Tuesday, February 1, 2011

Dramatically improving retailer performance

By how much can retailer performance be improved? To answer this question, we need to consider which operational measures of performance are important. Retail owners and managers typically understand that sales per square foot and inventory turns (how quickly the inventory is sold and replenished in the store) are important. Both of these measures of performance indicate how well the limited space of the store/shop is being utilized to improve the financial measures of performance.

Now that we agree on the measures, we can discuss how much potential for improvement exists. First, we need to understand that two major undesirable effects are blocking the ability of a retailer to significantly improve its performance: shortages and surpluses. Shortages occur when an item that is supposed to be on the shelf is out of stock. When there is a shortage, sales are being lost, although the amount of lost sales is unknown. Some customers will buy a different product (substitute), while others will choose not to buy or buy elsewhere. Surpluses occur when the level of inventory is too high. One effect of surpluses is blocked shelf space, which could be utilized to stock a larger variety of items to sell. The impact of both shortages and surpluses is detrimental to financial performance. What if we could find a way to dramatically reduce both shortages and surpluses? The result would be significantly improved performance.

Let’s begin by addressing inventory turns. Walmart, the world’s largest retailer, has on average about 12 inventory turns per year. This means that the stores are holding about 4 week’s worth of inventory. In other words, all of the inventory currently held in the store would sell out 12 times a year. Each of the Walmart stores receives deliveries from suppliers several times a week. If Walmart changed the supply-chain mode of operation to effectively react to actual consumption (sales) through implementation of the TOC pull distribution application, shortages and surpluses would be significantly reduced. How much improvement is possible? Walmart could effectively reduce the inventory level to about 2 to 3 week’s worth, meaning inventory turns of 17 or higher.

Let’s now address sales per square foot. It would also improve dramatically as a result of reduced shortages and surpluses. A financial measure that provides a good indication of improvement in sales per square foot is the net profit to sales ratio. After D’Agostino’s supermarkets in New York implemented the TOC pull distribution application, its net profit to sales ratio increased from about 2 to 3% (the typical ratio in the grocery industry) to over 8% - almost quadrupling the ratio!

What could happen to the net profit to sales ratio of Walmart, which is currently 6%? Experience in implementing the TOC pull distribution application indicates that it is not uncommon for up to 30% of the items to be in shortage and 50% to be in surplus. If Walmart reduced both shortages and surpluses, the sales could easily increase by 10% or more. In 2010, its sales and operating income were $405B and $24B, respectively; the gross margin was 25%. If the sales increased by 10% and the costs were unchanged, the new ratio for 2011 would be almost 8% ((24 + 40.5*0.25)/445.5).

The result that can be achieved with the TOC pull distribution application is a substantial decrease in inventories coupled with a significant increase in availability and sales, in a matter of a few weeks. Since the shortages are of high runners, it is likely that the sales will be much higher when shortages are reduced because we cannot really know how much sales of high runners are lost when shortages occur. We will only know how much sales actually increase once the shortages are reduced. Reducing the surpluses decreases the level of investment needed in inventory. In addition, reducing surpluses frees up valuable shelf space for a larger variety of products to offer for sale. Thus, significantly reducing the surpluses and shortages dramatically improves the inventory turns, net profit, return on investment and cash flow.

To learn more about the TOC pull distribution solution, read my book chapter on Strategy and Tactic trees in the Theory of Constraints Handbook and the novel Isn’t it Obvious?, which is co-authored by Dr. Eli Goldratt, the founder of TOC.

1 comment:

  1. You are dead on, Lisa. We implemented exactly what you describe with a $10b brand/retailer. As you suggest, their stores had about 2100 SKUs actually on shelves (we counted them) out of 3000 they intended the stores to offer - 30% shortages. By letting sales pull products back into the stores, we were under 4% shortages in 3 weeks. The really cool thing was same store sales shot up over 100%! We were shocked until we realized that the actual velocity of the fast movers were much more than they had previously thought and substitution, by comparision, was a much much smaller offsetting factor. We proved 30% return on sales was possible with the right inventory at the distribution centers - enough profits to justify faster replenishment within their seasons, even if it had to be at a higher cost. At the same time that they were selling twice as much there was no change in inventory investment, so they were getting twice the turns too. Less investment + higher return. We became very popular to say the least!