one organization function can often
contribute to stock outs (e.g. not dispatching less than full trucks) or overstocking
(sending excessive stocks), or reducing manpower costs can result in lost productivity
(based upon poor customer service levels during peak hours), or minimizing stockholding
or inventory carrying cost can contribute to stock outs and dissatisfied customers. While I
was working with a distributor we had a situation where reducing distribution intensity
increased sales and profits because increased distribution was coming from increasingly
marginal outlets, outlets where the sales and margins barely covered the distribution and
account management costs. The difference between managing the results of discrete
organizations functions focused upon achieving overall organization profits is ‘Managing
profitability.’ Whereas focusing upon the interaction of the different organization
functions is ‘managing profits.’ The difference is best exemplified by the role of a
conductor in an orchestra. Each member of an orchestra has their music piece on the easel
in front of them, can play their piece well, but a conductor is required to coordinate the
different elements to create fine music. Amongst the more visible retailers Zara (Inditex)
exemplifies this difference. Inditex is a company that turned the traditional business logic
of apparel manufacturing and retail on its head by organizing a major proportion of its
manufacturing in Europe, not the Far East, and manufacturing a portion of its products on
demand. Zara offset the extra cost of manufacturing in Europe, manufacturing based
upon market trends, and speed to market against the improved store productivity and cost
of stock provisioning apparel at the end of a seasonal cycle.

So what does managing profits in retail entail?

In figure 1 I have identified items that constitute a typical Profit and Loss statement of a
retailer.

Figure 1 – P&L account items

Items of a P&L account

Revenue
Cost of sales
Gross margin
Direct staff costs
Indirect staff
Direct store rent
Logistics & warehousing
General & Admin
Marketing
Shrinkage
Provision for stock
Maintenance
Depreciation
Interest
Net profit

Managing profits requires understanding what lies behind each item of the P&L
statement. The analysis is a three stage process.

First we ask ourselves the question – what is ‘driving’ the item or what is influencing the
item value? In figure 2 I have partially developed a chart to show various factors (not a
complete list) that contribute to the item head ‘revenue.’ Let us track the lower trajectory
– revenue per store. This is a function of sales per invoice and number of customers.
Sales per invoice are a function of sales transactions at full price and discounts, which in
turn is a function of customers at buying at full price and discount prices. And number of
buying is function of conversion of customers walking into the store. This process of
developing a chart linking the P&L item ‘revenue’ to the factors like ‘conversion,’
‘customers walking in,’ number of ‘full price’ and ‘discount’ customers is referred to as
preparing a profit map.

The second question we ask is – what are the factors that are influencing the underlying
factors identified by us. Conversion of customers is a function of two dominant factors
(amongst others) – merchandise assortment and staff interaction with customers. See the
 Figure 2 – Influences on the item
‘revenue’

Store location

Sales per linear Store

meter or fixture product
positioning
No
of
outlets Sales per sq ft No of full
price
customers

Revenue Margin per Products

invoice
Sales per Number of
Invoice discount
Revenue customers
per
store
No of
visiting
Number of customers Marketing
buying
customers

Conversion
Quality
of
customer
service
Training Staff
quality

circles in the figure 2. Similarly the proportion of full to discount merchandise sold is
predominantly a function of ‘merchandise assortment’ and ‘price.’ This process enables
us to identify measures that we need to control or influence to achieve the item ‘revenue’
of the P&L account. The process of identifying linkages between P&L item ‘revenue’ to
intermediate indicators / measures like ‘merchandise assortment,’ ‘customer service,’ and
‘price’ is referred to as identifying profit levers – what we can do to influence P&L item.

The third question we ask is – what are the organizational processes that we need to
manage / control to influence the profit levers identified in stage 2, which in turn will
influence the P&L item value? Let us again track the lowest link in figure 2. It is through
‘selection of quality staff’ (organization process – recruitment), ‘training’ (organization
process – training and development), and ‘quality of customer service’ (creating an
organization process to track customer satisfaction) that we can manage store conversion.
Understanding this linkage ensures that we can monitor the quality of different
organization processes at any time by tracking store ‘conversion’ and make nearly real
time changes in organization processes to achieve targets, which is different from looking
at the P&L item ‘revenue’ as fait accompli. A similar map can be developed for each
P&L account item with identification of intermediate indicators and associated
organization processes. This is a profit management process.
Managing profits requires focusing upon key organizational processes behind the items
that constitute the profit and loss account, and asking basic questions like – what are the
things we do that influence the profit & loss item, can we do what we do more efficiently
(e.g. Wal-Mart’s focus upon having the lowest logistics cost) or in an entirely different
way to achieve better results (e.g. Zara’s manufacturing on demand by creating a trend
monitoring system).

The managing profits concept is depicted in figure 3.

Figure 3 – ‘Managing profits’

Intermediate Efficiency
Measure –
Conversion
Organizational
process – training,
staffing, etc
Intermediate
P&L item Measure – Innovation
value - full price to
Revenue discount ratio
Organizational
process – buying
Intermediate and merchandise
Outcome Measure – selection How to
margin per manage
invoice Process to be profits?
managed
Measures for
managing process

Managing profits in retail requires managing six key organizational processes.

Managing the buy or merchandise

Retail buyers need to manage the width (assortment variety) and depth (number of each
product). Excessive variety complicates the life of both store sales staff (ability to
understand and respond to customer queries about diverse products) and customers
(complicates choice process), reduces stock turn, increases inventory carrying costs, and
reduces net margin (excessive stock sold during reduction sales / promotions). In addition
to balancing width and depth, it is necessary to include products that silently influence
the consumer choice process when displayed – products to communicate price points,
assortment identity or positioning, store location, type of display, etc. Buying is process
that influences directly and indirectly influences many items of the P&L account. A P&L
item that managers (and auditors too) often overlook or slip under the carpet is the charge
/ accounting for provisioning for dead or un-salable stock.
Managing customer service

Store level customer service is a multi-dimensional process. On one side is the traditional
approach that consists of serving the customer (engagement with the customer,
understanding customer need, assisting in the sale, and completing the sale). On the other
side is a more strategic role of managing the merchandise presentation within the store by
moving merchandise around (repositioning on displays) to enable the variety of stock to
have an equal opportunity to catch customers’ eyes, particularly during the early stage of
the season to achieve higher store productivity.

It is rare for me to find retailers in the region who manage their HR in a strategic way
focused upon staff productivity – sales per staff. I believe that managing HR through
proper selection, training, and reward systems has a dramatic influence on in-store
conversion, an outcome of store staff knowledge, self motivation, acquisition and
implementation of selling skills, and timely implementation of store level initiatives.

Customer relationship management

Retailers need to graduate from a transaction-by-transaction relationship based upon each

sale to a developing a long term relationship with loyal customers. Loyalty management
is the heart of this process. Retailers will need to first create processes to collect customer
information followed by analysis to identify key customers, followed by understanding
their buying behavior (e.g. differentiating between full price and discount customers,
fashion or basic products, etc), and then use direct mail and other highly-targeted means
of driving customers to visit the stores more often to increase both the scope and
frequency of their purchases.

Logistics

Wal-Mart typifies the extent to which retailers can gain by understanding and managing
the flow of merchandise across the entire supply chain – supplier to shelf. My experience,
both domestic and in some other countries, suggests that retailers follow a wide variety of
practices to manage the supply chain, often not realizing the value that can be extracted
by managing the supply chain. Retail business can be visualized as a supply chain, and
managing the supply chain strategically enables capturing the value associated with time-
value of stock (realizable value of retail stocks rapidly falls with time), reduction in
inventory carrying cost by improving stock turn, elimination of redundant organizational
processes (e.g. double checking stock at multiple locations), minimizing stock outs, and
increasing cash flows (reducing time from supplier to shelf but retaining the payment
terms), etc. Retailers often outsource logistics to specialized firms, not realizing that the
goal of a logistics service provider is keeping costs of storage and delivery low, and it
doesn’t matter to the logistics provider of the stock remains in the warehouse for a longer
time since increasing the time of storage increases their revenue, whereas the goal of a
retailer is optimizing stock variety and depth on shelves, minimizing stock outs to deliver
customer service, maximizing stock turns by minimizing stock in the entire supply chain,
etc., and the effects of these diverse goals on profits is often conflicting e.g. minimizing
stock outs is at odds with maximizing stock turns. On account of this a retail logistics
plan needs to be developed and managed based upon flow of products through the supply
chain by clustering different products according to their demand characteristics (e.g.
seasonal, promotional products, daily versus weekly deliveries, etc.), merchandising
characteristics (e.g. confectionery is different from diapers, clothing requires preparation
before delivery, etc.), and physical characteristics (e.g. size, shelf life, packaging, etc.).
The clustering of products will be based upon the need to manage the supply chain for
each cluster with a different set of operating policies and procedures. This is best
exemplified in the development of supply chains for supermarkets. To minimize
inventory and handling of the relatively fast-moving products the logistics system will
need to ensure that products from the suppliers flow smoothly through distribution
centers to the stores at regular intervals without the need of stocking (cross docking
system of Wal-Mart). The ‘smoothness’ of operation of this process will determine the
cost savings and service levels at the store level, but the pre-requisite of an efficient flow-
through is a high level of coordination with suppliers and internally within the
organization. Wal-Mart even imposes penalties on suppliers not meeting delivery time
standards. Again when handling fresh products like dairy or fresh fruits and vegetables
(or even promotions) speed of product flow is of essence otherwise spoilage loss (or
stock-outs) will eat away any other cost savings.

Information Technology

If logistics is the backbone of retail, then IT is the central nervous system. The starting
point of managing IT is to look upon IT as a strategic capability of the organization that
can be used to influence the P&L items, a linkage that is often fuzzy. No wonder that
when financial statements of Wal-Mart and its competitors are compared, in only the IT
expense as a ratio of sales does Wal-Mart outspend competitors. Retail IT systems, at
least for new retailers, can be strategically engineered around the decision-making used
to manage different organization processes that impact the P&L account. Once the
linkage between decision, organization process, measures, and outcome (Figure 3) is
understood, IT processes can be engineered around the data gathering (what data is to be
collected from where in the product flow process, and by whom), data analysis required
for decision-support, and analyses to enable decision-making.

Organizational culture that focuses upon profits, efficiency and innovation

Efficient retailers require creating a culture of managing profits with their organizations.
Embedding a culture of profits starts with enabling all key managerial personnel
comprehend charts like Figure 3 ‘managing profits,’ to help them understand how the
actions they undertake are directly related to profits. Mangers then need to understand
how the products flow from suppliers to the store shelf, how costs are incurred and profits
arise at each segment of the supply chain, and what are the benchmarks of efficiency,
productivity and profitability as the product flows through the supply chain. It will then
necessary to focus upon implementing the ‘managing profits’ strategy by tracking data to
manage the organizational processes that result in profitability. The role of top
management will be to coordinate across the different functions emphasizing profits, and
the need to develop milestone-based initiatives to manage and improve profits based
upon efficiency and innovation.

Conclusion

Conscious management of profit in retail requires recognizing the interconnection

between the items of a profit and loss account, and key organizational processes through
measures that are indicative of the operational quality (efficiency, and productivity) of
the organizational processes. Effort then has to be on managing the different
organizational processes on a regular basis by focusing upon either becoming lowest-cost
and efficient (Wal-Mart) and / or innovating different organizational processes (Zara). At
a macro-level the critical retail processes are – buying, supply chain management, human
resources, extracting value from customer relationships, and creating an organizational
value system focused upon profit management.

© Manoj Nakra 2006