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Retail: Gross margin is the key - Views on News from Equitymaster
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Retail: Gross margin is the key
Oct 8, 2007

The most important goal of a company is to make profits and grow, which depends on liquidity and efficiency (how efficiently the company uses its resources and the ability to generate income from operations). These variables in turn decide the company’s ability to pay dividends. Thus, profitability is the one of the key parameters used to analyse the efficiency level of the company. The first thing everyone looks at is net profits or the bottomline. While this is an important parameter, for a retailer, gross margins are more important and in this article we shall find out why. Why gross margins?
Gross margins are nothing but profits that a retailer earns after subtracting cost of goods sold from the total sales. Gross margin is an important tool or an indicator of profitability and cash flows. A retailer's cost of goods sold includes the cost from its supplier plus any additional costs necessary to get the product into inventory and ready for sale. For a retailer these are the main costs. Then follows the operational and other expenses.

Irrespective of the growth phase, a retailer needs to maintain gross margins on an on going basis to be in the business. If the retailer is able to maintain margins and /or improve them, then it indicates the retailer’s control over merchandising and supply chain costs and its ability to make required changes to suit the changing customer profile on a timely basis.

Retailers often have minimum margin requirements, which determines price. Although minimum requirements will vary widely depending on the type of retailer, it is not uncommon for a retailer to expect a minimum gross margin of 50%. This is often referred to as a “keystone” markup. However, gross margins fluctuate depending upon level of operations, region, competition, type of business and the like.

There is also a concept of maintained margin i.e. profit actually earned after selling the product or service at a discount or markdowns. This spread varies depending upon the business and the level of promotional and clearance activity.

Factors that affect gross margins and strategies adopted to mitigate margin pressure…

Several factors can cause overall margins to erode such as competitive price pressures, increase in cost of operations and unanticipated shifts in sales mix toward lower-priced and lower-margin goods and services.

Rising costs of operation would be an industry wide issue until and unless the retailer has not done the homework before starting the business. A shift in a sales mix is more of a marketing strategy used by retailers to attract customers, maintain market share etc. The pressure is for the short to medium term and once the retailer is able to satisfy customer needs and wants and has created a loyal base of customers, the margins tend to stabilise.

To mitigate competitive price pressures, retailers need to reduce costs by improving supply chain efficiencies, improve stock turnaround time, etc. It has also been observed that retailers have chosen private labels as a differentiating factor to maintain margins.

The costs of operation are rising on account of increasing competition and sky rocketing rentals and property prices, rising freight and fuel expenses resulting into increased selling and distribution expenses. Employee costs have also been moving upwards, attributed not only to the expansion of outlets, but also due to pay hikes and high attrition rates. In order to curtail the high attrition rates, players have to review salaries/wages on a time-to-time basis.

To maintain and expand margins, players have to curtail costs. However, as mentioned, major cost heads are increasing and that is an industry wide issue. The players, who have been proactive and have purchased or contacted property on long-term lease basis before the prices started scaling upwards, are placed in a better position.

Thus, to mitigate the impact of rising cost pressure on margins, players have chosen private labels to maintain and/or improve margins. Private labels are brands created by retailers. As they are bought at lower prices, retailers are able to pass on the cost savings to the consumers while still generating higher margins than on comparable branded products. Further, it also helps customers to make modifications to suit its customer changing tastes and preferences and helps control the stock of inventory in a better way. The largest incidence of private labels has been in apparel retailing.

Generally, private labels margins hover around 40% to 50%, while on branded goods they earn margins ranging between 25% and 30% depending upon bargaining power. The two main reasons why retailers opt for private labels are to negotiate a better margin from the manufacturer and to use it as a differentiating factor to position themselves against the competitors. While a larger component of private labels definitely result in better margins, a retailer needs to maintain a judicious mix of both private and branded products.

As can be seen in the adjacent chart, Trent Ltd, whose sales mix has got the highest share of private labels, enjoys higher margins as compared to its peers. However, the margins have been shrinking over a period of time as it ventured into food retailing by setting up a hypermarket Star India Bazaar. Value retailing is a low margin, high volume business. While Star India Bazaar’s overall share of private labels is still low at 10% of its total sales, the company is planning to increase it to 20% to 25% going forward.

In case of Pantaloons, the margins have been quite volatile on account of its expansion plans, venturing into different formats and on account of its positioning as a discount store. Having said that, the company now has made few strides such as improving sourcing efficiencies (farm out purchases), tying up with local manufacturers and adopting a judicious mix of private and branded labels.

Shoppers Stop as compared to its peers offers a wide range of products. Private labels account for only 30% of the company’s total sales, while in the case of its peers it is the other way round. Though private labels have higher gross margins, the company’s strategy helps it to attract more customers by virtue of being able to cater to the needs of the diverse set of consumers. This is important for players like Shoppers Stop whose brands are still not that well recognized across customer profiles and whose target base focuses on premium category customers.

To conclude…
Thus, a look at margins especially gross margins helps one to understand how effective the management is in maintaining and improving them and whether the company can withstand a downturn or face competition, learn from its mistakes and grow.

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