RETAILERS AT THE
CROSSROADS:
HOW TO DEVELOP
NEW PROFITABLE
GROWTH
STRATEGIES
June 2003
Management consulting at Charles River Associates
Retailers at the Crossroads: How to Develop New Profitable Growth Strategies
Many industries have been hit hard by the current
recession, but none more so than the retail sector.
A number of large U.S. chains that were once
household names – Ames, Bradlees, Caldor and
Montgomery Ward, to name a few – have folded.
Others, such as Toys “R” Us, J.C. Penny, Radio
Shack and AutoZone have been closing outlets to
avoid a similar fate.
As these retailers have struggled, a select number
of major chains has found ways to increase
earnings and sales. Companies such as Staples,
Bed Bath & Beyond and Office Depot have
consistently posted top-quartile earnings growth
relative to peers. Furthermore, food retailers, while
representing only 19% of retail sales over the past
decade, have captured 28% of industry profits.
What – if anything – are these companies doing
differently than their competitors?
Our research and client experience indicate that to
excel in today’s highly saturated retail markets,
companies need to abandon the geographic
expansionism that, ironically, created their original
success. Instead, they need to initiate new
management strategies based on profit-driven
product selection and customer targeting. At the
heart of the shift is the introduction of financial
discipline into the marketing process. Retailers
need to be ruthless about pulling unprofitable
products from the shelves and avoiding highvolume but low-profit customer segments.
This shift represents more than a stopgap to
survive the downturn. Rather, as we will show, it
signifies a major transition in how retailers will
compete with each other in the future. It will
require changes in culture, operations, strategy
and finance. Those that develop the capabilities to
manage product and customer profitability will
have the earnings to support future investment and
value growth. Those that stay focused on sales
growth through square-foot expansion will find
themselves with shrinking margins and less capital
to invest in profitable growth – a sure recipe for
competitive failure and shareholder
disappointment.
To maximize profits, retail companies need to
excel in three areas. First, they need to approach
the early years of their growth in the same way
that Napoleon approached empire building: the
more territory, the better. When they find a
successful new retail format, such as a stylish
clothing specialty store or a super-supermarket,
they need to roll it out as quickly and as broadly as
possible to preempt copy-cat competition.
Second, once they saturate their markets with
outlets, companies can sustain their earnings
growth by improving the mix of products they sell.
Shelves may be stacked with money-losing
products that were helpful in attracting customers
during the early growth phase, but which now
create a drag on profitability.
Finally, as gains from improved product mix level
off, retailers need to alter their promotion,
advertising and merchandising strategies to better
respond to local market preferences (see Figure 1).
Stores may be in locations that can no longer
support profitable operations, or demographics
may have shifted since the store opened.
Most retailers have learned the skills associated
with the first phase – real estate acquisitions and
store openings. Few have the requisite
management capabilities for the second two:
improving product and customer profitability.
Figure 1: Three Phases of Profitable Growth
Phase 1
Phase 2
Phase 3
Pursuing
Geographic
Expansion
Improving
Product
Selection
Increasing
Customer Value
• Acquiring Real
Estate
• Developing
the Supply
Chain
• Recruiting &
Training Store
Personnel
• Building the
Brand
• Understanding
Category
Profitability
• Eliminating
Unprofitable
Products
• Managing the
Product
Offering
• Understanding
Customer
Profitability
• Targeting
Desired
Customers
• Managing
Customer
Value
Three Retail Management Strategies
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Retailers at the Crossroads: How to Develop New Profitable Growth Strategies
Strategy 1: Pursuing Geographic Expansion
Retailers grow to national prominence by
developing a successful store format, aggressively
acquiring real estate and investing heavily in brand
building. This strategy works well in the early
phases of a company’s growth – and, in fact, is the
only way to become a national company. The
trouble begins, however, when the retailer
becomes so big that its returns on incremental
investment deteriorate and its earnings plateau.
Soon, management fails to develop other ways to
run the company.
The most recent examples of this are the so called
“category killers,” such as Circuit City, Staples,
The Home Depot, Bed Bath & Beyond and Toys
“R” Us. Seemingly coming from nowhere, 17
chains created successful store formats in one
product category after another – consumer
electronics, office products, home improvement
products, white goods, toys and so on. By offering
wide product selection and prices within their
specific categories, these format innovators won
over millions of consumers, transformed the
operational methods of North American retailing
and changed the look and feel of many Main
Streets. In financial terms, they generated a third
of the growth in market capitalization for the
industry and earned nearly a third of the industry’s
economic profits over the 1990s (see Figure 2).
capabilities developed at corporate and/or through
corporate programs. While these skills were
important in the early years of their growth, the
format innovators have saturated most markets.
If retailers are to avoid flat or declining earnings in
the coming years, they must master two alternative
approaches to managing their operations. First,
they will need to develop a more accurate
understanding of the profitability of the different
products they offer in their stores and more knowhow on how to position those products to take
advantage of high margins and/or turns. Second,
they will need a more accurate picture of which
customer segments are profitable and an improved
ability to position their products and stores to reach
those customers. In short, the focus will have to
shift from adding new stores to improving the
profitability of existing stores, and with that a shift
from corporate control to local autonomy
and experimentation.
Unfortunately, their performance as a group of late
has been less impressive. In the last few years,
while the group has been adding square footage at
a rate of 14% per year, same-store sales have
been increasing at only 2%. And, as highlighted in
Figure 3, the economic profit for the group has
been declining since 1999 as retailers continued to
add square feet without accompanying profit gains.
While the overall economic slowdown has played a
role in declining sales and profitability, the main
factor has been that these retailers have become
overly reliant on their ability to roll out new stores –
i.e., a geography-based management strategy.
They excel at activities like real estate acquisition
and construction, supply chain development and
store personnel recruitment and training –
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Retailers at the Crossroads: How to Develop New Profitable Growth Strategies
Figure 2: Sales, Economic Profits and Market Value Growth in the U.S. Retail Industry (1990-2000)
Distribution of Cumulative
Sales (‘90-00)
Distribution of Cumulative
Economic Profits (’90-’00)
All Other
2%
Speciality
12%
Food 19%
Drug 6%
Discount
13%
Dept. Store
19%
Specialty Food
8%
10%
Food 28%
Wal-Mart
39%
Format
Innovators
14%
Wal-Mart
17%
Distribution of Market Value
Growth (’90-00)
Format
Innovators
31%
Drug 8%
Discount
6%
Dept. Store
6%
Format
Innovators
30%
Wal-Mart
32%
Format Innovators Include: Abercrombie & Fitch, AutoZone, Barnes & Noble, Bed Bath & Beyond, Best
Buy Circuit City, Claire’s Stores, Gap, The Home Depot, Intimate Brands, Linends ‘n Things, PETsMART,
Stables, The Sports Authority, Toys “R” Us
Figure 3: Square-Foot Expansion Versus
Profitability
Square Footage (M)
Economic Profit ($M)
450
5000
400
Square
Footage
350
4000
300
250
3000
200
Economic
Profit
150
100
2000
50
1000
2001
2000
1999
1998
1997
1996
(50)
1995
0
0
Strategy 2: Improving Product Selection
During their rapid geographic expansion, retailers
typically bring together a vast array of products to
attract customers. This may make economic sense
at first, as retailers are trying to generate
excitement and offer convenience. But over time,
rapid growth can conceal the fact that many of
these products do not make money for the
company. The next step is to become more
selective in which products to offer and which to
discontinue. There are three things in particular to
focus on:
1. Understanding Category Profitability – It is
important for retailers to have an accurate
understanding of which products are
contributing to the value of the company.
Typically, product profitability is measured
superficially – in terms of gross margin or
operating contribution, for example. But each
product’s profitability is also affected by shared
costs, such as store operations, head office
marketing and administrative expenses. It is
also affected by capital costs, such as the
holding cost of inventory or the capital cost of
physical facilities that are related to the
product category (see Figure 4). Unfortunately,
most companies have not developed the
ability to track these costs on a productspecific
basis and thus lack a clear picture of which
products are economically profitable.
When retailers do study product economics at
this level of detail, however, they typically find
that a third of their square footage is being tied
up by products that do not make an economic
profit (above the cost of capital) for the store.
Another third of space is typically allocated to
product categories that have break-even
economics. And the final third of space
actually creates more than 100% of the
economic profit. Unfortunately, most retailers
are unaware of which third of their products is
generating all the profit (see Figure 5).
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Retailers at the Crossroads: How to Develop New Profitable Growth Strategies
Figure 4: Measuring Total Product Profitability
$
Traditional
Profitability Measures
“Fully Loaded
Profitability Measures
Revenue Net
Sales Price
COGS
Gross Margin
Direct Marketing
Expense
Operating
Contribution
Shared Services
Taxes
Capital Costs
Economic Profit
Figure 5: Economic Profit by Merchandise Categories
Economic Profit ($/sq.ft.)
2,000
Low Profit
Lowfit/low profit
Average $250
EP/Sq. Ft.
1,500
1,000
ROC = (3.2%)
55% of Assets
500
0
ROC = 82.7%
45% of Assets
(500)
(1,000)
Product
Ranges
A
B
C
D
E
F
G
H
I
J
K
L
M
N
O
P
Q
R
S
T
U
V
W
X
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Retailers at the Crossroads: How to Develop New Profitable Growth Strategies
2. Eliminating Unprofitable Products – A more
accurate understanding of product economics
can help retailers put their existing square
footage to more profitable use. This requires a
“house cleaning” to prune those categories
that are creating a drag on the bottom line,
which in turn may require major changes in
corporate and business unit strategy.
For example, one reason that stores end up
with so many unprofitable products is that
corporate headquarters has a policy of
shipping each product to all stores – and in the
same quantity. As a result, because of local
market differences, some stores run out of
inventory for products that sell well in their
local market and are at the same time
overstocked on products that don’t sell well.
Here, the answer lies in refining the corporate
policy so that instead of prescribing the exact
product assortment to the local store, the
corporate headquarters offers a menu of
products that local stores can choose from in
the quantities they need. This can result in a
higher percentage of the store space being
used to sell high-margin and/or quickturn
products.
Executives grew the business smartly, picking
a few categories, like cosmetics, where they
had a pre-existing brand position on which to
build. Over time, Boots offered new products
within the category and improved its brand
communication both in the UK media and in
stores. Most importantly, the company gained
new skills in brand management, product
development and marketing communications
on top of its category planning expertise..
Boots has gone on to create own brands that
are leaders in a number of categories,
including Botanics and Soltan personal care
products, over-the-counter health products like
Strepsils cough/cold medicine and Boots
brand vitamins. The pay-off for Boots has
been the capture of significant gross margins
that would have ordinarily gone to global
consumer products companies. Even more
remarkable is that Boots has accomplished
this without alienating the major consumer
brands, by creating products that nicely
complement the strongest and best brands
from Procter & Gamble, L’Oréal, Gillette and
others.
Strategy 3: Increasing Customer Value
3. Managing the Product Offering – One of the
more impressive examples of marketing highmargin products is the UK health and beauty
retailer Boots, which over the last decade has
become an industry leader in knowing where it
makes money in its product portfolio and how
to exploit that understanding through
merchandising, store layout and other
marketing techniques.
Even when unprofitable geographic expansion has
been halted and product lists pruned, companies
squander resources chasing the wrong customer
segments. In order to maximize earnings, there is
a third strategy to master: increasing customer
lifetime profitability, i.e., understanding and
maximizing the profitability of a customer’s longterm relationships with the retailer.
For example, the company recognized that its
“own brand” toiletry and cosmetics products
were doing extremely well. These products
weren’t low-price private labels; instead, they
were distinct brands created by Boots as real
alternatives to global consumer brands.
Management realized that the chain’s ubiquity
in the UK (more than 1,400 stores) presented
an opportunity to increase the percentage of
own brand products in its product mix.
Doing this requires knowing which segments of the
customer base are profitable – down to individual
names in some cases – and what will make those
customers more profitable in the future. Knowing
or predicting sales is not enough. It is also
necessary to know all of the factors that contribute
to the profitability of each customer segment, such
as the total cost to serve each customer group.
There are three basic elements to successful
customer value management:
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Retailers at the Crossroads: How to Develop New Profitable Growth Strategies
1. Understanding Customer Profitability – few
retailers can say which of their customers are
creating economic profit – and hence long
term value. They may track revenue by
customer using sales information from instore
scanners, Internet purchases and catalog
orders. Some may even track other
information, such as cost of goods sold for the
products customers purchase or directly
targeted marketing spend per customer. But
the idea of “fully loaded” customer economics
as the basis for strategic decision making is
not present in many retailers: Few companies
take into account the amount of shared costs,
back-office support, corporate wide branding
expense and capital costs that each customer
requires.
This is becoming more feasible today as more
retailers have the technology to identify
individual customers and their purchasing
patterns through loyalty cards, credit cards
and automatic payment systems. When retail
companies use this information to manage
customer value, they usually see that
economic profits are even more concentrated
in customer relationships than within a product
portfolio, i.e., very few customers are actually
driving all the value creation of the retailer (see
Figure 6).
2.
Targeting Desired Customers – Customer
profitability analysis as highlighted above
helps retailers redirect their marketing
strategies toward the highest-value customer
segments. Consider the experience of a major
clothing retailer, which had grown to
prominence by serving highly profitable 40-60year-old, whitecollar professionals in largestore formats. Experiencing market saturation
and being offered significant incentives by
property developers, the retailer had decided
to enter smaller local markets with a smaller
store format. However, profitability at these
smaller stores had been disappointing relative
to larger stores, due mostly to lower sales per
square foot. The reason? The residential
areas surrounding the smaller stores had a
much smaller numberof customers in the 40-
60-year-old, white-collar professional segment
(see Figure 7).
In response, the retailer used a database to
track the purchasing histories of credit card
holders who shopped at the smaller stores.
The database revealed the relative sales and
profitability of those customers down to
individual customer names. What the company
discovered was that the most profitable
customer segments in the smallstore format
looked very different than those in the largestore format. In many cases, the most
profitable customers were 20-40- year-olds,
who were more interested in designer fashions.
3. Managing Customer Value – Understanding
which customers are the most valuable to the
retailer and what/why they buy allows
companies to increase the total economic
profit contribution of the customer base. At the
same time, it benefits the customers that
management is targeting with a better offer
and/or price. For example, leading retailers are
using point-of-sale data to capture purchasing
information and forecast purchase patterns
(and therefore profitability and value) over the
lifetime of the customer relationship. This
allows the company to tailor its customer
acquisition and retention strategies, marketing
communications and promotional policies
based on the expected lifetime profitability of
the customer. Customers benefit because the
retailer understands their needs better and
provides a superior selection in return.
In the case of the clothing retailer discussed
above, management chose a number of trial
stores to roll out a new format targeting
younger customers. Customer purchase
history was analyzed to determine which
products were of greatest interest to targeted
customer segments. The analysis prompted
significant adjustments to the merchandising
mix according to style and price point, as well
as targeted promotions and an investment in
marketing and sales. The impact was
dramatic: Two months into the experiment, the
trial stores were outperforming the rest of the
small stores. As a result, the retailer decided
7
Retailers at the Crossroads: How to Develop New Profitable Growth Strategies
to implement the customer-focused strategy
across all of its small stores.
The Next Season of Profitable Growth
Despite their disappointing performance in the last
few years, well-managed retailers have plenty of
opportunities to grow profitably by improving their
management capabilities along two dimensions:
product selection optimization and customer value
management. As retailers make this transition, it
will have implications for what kinds of skills,
information and management processes are
required to succeed and where these skills reside
in the corporation. These are demanding and
difficult changes. The key for many retailers will be
to determine when and at what pace they should
develop these competencies. Waiting until
geographic expansion has been exhausted will
undoubtedly lead to further shareholder
disappointment and painful restructuring.
Figure 6 Customer Profitability Illustration
Economic Profit ($)
Current Customer Profitability
No. of Customers
Figure 7: 2001 Store Sales vs. Number of Households in Top Three Customer Segments
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Retailers at the Crossroads: How to Develop New Profitable Growth Strategies
Written by:
Uta Werner, John McDermott and
Greg Rotz
Key contacts in our Consumer
practice:
Tim Romberger
North America
[email protected]
+1 (312) 377-2275
About Marakon
Marakon is a strategy and organizational advisory firm with the
experience and track record of helping CEOs and their leadership
teams deliver sustainable profitable growth. We get hired when our
client’s ambitions are high, the path to get there is not clear (or taking
too long) and lasting capabilities are as important as immediate
impact.
We help clients achieve their ambitions for sustainable profitable
growth through:
•
Stronger strategies and advantaged execution based on:
–
A better understanding of what drives client economics and
value
–
Insight into changing industry dynamics and the context in
which clients need to succeed
•
A stronger management framework to generate better ideas and
link decisions and actions to value
•
A stronger organization with a more focused top management
agenda and well-aligned resources
•
A more confident and effective leadership team that’s focused,
decisive, and strategic
We have a joint team delivery approach where client ownership and
engagement is paramount. Partners are highly engaged in the work
product and supported by strong analytical and industry relevant
capability. We work as advisors and catalysts in close, trust-based
relationships with top management teams.
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