Chapter 11: Profitability Flashcards
Within the retail sector, two approaches to optimizing cost-effectiveness are currently in use.
On the one hand, systems that focus directly on influencing R in the formula R = S x M – C. We could call these top-down systems. Among these methodologies are the techniques of DPP/DAP (direct product profitability and direct assortment profitability)
On the other hand, we have systems that focus more on the mutual relationship between and influence of S, M and C. An example of the latter methodology that we can call bottom-up approaches is the trinity model (also called the strategic-retail resource model).
DPP systems
In most general terms, DPP refers to methods in which we substract the (variable) direct costs (DPC = direct product costs), associated with managing a product, from the gross margin achieved with the product, i.e.:
DPP = Margin – DPC
We obtain a kind of contribution margin of the product which gives a better impression of the contribution of the product to the total profitability than the gross margin alone.
In fact, by using DPP we are trying to achieve a kind of reverse costing. In manufacturing, it is customary to determine the selling price of an item by cost calculation, including the calculated profit margin.
In retail we often work with storage calculation:
we apply a fixed factor to the purchase price that should be sufficient to cover all costs plus profit. We call that factor the storage factor (or calculation factor). With DPP we try to find out, assuming an average goods margin, what remains of this margin after deducting directly attributable costs. This immediately highlights one of the difficulties in applying DPP: DPP is extremely difficult and time-consuming.
The real DPP systems are much less applicable in the non-food sector. The reason for this is twofold.
- Due to seasonal influences, it is rare for individual products to have a fixed space. Therefore, the direct space costs may vary depending on the time of day.
- The assortments in the non-food sector change several times a year. In the fashion industry, assortments are even changed continuously.
The increased digitalization in the non-food sector has brought the use of DPP closer. Still, often another solution is chosen. This is DAP (direct assortment profitability), a method in which costs and revenues are not allocated to the space unit per article, but to the space units for complete (sub) assortments.
Strategic retail resource model (Trinity Model)
Is a system inspired by the DuPont model of financial performance: it not only looks at the ultimate bottom-line profitability of a company, but also tries - by establishing links between the various financial ratios - to identify which key success factors influence profitability.
The trinity model allows
● internal comparison for stores and departments over time
● external comparison of the competition to get an impression of the strength and weaknesses
Structure and application of the trinity model
The model is based on the idea that in retail only these 3 assets need to be managed:
- People (human assets) → labour efficiency (return on labour) → expressed in full-time equivalent (FTE)
- Products (variable assets) → stock efficiency (return on inventory)
- Square metres (fixed assets) → floor efficiency (return on floor)
What matters for longer-term optimisation is not productivity, but the effectiveness of the asset. Effectiveness = productivity * profitability.
It is not about the lowest cost solution but about the highest efficiency solution
Analogous to the Dupont financial model, the trinity model uses intermediate variables:
good intensity and self-service ratio.
self-service ratio
Is the link in the model between floor productivity (sales per unit of space) and labour productivity (sales per FTE). The self-service ratio is defined as ‘the number of space units that must be maintained per FTE’: the higher that number, the less service is offered.
(sales / metre^2) * (metre^2 / FTE ) = sales / FTE
Or
Floor productivity * self-service ratio = labour productivity
good intensity
Is a measure of the dominance of the presentation of the assortment. The higher the goods intensity, the more compelling the assortment comes across to the consumer.
The relationship between goods intensity and sales per metre can vary greatly from one sub assortment to another. For assortments in fashion, the sensitivity of sales per metre as a result of increased stock pressure per metre is virtually zero. Consumers, when buying fashionable, trendy articles, require space and overview rather than a lot of goods. For functional sub-portfolios, the correlation turns out to be strongly positive, as consumers then need a lot of choice and a large assortment rather than space.
Suppose we have a situation in which we have to be very careful about costs, but at the same time we have to work on strengthening the market position. In this situation, if we consider achieving our goals by increasing inventory, we must - in order to get the best result - differentiate between departments. In one department, increasing inventory pressure will yield much more profit than in another.
stock density
Is the link in the model between the sales rate (sales divided by average stock) and product productivity (sales per unit of space). The stock density is defined as stock per unit of space.
(sales / stock) * (stock / metre^2) = sales / metre^2
Or
sales rate * stock density = floor productivity
Use of the trinity model
You can use it in two ways:
- sequential analysis: you actually measure how the operation of the formula in question develops over time
- Simultaneously analysis of two different providers: comparing the variables will then show how the performance of one provider compares with that of the other. You then use the model as a kind of benchmark in the competitive analysis.
Trinity model: three rules of thumb
- Optimize GMROI (Gross margin return on investment)
- Increase stock as long as GMROF increases (Return on floor)
- Optimize GMROL (Return on labour)
