How Private Equity is Changing the Metrics for Financial Success in Grocery

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1 COMPETITIVE EDGE By Craig Rosenblum August 2015 How Private Equity is Changing the Metrics for Financial Success in Grocery WillardBishop.com

2 THE PATH TO UNDERSTANDING They say the only constant is change. While that may be true, there s soon to be another constant: net profit. While net profit has always been paramount to an operator s success, quantifying true net profit has remained a challenge. But private equity has entered grocery retail, and companies like Cerberus Capital (owners of Albertson s and Safeway), are teaching us the three things that matter the most: Efficiency, net profits, and simply the money you take to the bank. In the early eighties, many companies began embracing Activity-Based Costing (ABC) methodologies as they sought to introduce new performance-driven business practices that increased operational efficiencies, and ultimately delivered greater net profits. By adopting ABC, organizations could assign specific costs to areas, functions, and products based on their actual consumption rates. However, managers soon realized that indirect costs (overhead) were often dispassionately allocated and that decisions based on specific cost metrics were diluted by the ambiguity of overhead allocations. In addition to needing better insights into the actual costs of each activity, the industry sought ways for measuring profitability at the SKU level. Willard Bishop, having introduced the first ABC models built specifically for the grocery industry, expanded the process, which later became known as Direct Product Profitability or DPP. The original purpose of DPP was to help retailers understand the profitability of an individual product at a more granular level than the traditional gross margin. In 1986, The Food Marketing Institute coordinated the development of the Unified DPP Method based on the following formula: Sales Cost of Goods Sold Gross Margin + Deals, Promotions, Allowances, etc. Adjusted Gross Margin Direct Product Costs (warehouse, transportation, and store costs) Direct Product Profitability

3 Understanding the power of making better strategic and tactical business decisions based on costs and true profits led Ahold USA to embarked on an initiative called economic value added (EVA). In 2002, the purpose of moving down the EVA path, according to Bill Grize, Ahold USA President and CEO at that time, was driven by four objectives: Organic growth, margin improvement, reduced operating expenses, and efficient use of capital. By moving to EVA, Ahold was able to transition the culture and the decision-making processes to really understand capital efficiencies something most retailers paid little attention to in the past. This understanding was at the core of decision-making at Ahold USA, and lead to the development of Activity-Based Category Management (ABCM), which incorporated the understanding of efficiency and true profit into the merchandising decisionmaking process. Four Key Areas that will Improve Decision-Making and Increase Net Profits 1. Understand your costs, then build upon that knowledge 2. Connect category management to operations 3. Integrate operations, merchandising, and supply chain when feasible 4. Make change management a critical element in your company s strategic plans

4 1. Understand Your Costs A private equity partner who now owns a grocery retailer recently said to me, Don t let perfection be the enemy of the good. This statement has never rung more true as it relates to ABC, DPP, or EVA. While many organizations have attempted to go down the path of understanding direct product cost, they have given up due to their inability to allocate costs or adjusted gross margin at SKU level. Unfortunately, this was one of the reasons Ahold abandoned their efforts. Yes, allocating every vendor and marketing dollar down to the SKU level, or every penny of operating cost to an activity is difficult. But even at an 80% - 90% confidence level, we d make better decisions. Some of the road blocks can be overcome as follows: Adjustment to margins - Allocate adjustment to margins top down and bottom up to the department level. Trying to build from the SKU level up and allocating marketing funds (e.g., Ads, TV, etc.) is almost impossible. Update frequency Attempting to align the daily derivations of business is unrealistic. Calibrating cost and activity drivers annually, and reconciling adjustments to margin monthly or quarterly, will be sufficient for making better merchandising decisions. Avoid P&L confusion This approach is not meant to replace the arduous task your CFO has in running the business or to become the new company general ledger. Reconciling costs, activity drivers, and making margin adjustments semi-annually or annually will ensure directional accuracy. Again, don t get caught up thinking reconciliation needs to be at 100%. Private equity companies have been able to enhance their strategic and tactical decisions by improving cost visibility across their operations.

5 2. Connect Category Management to Operations The grocery industry has made great strides over the last 30 years in moving from relationship selling, to category management, to fact-based selling. We all have more data about our stores, products, shoppers, markets, and competition than ever before. Today, most Category Managers/Buyers make their strategic and tactical decisions without the ability to consider how their actions impact operations or logistics. Unfortunately, looking at an item based on its gross margin percentage or sales doesn t always tell the true story. In fact, applying these tactics for measurement can generate false positives in the area of true profit. In the example below, SKU A and SKU B are very similar in retail price and in adjusted gross profit. However, the store level ABCs for SKU A are almost twice that of SKU B, and hence the true profit of SKU B is almost 20 times greater. SKU P&L SKU A SKU B Retail Price $2.45 $2.52 Cost of Goods $1.59 $1.81 Gross Margin $ % $ % Trade & Terms $0.06 $0.30 Adjusted Gross Profit $ % $ % Warehouse ABCs $0.12 $0.09 Store ABCs $0.76 $0.43 True Profit $ % $ % Understanding this level of detail during the strategic and tactical decision-making process will enable merchants to: Identify which categories, brands, and SKUs are truly profitable Understand store and banner performance Highest volume stores/banners may not be the most efficient Evaluate true shopper performance and profitability Our most loyal shoppers are not always the most profitable (e.g., if they buy most items on promotion)

6 Assortment New item introductions, along with the growth of natural and organic products, and the expansion of private label offerings, is requiring more item maintenance than ever before. Today, most merchants consider sales, GM%, and shopper input when conducting routine item maintenance; however, very few are looking at true profits. This can severely mask profits as most categories begin to experience diminishing returns where ABCs exceed gross profit dollars. Knowing when that occurs is critical to improving ROI. As illustrated below, only 35% of the SKUs are driving profits. Conversely, 25% of the category s SKUs are losing money. Typical True Profitability in a Category (Profit Rank of Best to Worst SKUs) 40% of SKUs = no profit 35% of SKUs are profit drivers 25% of SKUs are losing money Which SKUs, brands, and segments are adding value? CATEGORY SKUs Space Although retailers have significantly expanded the perimeter, it is the center store which drives most of the true profit. Research shows nearly one-third of the categories in the store are unprofitable. In most instances, the profit drains included: Too many facings Too much inventory on the shelf Slow unit volume High labor due to conditioning and rotating product A case in point - Recently a pasta manufacturer began offering customized case-pack configurations for each of their long and short products by retailer. By right-sizing the cases, the manufacturer increased profitability and improved shopper satisfaction by offering an expanded, more relevant assortment.

7 3. Integrate Operations, Merchandising, and Supply Chain In most organizations, merchandising and marketing decisions are made without the ability to see how these decisions impact the supply chain or operations. However, competing in the future will required expanded views into each functional area in order to drive EBITDA growth and maximize the return-on-capital. For example: Resets Resets are operation s problems. Merchants add/delete SKUs, change planograms, and cut-in new items without any understanding of cost, ROI, or impact. Price changes Retail operations are the stores problem. The battle of value has forced changes in everyday and promotional prices like never before. Merchants do not understand the impact of the store-level labor required to make these merchandising changes. Receiving and stocking are also operational concerns; however, implementing programs such as scanbased trading, Collaborative Planning Forecasting and Replenishment (CPFR), perpetual inventory, and computer assisted ordering (CAO) can add efficiencies that fall straight to the bottom line. 4. Make Change Management a Strategic Initiative Getting an organization to embrace change is never easy, especially in an industry where tenure and experience are deemed essential. However, in this new competitive retailing environment where shoppers can buy product anywhere and anytime change is mandatory. Successful retailers, driven by advanced financial strategies and new tools of engagement, are likely to introduce change at exponential rates. For example: Reward systems based on market share, gross margin percentage, and units will no longer be sufficient. These systems will be revamped and evaluated based on EBIDTA growth and return-on-capital. Organizational structures will become more integrated as the need for understanding how up-and-down stream activities impact financial performance. Matrix-oriented decision-making will become commonplace as understanding and visibility improve across the supply chain, operations, finance, merchandising, and marketing. Technology will play a pivotal part in connecting decisions across the extended retail enterprise, which includes physical stores and ecommerce, as well as shopper analytics. Systems will deliver insights in real-time, thereby making predictive and prescriptive analyses readily accessible and actionable all while the collective team keeps a keen eye on EBITDA and return-on-capital.

8 Related Reading Future success is going to require a deeper understanding of true profits and costs. Moving forward, executives, management, buyers, category managers, and operations will have to integrate true profit and cost analyses into their strategic and tactical decision-making processes. To learn more about integrating true profit and cost analyses into your decision-making managing efforts, please contact Craig Rosenblum at or at craig.rosenblum@willardbishop.com. About the Author Craig Rosenblum Partner Mr. Rosenblum leads Willard Bishop s expansion efforts through business development and strategic alliances. Craig s expertise includes supply and demand side technologies, systems, and strategies. His rich expertise and leadership can be found in a number of industry initiatives, including Category Management, CPFR, ECR, Activity-Based Costing, and Data Synchronization. Craig has also been keenly instrumental in driving collaboration for companies such as CVS, SuperValu, Cadbury Schweppes, and Masterfoods USA. Prior to joining Willard Bishop, Craig led the business development efforts for Prescient Applied Intelligence, Milton Merl Associates, and Crossmark. He currently sits on the National Steering Planning Committee for UConnect, presents at CGIT, and has been published in GMA Forum. Craig earned his B.S. degree in Packaging Science and Technology from Rochester Institute of Technology. Want Willard Bishop to address a specific retail or CPG issue in an upcoming Competitive Edge? If so, send a request to jeff.rice@willardbishop.com stating your challenges, issues, or ideas. The Willard Bishop editorial staff will review all submissions and notify you if your topic is selected. This document may be shared freely. Copyright Willard Bishop, All rights reserved.

9 Solving Complex Issues for Consumer Goods Manufacturers and Retailers Willard Bishop uses its manufacturer expertise and unprecedented retailer knowledge to create performance-based strategies that work for the supply side, as well as for the demand side. Willard Bishop also integrates shopper-based analytics and cost modeling to identify and quantify hidden opportunities. The company further augments its solution matrix (manufacturer, retailer, and consumer) by providing custom-developed applications, models, and tools that improve client performance from concept to consumer. For Consumer Goods Manufacturers Capturing growth in mature markets and channels has always required a deep understanding of the manufacturerretailer-consumer relationship. However, the emergence of Omni-channel marketing and the evolution of the digitally-connected consumer, are creating new challenges and opportunities for consumer goods manufacturers. Willard Bishop helps manufacturers identify these opportunities; then develops specific road maps that enable clients to capitalize on these trends, while uncovering hidden growth opportunities. Areas of expertise include: For Consumer Goods Retailers Willard Bishop helps consumer goods retailers develop competitive platforms that attract and retain specific shoppers and optimize the sales floor. These platforms include a diverse solution set that connects the retailer s brand identity to the in-store experience. Using localized approaches to assortment, pricing, and promotion, Willard Bishop helps retailers increase shopper loyalty and basket size, while applying advanced analytics to increase efficiencies that span the extended value chain. Areas of expertise include: Growth Strategies Shopper Analytics Performance Optimization Store-Level Merchandising and Support Competitive Positioning Pricing and Promotion Profit/Productivity Optimization ecommerce and Delivery Products, Tools, and Data Through the years, Willard Bishop has developed products that bring new insights and understanding to the manufacturerretailer-consumer relationship. In addition to shopper analytics and merchandising data, Willard Bishop provides comprehensive decision support systems and promotion optimization solutions. AD-IN TM (Developed by Willard Bishop and Prognos) AD-IN TM is the first promotion productivity tool that optimizes the collective performance of retailers circulars (print and digital) and TPRs in order to gain margin and increase visits. Willard Bishop SuperStudy TM (Available for Grocery, C-Store, and ecommerce) SuperStudy TM is a subscription-based service for benchmarking product and category performance using expanded dataviews to provide critical financial insights that are not available from traditional syndicated data providers. Willard Bishop SuperShopper TM Database Improve decision making and business intelligence with the SuperShopper TM database, and benefit from more than two billion consumer transactions from key retailers, representing 20 million households. willardbishop.com