Financial Professionals: Maintaining Profitability Amid Lower Selling Prices

Developing a new business model
Higher average selling prices enhanced retailer and vendor sales growth in recent years as consumers traded up, purchasing more luxury and aspirational merchandise. Profitability was leveraged by lower sourcing costs due to both a more efficient model and increased imports. Now, the average selling price appears to be declining causing a decrease in financial resources.

Lower inventories and reduced markdowns are currently contributing to gross margin improvement, and lower sourcing costs later this year should also play a role in improving that margin. Expense reduction has been significant, minimizing the impact of lower sales, and profitability will likely be on an uptrend over the next few quarters.

A more profitable business model needs to be developed. Easy comparisons, low inventory levels and reduced markdowns will only be temporary contributing factors during an economic recovery, as will the store rationalization process. Retailers need to offset lower or slower growth in comparable store sales and the resultant cost pressures with increased focus on driving gross profit per square foot. They are past the days of moving the markup higher; rather, the strategy should evolve towards a higher rate of sell-through and inventory turnover.

Stores have long pushed many of the cost pressures back to the apparel vendor, with markdown allowances and charge backs intensifying annually, eroding their financial strength. Today, we need to instead see new programs aimed at increasing efficiency as well as efforts towards individual store profiling with appropriately adjusted size and product assortments.

Private label goods were a margin enhancer for retailers in recent years, although that has proven to be a two-edged sword because of the long lead time and inability to push back to the manufacturer. That percentage has probably peaked relative to the department store merchandise mix. Selling exclusive brands provides an alternate strategy, allowing the retailer the advantage of unique merchandise, competitive differentiation and the ability to have better control over margins. This represents opportunity for a vendor, but retailers need to ensure that both the brand and the products they offer remain relevant to the market's consumers.

Average selling price on the decline
Financial Executives are witnessing a broadening of price points and a shifting in the mix within product lines, both reflecting retailers' focus on a more value-conscious consumer. Saks Fifth Avenue is looking for its vendors to develop a lower starting price point, in an effort to offer its customers a choice of good, better or best within a number of vendor categories. This shift in mix could reduce the average selling price roughly 10 percent. At the same time, we see department stores that had already traded up from the lower end of better, going so far as to even eliminate moderate, now beginning to reverse that strategy. Macy's, in its first quarter report, noted women's moderate apparel was strengthening, whereas results for better women's apparel was softer.

Nordstrom indicated its average selling prices declined approximately 10 percent following several years of steady increases.  Lord & Taylor recently noted it was reintroducing the Liz Claiborne brand, which it eliminated five years ago. Lord & Taylor and Nordstrom are also adding assortments of Nine West apparel. Starting price points for many better apparel brands are being reduced 10 to 30 percent.

Coach experienced strong comparable store sales through 2007, partly benefiting from an increase in store traffic, better conversion and a higher average selling price. Perhaps the latter contributed 4 to 5 percent of incremental sales for several years, but now Coach's results are trending in the opposite direction with the average handbag price expected to decline 10 to 15 percent this summer, compared with 2008. It is important to note this represents a shift in mix, rather than a reduction in gross margin. As an example, Coach Management noted 50 percent of its handbag offerings were priced between $200 and $300 this year, compared to 30 percent of its offerings last year.

Sales increases will remain challenging
Rationalizations of store space, inventory reduction, and a slower consumer recovery have been the key issues behind tempered growth expectations by retailers and vendors. The lower average selling price will be a major contributing factor, although perhaps offset by market share gains. Vendors will likely experience additional pressure as store consolidation and space rationalization continue. Finally, consumer spending will probably trail income growth as consumers rebuild savings and liquidity.

Adding to the uncertainty is the merchandise planning process; open-to-buy is usually based in dollars. Unit growth exceeded dollar growth last year because of sharp price reductions, making it difficult to develop a base to plan growth over the next 12 to 18 months. Conservatism will prevail and most stores still appear to be budgeting lower inventory dollars.

One potential offset for vendors may be broadening a brand's product line and expanding channels of distribution wherever applicable.

Maintaining profitability will be difficult
According to Financial Professionals the recession created excess production capacity such that value pricing can be maintained over the near term; margins could probably improve because of lower inventories and reduced markdowns. However, over the longer term, a more efficient business model needs to be developed – one that has a lean and scalable cost structure.

Financial Resources and expense reduction and cost savings programs have already been implemented by most CFO's and Financial Executives, but many of those programs need to be escalated. Initiatives should include sourcing, productivity and inventory management. In some instances, streamlining and an altering of the buying decision-making process should also be considered. This focus has to be ongoing and similar to the painting of the Golden Gate Bridge – when you get to the end of the process, it is time to begin the process anew.

Retailers should engage in an on-going, extensive sourcing analysis, examining the costs of direct sourcing versus agent sourcing, as well as consolidating suppliers. Most suppliers have excess capacity today and have reduced prices to maintain sales volume, however, further economies could be achieved through collaboration and more efficient planning to maintain or improve quality. Logistics and distribution also have to be factored into the equation. The lowest manufactured cost in a remote region might not be the lowest landed cost due to a longer lead time and/or greater shipping distance. Further savings could probably be achieved through exploring direct shipping to a store or regional distribution center to minimize handling and time in transit.

Accountability could also produce incremental savings with respect to brand management and customer responsibility. A detailed cost analysis of each product should determine whether it needs to be redesigned or eliminated. Intense scrutiny by retail customer and store distribution should provide insight into improved sell-through and profitability. Markdowns and promotions generally degrade the brand instead of building a base upon which to grow business profitability. For Financial Executives it would be idealistic to say, "Ship to only A and B stores," as the retailer generally needs to assort its less profitable "C and D" stores.

Unfortunately this practice is a large source of markdowns. Retailers and vendors need to routinely monitor poorly performing locations. Rent reductions might be an option today, but in reality, such actions are only a band-aid if traffic and customer base have deteriorated. Store renovation might be an option to enhance attractiveness, but such a decision must be justified by a targeted return on investment.