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Managing Inflation Risk in Retail: Leveraging advanced analytics to weather the storm
 

Managing Inflation Risk in Retail: Leveraging advanced analytics to weather the storm

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Significant jumps in the price of crude oil, food, cotton, and other commodities are squeezing margins and eroding earnings. With a sluggish economy and skittish consumers, retailers cannot uniformly ...

Significant jumps in the price of crude oil, food, cotton, and other commodities are squeezing margins and eroding earnings. With a sluggish economy and skittish consumers, retailers cannot uniformly pass along price increases. Adding to the challenge, most retailers already pulled the traditional cost-reduction levers during the recession.

Feeling boxed in, they are now left searching for an escape from inflationary pressures. An emerging set of analytical capabilities focused on sourcing, pricing, assortment optimization, and inventory productivity may provide immediate relief.

Retailers are facing a set of challenges that require a new set of solutions to address them. Margin declines can no longer be offset by improvements in selling, general, and administrative (SG&A) costs and reduced inventories. Retailers will once again need to selectively employ a set of “go-to” levers that they have utilized in the past to manage costs in the short term, and a series of more-advanced levers to build a sustainable, competitive advantage.

To learn more, please find the attached Managing Inflation Risk in Retail report

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    Managing Inflation Risk in Retail: Leveraging advanced analytics to weather the storm Managing Inflation Risk in Retail: Leveraging advanced analytics to weather the storm Document Transcript

    • Managing inflation risk in retailLeveraging advanced analytics toweather the storm
    • 2
    • Feeling the pressures of inflationRetailers are increasingly feeling Within the last two years, oil prices have risen over 110%1 – an increase which impacts virtually every segment ofthe pain of inflation. Significant the economy. Other commodities and critical retail inputs, such as cotton, food, leather, silk, and other textiles havejumps in the price of crude oil, experienced significant price jumps as well (see Figure 1). Cotton prices have almost tripled in the past two years,food, cotton, and other driven largely by a supply shortage. Additional price increases are anticipated, with many analysts expectingcommodities are squeezing margins cotton prices to hit $3 a pound after trading for decades around $0.40 to $0.50.³ Food prices have risen at similarlyand eroding earnings. troublesome rates, jumping by 57% over the past two years. These increases are likely to be exacerbated by rising crude oil prices, which may cause farmers to gravitate toward supplying ethanol producers. Consequently, this With a sluggish economy and skittish consumers, retailers may trigger inflation in grain, which could trickle down to cannot uniformly pass along price increases. Adding to the overall food market. the challenge, most retailers already pulled the traditional cost-reduction levers during the recession. Feeling boxed These rising prices in crude oil, food, and retail raw in, retailers are now left searching for an escape from materials have significantly outpaced core inflation, which inflationary pressures. An emerging set of analytical was only 1.29% in 2010.⁴ This trend is anticipated to capabilities focused on sourcing, pricing, assortment continue, and will likely impact retailers in two critical optimization, and inventory productivity may provide ways: reduced consumer discretionary spend and immediate relief to retailers. diminishing product margins. Figure 1. Food Price, Cotton and Crude Oil Indices² (monthly trends since December 2008) 200.00 180.00 160.00 140.00 120.00 Index 100.00 80.00 60.00 40.00 20.00 0 Dec-08 Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sept-09 Oct-09 Nov-09 Dec-09 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sept-10 Oct-10 Nov-10 Dec-10 Jan-111 International Monetary Fund, Month January 2011.² Ibid. Food Price Index Cotton ‘A’ Index Crude Oil Index³ “Cotton Price Forecast.” (2002-2004 =100) US cents per pound (lb) (2005 = 100) Seeking Alpha. 4 March 2011.⁴ OECD Statistics. 18 March 2011. Managing inflation risk in retail Leveraging advanced analytics to weather the storm 3
    • Dampened consumer discretionary spend selling, general, and administrative (SG&A) costs. WithWhile retailers may hope to offset higher input costs by retailers already running relatively lean operations, theraising prices, inflation will have a significant impact on convergence of rising input costs and declining consumerconsumers’ ability to spend. When food price increases spend will require new strategies to stay ahead of theare paired with steadily increasing gasoline prices, one game this time around. Retailers will continue to turn towould expect that the discretionary spend of the average historical “go-to” levers, such as sourcing, design, andconsumer will likely trend downward. Consumer shopping private brands. These tried-and-true tactics should helppatterns will likely reflect tighter pocketbooks in a variety them combat inflation to some degree. With inventoryof ways, including fewer shopping trips, accelerated to sales ratios at the lowest levels in the last 10 years, amigration to the Internet, a shift to neighborhood new “art meets science” approach can help to addressshopping locations and one-stop centers, and an increased the inventory investment (see Figure 2). To execute thisfocus on low-cost options, such as private-label goods approach successfully, retailers should focus on precisionand discounted merchandise. Fewer shopping trips will and leverage new analytical tools to impact levers, such aslikely mean a reduction in impulse purchases and may pricing, assortment, and inventory.drive overall unit decreases. Additionally, the new Internet-savvy customer is much more equipped to bargain shop, Retailers are facing a set of challenges that require a newavoid price hikes, and buy more with less, which will limit set of solutions to address them. Margin declines can noretailers’ ability to pass along price increases and force longer be offset by improvements in SG&A and reducedthem to be more scientific in their approach. inventories. Retailers will once again need to selectively employ a set of “go-to” levers that they have utilized in theRecent actions past to manage costs in the short term, and a seriesDuring the recent economic recession, retailers were forced of more-advanced levers to build a sustainable,to aggressively reduce costs and pull the typical downturn competitive advantage.levers. They cut capital spending, closed underperformingstores, pared back labor, and slashed inventory levels.The result has been improved cash positions and lowerFigure 2. Non-Auto Retail Inventories to Sales Ratio1.801.701.601.501.401.301.201.101.00 1992 1995 1998 2001 2004 2007 2010Source: U.S. Department of Commerce4
    • Traditional “go-to” levers: sourcing, design andprivate brands Go-to levers to combat inflation:Sourcing • SourcingRetailers have historically been fairly nimble in shifting • Designproduction to lower-cost countries. While there may • Private Labelcontinue to be some marginal benefit to moving andconsolidating production, the bigger sourcing plays may New advanced analytics levers:be around raw materials. For retailers and manufacturers • Pricingwho continue to use raw materials, such as cotton, that • Assortmenthave experienced volatile price changes, there will likely • Inventorybe tremendous risk in the timing of purchases. Whether acompany locks in a price a year before production or buysproduct at the last minute, prices and margins will either explore alternative fabrics, including synthetics and otherreap the rewards of a favorable buy or pay the penalty non-cotton or non-petro-based blends. Some clothingfor an ill-fated purchase. Even hedging in the futures manufacturers have already begun incorporating rayonmarket does not fully eliminate commodity purchasing into their offerings to save on input costs. However,risks as buyers have increasingly been left on the wrong alternative fabrics are not a panacea as increased demandside of the contract. In addition to managing the cost is pushing prices higher.of raw materials, retailers and manufacturers will likely Design As an alternative to or in addition to direct sourcing initiatives, some retailers and manufacturers will reengineer products to maintain current price points. Popularized during the recent recession and applied most commonly in the food sector, retailers and manufacturers will continue to employ a handful of common tactics to reduce product costs. Packaged food producers have been known to keep ingredients constant, but reduce the pack size. Savvy shoppers will have noticed that ice cream and peanut butter containers have shrunk over the past few years with little or no corresponding price adjustment. In apparel, designers will look for opportunities to reduce or eliminate features, such as pockets, washes or embellishments. Additionally, many fashion retailers may push styles that require less fabric, although that could be counter to recent fashion trends. However, discretionary spend reductions will mean that products will have to be on-trend and differentiated to sell-through at higher prices. For retailers and manufacturers looking to design enhancements as a means of justifying a price increase, simply tweaking a style from last year likely will not be sufficient. Managing inflation risk in retail Leveraging advanced analytics to weather the storm 5
    • Private brands forced to increase overall prices and leverage other leversThe third traditional lever retailers will pull to combat to drive traffic into their stores. Dollar and value-driveninflation is increasing the mix of private brand products. formats will be under tremendous pricing pressure as theirBoth private brand share in existing spaces and entry lower-income shoppers, who are traditionally more priceinto new categories will continue to grow as they have sensitive, will be increasingly forced to make fewer andover the past couple of decades, accelerating in the more selective purchases.recent recession. The extra margin private brand productsprovide, usually 400–500 basis points, gives retailers the The rapid adoption of mobile commerce is likely to haveincremental margin to absorb some of the cost of inflation a significant impact on retailers’ ability to pass alongif the consumer reacts negatively to increases in unit prices. price increases to customers. Consumers’ ability to priceSome retailers have already begun implementing private shop competitors instantaneously will handcuff retailers’brands in their sales mix as a margin-protection strategy. ability to significantly raise prices on comparable items. With declining brand loyalty among Generation X and YThese tried-and-true levers will help retailers pinch pennies consumers, the premium placed on brand will be underto stave off diminished margins, but many retailers have further attack and product substitution will become aalready made these moves and are unsure of what to do greater threat.next. They also fear fallout from pushing too far, and maystruggle to predict the effects of their actions, which iswhere a new advanced analytics approach comes into play.Advanced analytic levers: pricing optimization,assortment analytics, and inventory productivityRetailers have long been awash in data, but the emergenceof advanced analytics has made generating insights from itmore feasible. Advancements in technology have enabledretailers to run more sophisticated analyses, using massivesets of transactional data, to provide precise answers toquestions once left up to gut instinct. While there willalways be an element of art to merchandising, it is thescience that underpins new tools now available that havethe immediate potential to help merchants make moreinformed, data-driven decisions.Pricing optimizationPricing is the lever that will likely get the most attention asinflationary pressures intensify. However, retailers’ abilityto pass along pricing increases will likely vary dependingon the company’s market position and value proposition.Market leading retailers, with solid and consistent foottraffic, are well positioned to hold retail prices flat.However, secondary competitors, perhaps more desperateto maintain current levels of profitability, will likely be6
    • These influencing market factors will force retailers to this approach is largely utilized by many retailers, as abe more strategic and scientific in price execution, and localization strategy based on demand patternsmore agile in adapting to changes in the market. Retailers has historically been too difficult and time-consumingwill have to closely monitor competitors’ pricing moves to develop.and determine how to rapidly adjust accordingly. Priceoptimization solutions will continue to provide the key However, the advent of advanced analytics is changingto unlocking this level of knowledge, allowing retailers to the game. Leading retailers are making groundbreakinganalyze price elasticity and make smarter, more confident strides in using attribute-based analyses to maximizingpricing decisions. These sophisticated analyses will help product mix. Product- (color, fabric, size, brand, price),pinpoint price elasticity down to the “SKU x location” store- (space, productivity, assortment), and/or consumer-level, measuring price sensitivity by attribute or a set based (shopping behavior, demographic, psychographic,of attributes. geographic) attribute analyses provide insights beyond the traditional ranking reports used by merchants. ItSimilarly, the importance of promotional effectiveness is allows merchants to more accurately determine locallikely to be magnified. As retailers seek to generate foot demand patterns and decide on how best to optimize theirtraffic from people who are making fewer shopping trips, assortment at the local level. In addition, there are someknowing which offers will activate consumers to buy will software companies that are able to provide sustainablebecome critically important. More retailers may look to solutions to analyze both consumer and transactional datastart or expand a “high-low” pricing program using deep to model local demand and help retailers determinepromotional discounts to drive store traffic and mask price which items should be included in the mix, by store orincreases elsewhere. By employing analyses to consider store cluster.product attributes of importance, consumer spendingpatterns, and pricing tolerances, retailers can identify Assortment localization is a powerful tool in fighting theproduct combination promotions that will motivate pressures of inflation. The insights derived from thesedifferent customer segments. Introducing this level of analyses will help merchants be more selective in shapingsophistication to pricing and promotional decisions will their buys, choosing relevant products in better quantitiesallow retailers to avoid risking fallout from the gut-instinct and more accurate size scales, and allocating themtactics employed in the past and ensure that pricing and more efficiently. Given the convergence of rising costpromotional plays generate the intended results. of goods and flat inventory dollars, this enhanced confidence in defining a core assortment and addingAssortment analytics localized layers will be critical for developing a sustainableBack when most retailers only had a few dozen stores competitive advantage.and were heavily concentrated in one region, localizingan assortment was easy. The buyer knew each store, each Inventory productivityneighborhood, and many of the shoppers. He or she Many retailers continuously swing between eras of highwas able to use this intimate knowledge of the market inventory, when customer service concerns top the priorityto customize the assortment based on the nuances of list, and low inventories, when business slows down andthe local demand. As retailers continued to grow, they leadership looks at the cost of holding all that inventory.began to “cluster” stores based on market characteristics The Great Recession may be over, but the long-termand develop uniform assortments based on broad- inflationary environment will pressure retailers to generatebrush customer and store segmentations. Even today, greater productivity out of their inventory. Financial analysts will not focus so much on the inventory reduction, but rather on limiting exposure to large markdowns that will hit retailers’ margins. Managing inflation risk in retail Leveraging advanced analytics to weather the storm 7
    • Additionally, other factors will emphasize the importance Advanced inventory optimization tools are now able toof managing inventory productivity: zero in on the right amount of inventory, in just the right• The rise in transportation costs may lead to decisions places, to meet customer service and revenue goals. This resulting in increased inventory levels to manage level of accuracy in demand forecasts allows for time- logistics spend. phased purchasing; decreased safety stock levels, stock- outs, and overbuys; optimal replenishment parameters;• The rise in commodity prices can also cause retailers and enhanced stock balancing. With inflation compressing to overbuy, particularly on imports, to avoid future margins across the retail industry, leveraging advanced price increases. analytics to manage a lean and productive inventory may• Most retailers house and manage e-commerce just be the answer to coming out of this period on top. inventories separately from their brick-and-mortar counterparts. However, as e-commerce continues to Building a new capability become a greater portion of many retailers’ business, it To come out of this inflationary period ahead, retailers will will be imperative for retailers to adopt a cross-channel likely need to develop an advanced analytics capability that approach to inventory management. is a step removed from day-to-day operations and enables proactive improvement of the business. Across the industry,Given all that, retailers may want to evaluate the merchants are overwhelmed with the operational taskseffectiveness of the entire inventory life cycle, across of running their businesses. Buyers are under constantchannels and, for global retailers, across countries and pressure to make their numbers, maximize the currentregions. Using advanced analytics, retailers may be better assortment, and identify the next “got-to-have-it” product.prepared to deconstruct the entire life cycle in four Planners are scrambling to manage their open-to-buyprimary ways: dollars, receipt flow, and inventory position. Meanwhile,• Evaluate the impact every planning, particularly replenishment and allocation is often bogged down by assortment and space, forecasting, and management reactionary and last-minute changes. Organizationally, no decision has on other upstream or downstream one has the time or mandate to perform the deep-dive functions. Most retailers look at this problem in (SKU/Store/Week), holistic (companywide) analyses that functional silos, in effect “optimizing” inventories within allow for sustainable gains in inventory productivity. each function without considering the big picture. Additionally, advanced analytics require deep quantitative• Build visibility and flexibility into the life cycle, including skills that do not traditionally reside inside most supply chain, to rapidly identify and react to market retail organizations. changes. To fully benefit from the advanced analytics available today,• Take into better account the impact of variability in retailers should address this capability gap by developing demand or supply plans before recommending inventory new skills, structures, and tools. From a skills perspective, levels. As with many things in the supply chain, use of while buyers’ core competency is picking product and “averages” in planning inventories can lead to problems. planners excel at managing the money, few have a• valuate opportunities to “merge” inventory into a E sophisticated understanding of statistical analysis. Given common pool that feed demand across channels the differentiated skills required to perform advanced or geographic areas, maximizing sales and margin analytics, it logically follows that these resources should performance. be structured as a center of excellence. As a centralized8
    • group, they can more efficiently and effectively evaluate Retailers will want to start small to build the capability.business performance. Finally, though many retailers have Select a department or two and build the analytics.sophisticated software tools to help merchants plan and Determine what attributes really matter. Prove to themanage their buys, few use these tools to drive the leading organization that this knowledge translates into marketedge, detailed, and expansive analyses that would allow power. Once you have proven to the organization thefor proactive optimization of the business. value of these advanced techniques, attack the other departments systematically. Take the time to learn fromThe good news is that retailers have the option to build each wave, constantly refining the models and analytics tothis capability and unlock opportunities to impact lever, get more precise.such as assortment, inventory, and pricing. Merchantscan effectively localize assortments based on multiple There will never be a model or set analyses that will beproduct, consumer, and store attributes. Pricing can use able to replace the importance of the merchant’s feel foroptimization tools to read demand and selectively pass the market. However, arming the merchant with the latestalong price increases. Impacting each of these levers will and best possible insights will provide additional leverage,allow retailers who move swiftly and smartly to stay ahead especially in an inflationary environment. The time to actof inflation, but it will not be easy. is now, the market is shifting daily and the consumer is constantly evolving. Building this capability will require deep commitment and will challenge retailers across product, channel, and geographic boundaries over the coming years. Managing inflation risk in retail Leveraging advanced analytics to weather the storm 9
    • AuthorsRod Sides Jean-Emmanuel Biondi Kyle VahlePrincipal Principal Senior ManagerDeloitte Consulting LLP Deloitte Consulting LLP Deloitte Consulting LLP+1 704 887 1505 +1 404 631 2503 +1 212 618 4537rsides@deloitte.com jebiondi@deloitte.com kvahle@deloitte.comFor more information about Deloitte LLP’s Retail & Distribution services, contact:Alison Paul John RooneyVice Chairman & U.S. Retail Leader U.S. Consulting Leader, RetailPrincipal PrincipalDeloitte Consulting LLP Deloitte Consulting LLP+1 312 486 4457 +1 215 446 3600alpaul@deloitte.com jrooney@deloitte.comKeith Dorris John SchefflerU.S. Tax Leader, Retail U.S. Assurance Leader, RetailPartner PartnerDeloitte Tax LLP Deloitte & Touche LLP+1 214 840 7361 +1 415 783 6827kdorris@deloitte.com jscheffler@deloitte.comRamesh Swamy John LittleU.S. Financial Advisory Services (FAS) Leader, Retail U.S. Financial Advisory Services (FAS) Leader, RetailSenior Manager PrincipalDeloitte FAS LLP Deloitte FAS LLP+1 213 688 3356 +1 214 840 7383rswamy@deloitte.com jolittle@deloitte.comLawrence HutterGlobal Consumer Business LeaderPartnerDeloitte Touche Tohmatsu+44 20 7303 8648lhutter@deloitte.comVisit Deloitte.comTo learn more about our Retail & Distribution practice, visit us online at www.deloitte.com/us/retail-distribution. Here youcan access our complimentary Dbriefs webcast series, Deloitte Insights podcast program, innovative and practical industryresearch, and a lot more about the issues facing retailers from some of the industry’s most experienced minds.
    • Managing inflation risk in retail Leveraging advanced analytics to weather the storm 11
    • This publication contains general information only and is based on the experiences and research of Deloittepractitioners. Deloitte is not, by means of this publication, rendering business, financial, investment, or otherprofessional advice or services. This publication is not a substitute for such professional advice or services,nor should it be used as a basis for any decision or action that may affect your business. Before makingany decision or taking any action that may affect your business, you should consult a qualified professionaladvisor. Deloitte, its affiliates, and related entities shall not be responsible for any loss sustained by any personwho relies on this publication.About DeloitteDeloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited byguarantee, and its network of member firms, each of which is a legally separate and independent entity.Please see www.deloitte.com/about for a detailed description of the legal structure of Deloitte ToucheTohmatsu Limited and its member firms. Please see www.deloitte.com/us/about for a detailed descriptionof the legal structure of Deloitte LLP and its subsidiaries. Certain services may not be available to attest clientsunder the rules and regulations of public accounting.Copyright © 2011 Deloitte Development LLC. All rights reserved.Member of Deloitte Touche Tohmatsu Limited