Already industry analysts and experts are calling 2009 a write-off. Amidst a flurry of bad news that amounts to the most challenging retail environment in nearly a century, many industry giants are fighting to survive. Yet history demonstrates that investing in building key capabilities now will likely mean faster, stronger growth once the economy recovers. So what are the right priorities for retailers?

Certainly, cost reduction is critical for all retailers. For healthier retailers, aggressive but prudent cost reduction can fund an investment in key capabilities. whereas a more aggressive approach to cost reduction may be appropriate for retailers facing significant profit or liquidity issues. The key for both groups is to act quickly. Retailers that delay profit improvements run the risk of creating a liquidity crisis, which can result in ruin in the current credit crunch.

Thanks to the example set by Wal-Mart, most retailers are managing costs aggressively. So how can retailers find more places to save? To put it bluntly, this recession is forcing retailers to consider changes that would never have been investigated in the past because of perceived customer, supplier or financial risk.

In today’s environment, failing to slay “sacred cows” from the past will likely lead to financial failure. Given current revenue and margin shortfalls, a typical retailer needs to reduce its cost base by at least 5% to 10% to stay cash-flow positive. This means a much more aggressive program than the classic trimming of overhead headcount and costs by a few percentage points.

What are the best retailers doing to manage costs?

Culling the Asset Base

In good times, retailers see their store base and inventory as assets for generating growth. In bad times, retailers need to pull back to a profitable core of assets. Retailers in a tough financial environment need to do the following:

  • Assortment rationalization. Assortments expand during times of economic prosperity as retailers add new lines and experiment with derivative products. Narrowing the assortment is necessary to reduce development and management costs. It also allows inventory dollars to be invested in core product offerings. Further, a recession is one of the few opportunities retailers will have to rationalize assortments with a lower risk of alienating consumers.
  • Shrink store network. Most retail chains have stores that are a financial drain but are retained because they are in underdeveloped markets or show a modest improvement trend. Biting the bullet on store closures now will preserve a more profitable, healthy core to build from in the future. The retail space will be there when they again need it.
  • Optimize inventory service levels. Most retailers carry enormous burdens of low-productivity inventory due to visual minimums and autopilot buying habits. As shown in Exhibit 1, inventory levels are rising relative to sales. Each piece of inventory creates a coattail of supply chain costs, store backroom costs and working capital costs. Rather than cutting across the board, retailers can strategically target non-core categories with high sales volatility. Hold and flow inventory management techniques can also reduce inventory requirements by keeping more safety stock in (now less crowded) distribution centers rather than store sales floors.
  • Shift asset ownership. The shrinkage in revenue has created an overabundance of supply chain infrastructure. Retailers need to know how they are going to partner to either improve the utilization of their own assets or leverage someone else’s assets.
Focusing Beyond the Big 4 Costs

Retailers have four major costs that make up over 80% of their cost base: Store Operations, Supply Chain, Distribution and Sourcing. The remaining costs are easier and less painful to manage (and should be managed), but even deep cuts will not achieve the required cost base reduction needed in today’s environment.

  • Store Operations. In a shrinking revenue and inventory environment, store staffing models need to be redesigned. In one department store, over 20% of payroll could be saved by optimizing backroom operations and shifting the mix of part-timers. All of this could be completed without affecting the investment in face time with the customer.
  • Supply Chain. Many retailers have overbuilt their supply chains in anticipation of growth. The supply network needs to be redesigned to reflect the lower-growth environment and more compact store base. And, the current “buyers market” in transportation is creating excellent opportunities for reworking contracts and reducing costs.
  • Distribution. Downturns are also an excellent time to expand performance-based work standards, since employees can see the need for job-preserving changes. Even retailers with strong labor productivity programs have found that 10—20% reductions in direct labor hours are possible.
  • Sourcing. Until recently, the primary focus of sourcing has been increasing the mix of direct imported products. Even with mediocre execution, any retailer raising its mix of direct imported products was likely to enhance margins. Advanced retailers are now focusing on the next level of costs: cutting spending on buying offices, optimizing the mix of source countries, standardizing processes and standardizing fabrics/materials.

The mistake most retailers make is managing costs for each cost center while missing the cross-functional opportunities across cost centers. Taking an integrated view across the Big 4 cost centers provides a greater chance of finding untapped cost-reduction opportunities. For example, changing the cadence of product shipments can allow radically lower supply chain costs (e.g., shift to hold and flow) and store operations costs (e.g., prebuilt displays).

Preserving Key Capabilities

Surviving the downturn is useless if it means destroying the heart of what makes a retailer successful. The key is understanding which resources (people, assets, CAPEX programs) are most critical for the long-term business model. Kurt Salmon’s Act Vertical research has shown that a few key capabilities will be the drivers to long-term success in retailing. Creating a strategic framework to the cost-reduction process is critical. For example, one retailer’s strategic analysis of IT spending placed 25% of the budget in “continue,” 25% in “hold but sustain” and 50% in “cut.” Across-the-board arbitrary cost reductions often result in lost capabilities that can take years to rebuild.

Making Changes Fast

In the past, many core processes were not considered as sources for cost reduction because change was considered slow and complex. Merchandising plans were locked 12 months in advance and retraining the organization in a new process took years. Kurt Salmon has found that quite the opposite is true—change in all areas can be large and fast. Consider sourcing. Historically, it took 12—18 months to see results from changes in sourcing due to the lead time on fashion season purchases. Today the opposite is true. Order sizes and mix can be adjusted within weeks of shipment and everything can be changed within 6 months of a season. With underutilized offshore capacity, flexibility in 2009 will only increase. Key costs can be restructured within 6 weeks in many cases and no more than 12 weeks.

Getting Cost Reduction Implemented

Cost reduction is most effectively implemented with a partner. Only an objective third party can bring the outside experience from other companies to credibly overcome resistance to eliminating sacred cows. Partnership also provides focused and temporary resources during a period when existing staff is stretched thin. While using a third party has costs, the risk can be mitigated by tying fee levels to results.

24 August 2009