THE SMART PRICING INDICATOR

from HHIQ Q3 2023

Isn’t it your time to shine?

BY JIM INGLIS

Many retailers measure success by focusing on their profit and loss statement. This puts a spotlight on the gross margin percentage, since all expenses are deducted from that number. Therefore, it would seem that the higher the gross margin percentage, the more net profit can be achieved, assuming that expenses are held constant. However, this is only half the equation. It ignores the balance sheet, which has the inventory number—a significant element of the investment required to operate the business.

The better way to evaluate success is using the GMROI ratio, which compares the gross margin dollars from the profit and loss statement with the inventory numbers found on the balance sheet. GMROI is a measurement of the actual gross margin dollars generated in a specific time period, divided by the average inventory at cost during that period. This becomes a great

TABLE 1: Margin Does Not Define Profitability

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Objective is to maximize gross profit dollars not margin percentages tool to compare the productivity of departments, categories, or even individual SKU productivity.

Inventory is the major element in the retail business that affects the investment in working capital. Each time a retailing operation turns its inventory, it spins off gross margin dollars that its management can take to the bank. It is not the gross margin percentage that is most important. It is how often a retailer can generate real returns on the working capital invested in inventory.

Margin Versus Gmroi

Let’s look at a hypothetical situation. Say you’re evaluating the financial performance of a store that has both a hardware department and a lumber department. Both departments have an inventory that totals one million dollars at cost. The hardware department is making 50 percent gross margin. The lumber department is operating at a 25 percent gross margin. But the inventory turnover is quite different. Which is the most profitable department?

You cannot answer this simply by looking at the gross profit margin. You must also know the inventory investment and the rate of turnover of that inventory. We can see such a comparison in Table 1.

While in Table 1, the gross margin percentage of the lumber department was half that of the hardware department, it nevertheless generated twice the gross profit dollars. Therefore, it is not possible to judge the productivity and profitability of a business by looking solely at the gross margin percentage. The analysis is incomplete without knowing the relevant inventory turnover ratios.

The GMROI index tells us which department or category in a retail store is the most productive. Lumber, for example, is a commodity product with a small number of relatively high-volume items that should turn much faster than the hardware margins tend to have a strong relationship to normal inventory turns. This relationship is best expressed in the GMROI ratio. If the demand for a product is highly price sensitive, you may find that driving your pricing down leverages turnover by increasing sales. As turnover increases, the GMROI ratio will increase. If the demand for an item is somewhat inelastic, changing return on retail square footage instead of gross margin return on inventory investment as a measure of productivity. This is the kiss of death for most stores in general, and home centres in particular. department, with its thousands of specialized nuts, bolts, and fittings. Hardware requires a broad assortment of products, resulting in lower inventory turns. Yet both departments could achieve similar GMROI results. In the case of lumber, we will most likely increase GMROI by focusing on increased inventory turnover. In the case of hardware, increasing GMROI will most likely be achieved by focusing on increasing gross margins.

In our previous example regarding the pricing of lumber versus hardware, the lumber products are obviously large and require extra space to stock and load. Measuring return of gross margin on the space required would tend to make the case that the store should decrease or eliminate the lumber department, in order to give more space to the hardware department, which is more compact. This would create a huge decline in the company’s sales and profits.

Low margin products tend to be the faster-selling, commodity-type products, while slow-selling products are less price sensitive and tend to have higher gross margins. The market seems to understand that there is a relationship between margin and inventory turnover since prices and the price may not increase sales or inventory turn; but raising the gross margin percentage may increase gross margin dollars. Therefore, increasing the price will leverage gross margin dollars. In this case, as gross margin percentage increases, the GMROI ratio will increase.

Gmroi Measures Merchandising Competence

The job of the merchant is to understand demand dynamics and set the price that will most likely increase GMROI. This requires the merchant to have an exceptionally good understanding of the market and of the customer, in order to predict the customer’s reaction to a change in price, up or down. The goal is always to maximize gross margin dollars. This is accomplished by finding that sweet spot for the right price. Once again, the success of business and pricing strategies is driven by deep understanding of the customer’s perception of your brand and their response to your pricing decisions.

Measuring The Right Variable

Some consultants and professors will encourage retailers to use gross margin

First, you would lose much of the lumber sales, which drive related sales throughout the store. A strong lumber department creates demand for more hardware sales. You, obviously, also lose those gross margin dollars that the lumber department was providing. Expanding the hardware department would most likely drive the slow two turns to an even lower number, with a negative impact on GMROI.

This would be a good example of using accurate data to make a detrimental decision. Having both a strong lumber department and a strong hardware department is necessary for a destination project store. It’s a synergistic 1+1=3 equation. In other words, offering a project solution by supplying both lumber and the necessary hardware provides extra value to the customer. The whole is greater than the sum of its parts.

Make sure you are using the right metrics to measure your success. The formula to evaluate pricing acumen is GMROI.

Another example: The department that generates the most store traffic and sales in many home centre stores around the world is the garden and outdoor living department. This category of products has the unique ability to bring the customer back to the store multiple times throughout the year as the seasons change. Yet it is space intensive and cannot be justified on gross margin per square foot. However, a wellrun garden department in a home centre can generate an extremely high inventory turnover ratio and lead to a very favourable GMROI. and by smart pricing. Smart pricing that increases GMROI can only be achieved if the decisions are clearly focused on customer perception and made by people who can understand the impact of a price

(Editor’s note: These topics are explained in chapter 13 of Breakthrough Retailing.) Rational pricing demands good data and a complete market analysis of the pricing for every SKU in your product mix.

Maximizing gross profit dollars requires the merchant to go through a decision tree based on the customer’s perception of prices combined with a hypothesis of their likely response. Perhaps you’re asking, “What is the right or ideal GMROI number?” The answer is always the same, a higher number than last period.

Constantly Increasing Gmroi

The merchants’ job is to drive GMROI up. It should therefore be the major metric in setting their compensation package. The merchant can positively impact gross margin dollars and inventory turnover by designing the optimum model stock change from the customer’s standpoint. Implementing a policy of smart pricing will, most likely, result in both markdowns and markups, as you put yourself in your customer’s shoes and use benchmarking and price elasticity analysis to set rational pricing that maximizes gross profit dollars

Retailers are always competing against their own numbers by finding new ways to price right and thereby gain the customer’s business today and the customer’s trust for tomorrow. While it is impossible to increase gross margin percentage every quarter without destroying the business, it is very possible to increase GMROI every quarter, as we properly interpret and respond to the customer’s price perception, while maintaining smart inventory management.

The Inventory Factor

Another way the merchant impacts GMROI is by creating a more efficient model stock, which is composed of a SKU matrix that sets the store assortment of items based on feature, benefit, and price point.

Most merchants are constantly looking to add more items to the product mix, on the mistaken notion that more SKUs will automatically generate more sales. This is an oversimplification that often proves false. The customers do not really want more items, they simply want the right item for their need. The easier you can make it for the customer to zero in on the right products for their project, whether in the store or on the internet, the more you become the customer’s first choice to shop.

Instead of a product mix with redundancy and duplication, retailers need to make their stores easy to stock, easy to sell, and easy to buy. The same logic applies in making items on the website easy to locate, easy to distinguish, and easy to buy.

Overburdening the store with more and more SKUs makes it difficult to manage the display area without adding more manual labour to juggle the many items in a limited space. This also often results in being out of stock on the best-selling items, as valuable space is used for products with less customer demand.

An abundance of items with limited differences can make selling difficult for the salespeople. Too many SKUs with feature benefit redundancy can cause a customer to become frustrated and actually delay an intended purchase. This is true both off-line and online. Keeping the choices simple and logical will make the shopping experience more self-service, which is always the best service.

Over-assortment with redundant product ranges is a far too common practice and a major sin of most retailers. When the merchant tries to jam 50 pounds of stuff into a 25 pound bag, something has to give.

The customer loses because the store is: • Harder to stock. Salespeople are busy moving merchandise and stocking shelves instead of assisting customers. The store management is more likely to hire people with strong backs instead of strong product knowledge and experience.

• Harder to sell. When there is too much redundancy in the product mix, the salespeople cannot understand all the variations and, therefore, are of little help to the customer trying to make a decision. In fact, a confused salesperson will avoid helping a customer if they are not confident of their own product knowledge.

• Harder to buy. Having too many SKUs in the space available prevents the customer from quickly finding the product display, getting point-of-sale information, and more items than the competitor simply for bragging rights. This, unfortunately, is the direction merchants often receive from management. It is particularly grievous with regard to the internet and e-commerce assortments. There seems to be a race to out-SKU Amazon, without understanding the high cost of warehousing and logistics, in addition to the working capital tied up in the multitude of long-tailed products. Millions of SKUs produced by manufacturers may or may not be in demand at the mass-market level. Stocking some of these products in the store may be justi- lowest-cost price. Only when retail space becomes limited and, therefore valuable will vendors vie for shelf space and offer their lowest-cost price. Systematic line reviews will lower item costs while eliminating redundant inventory and, in some cases, unnecessary vendors. Both of these factors will positively impact GMROI. This same logic can be applied to increase the productivity of the many products sold online. easily obtaining the product for purchase. In addition, it often forces needed inventory of the better sellers off the sales floor and into storage areas, when they are not readily available to customers. Even more likely is an out-of-stock situation, as display space and inventory dollars are tied up in slow-moving items.

When you have redefined the appropriate model stock, you must control the depth of inventory in a store. The big danger here is that products may be reordered with the objective of filling the shelf space to make the store look good, instead of having a balanced inventory that works good [sic].

Looking only at the average inventory turnover for the total store to determine appropriate inventory is misleading. A closer examination of subclasses and SKUs within the product mix will generally show an incredible number of items that are slow sellers and turning well below the department average, while the best sellers are spinning too fast to assure a consistent in-stock position. The average turnover number may seem to be within acceptable standards, but the customers may be frustrated and not well served if the store is out of the one item they need. The inventory level of every SKU needs to be set by the rate of sale and safety stock required for that specific item.

Merchants need to avoid racing to have fied, while it may make sense to offer some additional items on the website. However, not everything made or offered by a manufacturer should be stocked in the store or even offered on the website. The rule must be to offer items that customers truly want to buy and then be able to deliver in a timely manner.

Smart merchants are curators who design model stock assortments, both off-line and online, to assure maximum choice of features and benefits for their customers with a minimum of needless redundancy and duplication. To this end, they must conduct systematic line reviews aimed at consolidating SKUs and vendors, in order to create a more efficient supply chain.

Sku Discipline Creates Cost Savings

Line reviews deliver a dual benefit, in that reducing the SKU count forces vendors to compete for the limited shelf space. This often results in cost reductions. When a vendor does not have to compete for shelf space, the retailer will not be obtaining the

Optimum inventory levels are dynamic and based on individual stores. The correct depth of inventory must be set by looking at each store’s sales by item and setting a safety stock that is adjusted by a logarithm applied to the dynamics of lead times and that store’s sales trends.

This whole process is best managed by computerized logarithms. Of course, provision should be made for human adjustment when outlying factors are involved that are not programmed into the logarithm. This requires proper education, as well as discipline to assure that the computerized orders are not overridden for the wrong reasons. It is also imperative that the inventory data maintained in the computer’s perpetual inventory number be accurate and dependable. A credible reorder system demands the data generated be dependable to project rational reorders on a store-by-store basis.

This article is an excerpt from Chapter 14 of Jim Inglis’s superb book, Breakthrough Retailing: How a Bleeding Orange Culture Changes Everything , available from Amazon.ca. You can see— and meet—Jim Inglis at the Hardlines Conference in Whistler, B.C., on Oct. 17 and 18. Inglis will be giving two presentations, the second one a workshop.

Your Guide

Kim Pefﬂey

Director of Organizational Development & Consulting, NHPA

Kim Peffley began her career over 25 years ago, working at her family-owned True Value, and then served as General Manager for a seven-store Ace chain. As a certified Everything DiSC® Facilitator and Consultant, Peffley uses her industry-specific retail management and leadership experience to offer professional training and support to retailers.