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Q: example by Omnivorous ( Answered 5 out of 5 stars,   0 Comments )
Subject: example by Omnivorous
Category: Business and Money
Asked by: ansgarjohn-ga
List Price: $20.00
Posted: 26 Dec 2003 08:08 PST
Expires: 25 Jan 2004 08:08 PST
Question ID: 290394
Hello Omnivorous,
In november I posted a question concerning retail planning/budgetting
(see below). You mentioned an interesting example that might be a bit
relevant. I would like to see it even if it isn't an exact answer to
my first question. Thanks in advance.

At IKEA we look at the buying prices, competition, price elasticities and
expected volumes at article level. Example:
            COGS     Retail     sls qty     revenue   gross profit  gross margin
article A     $0.5      $1         2          $2          $1         50%
article B     $1       $1.09        50       $54.5       $4.5        8%
artcile C     $0.1      $0.3       20         $6          $4         66%
total                                         $62.5       $9.5       15,2%

The idea is to change the parameters so that the sales and margin%
targets are reached.
Using DPP (Activity Based Costing) you might conclude that article B
is actually one of the most profitable products but in practice we are
constrained by the obstacle of the preset gross margin % target.
Are there retail companies that budget differently for example
STARTING with a gross profit target per square meter or something

Request for Question Clarification by omnivorous-ga on 10 Dec 2003 09:28 PST 
Ansgarjohn --

I've been working on this one and have at least one very interesting
example, though it may prove a bit controversial. (It's interesting
enough that I think it would make a GREAT newspaper column).

I'm continuing to poke into the issue and hope to have something for
you in a couple of days.  If not, I'll let you know as well.

Best regards,

Subject: Re: example by Omnivorous
Answered By: omnivorous-ga on 26 Dec 2003 08:59 PST
Rated:5 out of 5 stars
Ansgarjohn --

I did quite a bit of work on this question but was never satisfied
with finding store-level profitability models.  I'd looked through
industry literature; at some academic studies; and at Wall Street
analysts' reports on a number of retailers.  (I'd also listened to
several Q3/Q4 earnings reports for major retail companies.)

However, there's one store model, detailed below in which I'm certain
that gross profit percentage IS NOT the measurement model.  However,
GP/square foot MAY be one alternate measure.

Supply chain management software has made it possible to expand the
scope of retail profitability measures, though it's really been in
reaction to the reality of competitive dynamics in the market.

The best places to look are probably:
?	academic studies of retail modeling (including Harvard Business School cases)
?	retail software suppliers, who discuss algorithms

It's further complicated by the fact that in retail chains, many of
the gross profit decisions have been made by the company, so a local
manager has limited flexibility, mostly in positioning, display and
merchandising.  In fact, I'll supply an example below (Costco) where
the gross margins are probably being targeted in a narrow and very low
range -- for strategic reasons.

As I'm sure that you're aware, gross profitability can be influenced
by things external to the store.  Some examples:
?	slotting fees get paid to the parent; the store usually doesn't see
that money, though they're responsible for product placement in
end-caps or other premium positions.
?	company credit cards 
?	services and other merchandising may not fall to the store level. 
Fortune Magazine notes that Premier Retail Networks is now generating
$100M in in-store advertising in 5,700 chain stores:
Fortune Magazine
"Hey Shoppers:  Ads on Aisle 7!" (Boyle, Nov. 10, 2003),15114,538842,00.html


The developing warehouse store model, used by Costco (NASDAQ: COST)
and Sam's Club (subsidiary of Wal-Mart, NYSE: WMT) in the U.S., is one
clear example of a retail concept where gross profit percentage is not
driving the business.  Instead, it's more of a "financial services"
business model, under which:
?	gross margin is relatively modest, at 8.9% for Costco in 2002.
?	membership fees, paid up front, account for 68% of the operating income.
?	the float on payments to vendors is almost 30 days; or around 10%
($100 million) of the operating income -- even using a conservative
Treasury bill rate.  Using a corporate bond rate, it would contribute
twice that internally.

By contrast, American supermarkets run gross margins about 2.5x those of Costco:
Google Answers
"Published Supermarket Profit Margins" (Omnivorous, May 17, 2003)

You may not see Costco yet in Europe, though they have 15 locations in
the U.K.  They concentrate on volume sales, offering restaurant
quantities of commodities to businesses and consumers.  The have 14.9
million Gold Star members who pay $45 per membership; another 3.6
million who pay $35 for add-on memberships; and more than 1.75 million
Executive ($100) members who receive rebates of 2% at year-end (up to
"Company Overview" (Nov. 21, 2003)'over.htm'

The stores average about $105 million each and volumes more than 70%
higher than Sam's Club, according to Wall Street analysts.

As a result, in 2002, these were the key numbers (in millions):
Sales:  $37,993
COGS: $33,983
Operating income: $4,010
Gross margin: 8.9%

Membership fees: $769

Accounts receivable: $475 (4.6 days sales)
Accounts payable: $2,884 (31 days sales)

Membership fees, totaling $769 million last year, are one of the ways
in which Costco increased it earnings 16% last year, despite higher
SG&A costs and a sales increase of only 11%.  So, as a result, when
visiting a Costco you'll see aggressive merchandising of Executive
membership levels.
"2002 Annual Report"

Though I'm not familiar with the retail store manager's compensation,
a portion must be in cost control (particularly in inventory
shrinkage), a portion in volume and a portion in membership fees. 
Securities analysts track the sales/per square foot at Costco (about
$700 per square foot) as closely as they do store expense numbers.

Thus, as a senior Costco manager, the store level goals might be
expressed to the store manager this way:
"First, hold your store costs to x% of sales for the first leg of your bonus.
Second, mature store target is 10% gross margin -- and we want you in
a range of 9.5%-10.5% for strategic reasons.  Your goal is to get
volume as far above the $700/square foot range as possible.  An
additional $70 (10%) in yearly sales contributes $10 straight to
operating income.
Third, membership retention must be above the 85% target.  The
corporate average is 4,500 Executive memberships per store -- your
bonus will increase for every 10% above that number.  Those members
buy more; buy higher margin items (especially services); buy more
online; and buy more per visit -- more than offsetting the 1.6% rebate
(after membership fees)."

Having dealt with Costco from the vendor's end, the company holds its
costs down when dealing with vendors by:
?	having vendors manage inventory and ship just-in-time.  Some
contracts actually consign inventory to Costco -- and they take
possession only when the product crosses the cash register.
?	stretching the payment terms.  A major U.S. direct marketer of
personal computers turned down a contract to sell its systems at
Costco when the retailer wanted the PC manufacturer to hold the
inventory on the floor -- then agree to be paid 60 days after the
cash-register transaction, instead of the traditional 30 days after
shipment from the factory.
?	limiting SKUs to highest-volume models.
?	providing full-credit on returns any time during the warranty period.
?	and, of course, collecting promotional fees.

For further detailed reading, you may want to see these resources on
the "warehouse club" models:
Harvard Business School Case Studies
"Costco Companies" (Bell & Leamon, July 12, 1999);jsessionid=1JJCBCT1ANL5YCTEQENSELQ?id=599041

Fortune Magazine's recent article on Costco vs. Wal-Mart:
Fortune Magazine
"The Only Company Wal-Mart Fears" (Helyar, Nov. 10, 2003),15114,538834,00.html

Best regards,

ansgarjohn-ga rated this answer:5 out of 5 stars
Exactly the answer to this question (the example). Great article in Fortune.

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