“2X Tax Savings,” read the headline on the page 11 ad in last Sunday’s Boston Globe Magazine. “…Your purchase will be tax free, along with an equal savings from Leather Creations” during Massachusetts’ retail tax holiday August 12th and 13th.
“Save 55-65% off their original prices,” said the Filene’s ad on page A3 of the same edition, followed by “Savings throughout the store from 25-75%” by Alpha Omega on page A6.
“Spend and save – how sweet it must be,” says my wife Annie, looking up from the newspaper, a note of sarcasm barely detectable. Having become a successful Purchasing Manager during her many years of family- building, she knows better. She knows about loss leaders, and she knows that “original prices” may never have reached the sales counter. For sure she knows that there’s no such thing as saving by spending.
But even she asks from time to time “How do they stay in business?” especially when she sees markdown after markdown on brand-name merchandise that’s not a retailer’s overstock purchase.
The simple fact is that a lot of them don’t make it, and drastic price reductions often signal a death spiral not only for retailers but for all other types of business entities, as well. (Which is not to suggest that any of the three retailers mentioned above is currently in that situation.)
Here’s how it happens:
Sales: If we can just cut our unit price to this customer from $120 to $90, I’m sure their orders will increase our total revenue by at least 25% in the next year.
Owner: But then we’ll make only $15 gross profit per unit.
Sales: We’ll make it up in volume.
What does Sales know? That the easiest product/service feature to sell on is price, and that her/his sales commission is based on total revenue.
What does the Owner know? That his direct costs are $75 per unit. He also knows that his overhead costs – for the sales commission, for marketing expenses, for his salary, for rent, for utilities and for all of the other general expenses of the business – are about $35/unit. This usually leaves about $10/unit for profit, which is good. So Sales is suggesting that he sell below full cost.
When sales are down, the conversation gets more intense:
Production: If we start laying people off, we’ll never get them back, and the people we keep will start looking around.
Sales: This piece of business will take up the slack for at least the next quarter. Beyond that, we can get lots of new business at this price.
Owner: But if we get much more new business, we’ll have to add overtime, and maybe some new equipment, and we’re running out of space. All of these involve more overhead.
And then another element gets added to the management discussion:
Finance: Let me make three points.
- Direct costs tell only part of the story. Our materials, labor, and outside contractors don’t cover a number of other expenses that grow with volume, such as maintaining more inventory, running our machines longer, processing more incoming orders, sending more invoices, accounting for more transactions, and so on.
- Discounts create a very slippery slope. There are only a few steps between a one-time concession and an unwelcome “margin reduction program.” The D-word (Discount) will inevitably get around. Customers are always pushing back on price, and having conceded once, Sales will have trouble holding to the original line.
- Keep your eye on average margin. There will always be variations in our margin percentage based on market dynamics, product mix, customer needs, and sales effectiveness. But if we know what we need for an aggregate margin – across all products, customers, and markets – and we regularly track the actual average margin, we can match our discounts in some sectors with premiums in others to stay in control of the bottom line.
Sales: So we can never cut prices or offer discounts?
Finance: Discounting is like any other part of the marketing mix – advertising, promotion, trade shows, sales incentives, etc. You weigh all of these factors, budget for each, and an increase in one factor requires a decrease in a related expense. Is $50,000 in additional discounting worth taking $50,000 out of the budget for sales incentives?
Production: Our competition is continually underpricing us.
Finance: Then we have to reduce costs, or develop new products, or both. Everyone in the company has to understand that they have a stake in efficiency and economy. Hopefully we won’t need a layoff or two before the message hits home.
Owner: So if the margin percentage we get from our largest customer is only a third of what we’re getting from everyone else, then we’re losing money on their business, despite their volume?
Finance: The analysis (see sidebar) shows that if we dropped their business, and then consolidated staffing, reduced some space, sold off excess equipment, and thus eliminated their long-haul delivery costs, our lower expenses would more than offset the loss of their gross profit dollars. So we should push hard for a price increase with them, knowing that the loss of their business will not kill us if we have the discipline to cut back accordingly.
*****
Having made his points around the management table, Finance returns to the Home Front to take a call from a member of the Third Generation:
“Grandpa, I have a great deal for you. For school I’m selling holiday wrapping paper as a fund-raiser. It’s a discounted price. You can really save money.”
Finance takes a deep breath. Another generation to educate.
Alligator Bites
Professor John A. Quelch, Senior Associate Dean of the Harvard Business School, likes to joke that he’s a retailer’s kiss of death. At various times during his tenure in the marketing area at HBS, he has been both the Sebastian S. Kresge Professor of Marketing and the Lincoln Filene Professor of Business Administration. Kresge’s, of course was the precursor of Kmart, and Filene’s gave birth to Filene’s Basement, both of which have ended up in bankruptcy.
Among the auspicious declines…
Kmart Corp. is the biggest U.S. retailer to declare bankruptcy, according to data going back to 1980, with total pre- bankruptcy assets of more than $17 billion, Reuters reported. The following list ranks the 10 largest U.S. retail bankruptcies since 1980, by total assets before bankruptcy, based on figures from BankruptcyData.com :
| COMPANY(Note: Ames Department Stores are included twice as they filed twice) | BANK. DATE | TOT. ASSETS PRE-BANK. ($MIL) |
|---|---|---|
| Kmart | 1/22/2002 | $17,007 |
| Federated Dept. Stores | 1/15/1990 | $7,913 |
| Montgomery Ward Holding Corp. | 7/7/1997 | $4,879 |
| Macy (R.H.) & Co. Inc. | 1/27/1992 | $4,812 |
| Allied Stores Corp. | 1/15/1990 | $3,502 |
| Southland Corp. | 10/24/1990 | $3,439 |
| Ames Department Stores | 4/25/1990 | $2,130 |
| The Circle K Corp. | 5/15/1990 | $2,045 |
| Carter Hawley Hale Stores | 2/11/1991 | $2,045 |
| Ames Department Stores Inc. | 8/20/2001 | $1,975 |
| Revco D.S. Inc. | 7/28/1988 | $1,844 |
The Alligator remembers taking more than a few bites out of the “Special Sales & Savings” offered by all of these retailers during the past fifteen years…
Draining the Swamp
A customer profitability analysis with one of our clients recently revealed that without their major customer, who contributes 25% of their annual revenue, our client would save the following annual overhead expenses:
| Delivery (one dedicated truck + driver) | $ 60,000 |
| Sales time (to be redirected) | $ 40,000 |
| Rent (sublease freed-up space) | $ 20,000 |
| Released equipment (avoid depreciation) | $ 12,500 |
| Sales commission | $ 10,000 |
| Order entry and invoicing (.2 FTE) | $ 8,000 |
| Interest on working capital (portion) | $ 6,500 |
| Product liability insurance (% of revenue) | $ 4,000 |
| Avoided utilities expense | $ 1,800 |
| Entertainment | $ 1,200 |
| Owner’s time | Priceless |
| Total Savings | $164,000 |
The gross profit on this customer’s business during the past three years averaged less than $150,000. A decision to drop the customer is pending, contingent on the results of new pricing negotiations.