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category average margin

RIP Category Average Margin

Background

Category Average Margin is simply the average % margin a supermarket makes in a category before their CODB (cost of doing business). It is normally expressed as a % of retail sales, e.g. 30%. Different retailers will have different jargon / calculations. Personally, I calculate retail sales at full sell price, before in-store discounting due to short date / price matching other stores etc. The product cost is nett cost after all trading terms, including promotional funding such as case deals etc. So, if full sell is $3 and nett cost is $2 then category average margin is 33.3%. Calculation;

Sell$3.00
Cost$2.00
$ Margin$1.00
% Margin33.3%

Manufacturers can also use category average margin to calculate category profitability. Again, different manufacturers will have different jargon / calculations. For manufacturers I suggest using nett sell price (after all terms including case deals) minus COGS (cost of goods sold) to calculate category average margin. Similar calculation:

Nett Sell$3.00
COGS$2.00
Margin$1.00
Margin33.33%

In my blog, Which category metrics are relevant today? , I have already suggested category metrics that focus on shopper loyalty are key to financial success.

Inflation

As the chart below highlights Australia (and many other countries) are now moving from a low inflation economy to a high inflation economy. This change is being driven by numerous factors including COVID disrupting global supply chains and locally adverse weather events such as floods in QLD. The RBA governor, Philip Lowe, predicts that inflation in Australia shall continue to increase to 7% this year and will remain above the 2 – 3% goal for a couple of years (ABC). Other major economies such as the US and UK are experiencing a similar situation. The UK CPI (Consumer Price Index) rate is 9.1% (12 months to May 22), a 40 year high (ABC).

Source ABS

A recent example of inflation effecting supermarket prices has been iceberg lettuce retailing for $12 a head (news) in some Australian supermarkets. Logically shoppers were outraged at this high price (Sky news). KFC even temporarily changed their menu to include lettuce and cabbage on their burgers due to supply / cost constraints. As reported by news KFC shoppers were ‘not happy Jan’ about the change.

Why sell iceberg lettuce at $12?

So why, in the shopper led world with lots of shopper data / insights etc, would a supermarket sell iceberg lettuce at $12 a head? Category average margin. As the simple table below highlights as the cost price for lettuce from growers increases then so does the sell price to maintain the same category average margin. Buyers (like most employees) have KPIs / budgets to achieve. Category average margin is one of their KPIs.   

Sell$3.00$6.00$12.00
Cost$2.00$4.00$8.00
$ Margin$1.00$2.00$4.00
% Margin33.33%33.33%33.33%

Please note the $ margin for the supermarket has increased from $1 to $4 in this simple example. Their CODB (cost of doing business) has not increased 300% but their $ margin per unit has. 

Shopper led

In Australia as of July 2020, 91 percent of Woolworths and Coles in-store and online customers were “cross-shoppers”, meaning that they shopped at both stores.

Source: Statista

Major supermarkets, such as Coles and Woolworths, have adopted shopper led strategies to try to maximise long-term financial results. For example, customer obsession is one of Coles values. IMHO (in my humble opinion) this is due to the fact that Australian supermarket shoppers are not loyal. Australian shoppers regularly switch between major supermarkets (Aldi, Coles, Woolworths) as well as shopping at specialist retailers (e.g. baker, butcher).

Retail prices are a major factor influencing Australian supermarket shoppers’ loyalty to a chain. As reported by insideretailmore than half of respondents said consistently low prices are the top reason for staying loyal to a retailer’.  So, to maximise long-term sales / shopper loyalty supermarkets regularly position themselves as having ‘the best product at the best price’. For example, Aldi claims that ‘families can save up to $2400 a year with Aldi’ (Aldi).

Due to numerous factors, including press reports about higher retail prices, many supermarkets have attempted to increase loyalty with low price campaigns recently. For example, Fresh and Save (7 stores in QLD) had a ‘$2 week’ with many SKUs (including fresh produce) at $2 (news). On the other end of the spectrum Woolworths has announced a ‘price freeze’ on almost 200 SKUs till the end of the year (nine news). This ‘price freeze’ is in addition to their low price guarantee on over 300 ‘Winter Staples’ SKUs for Winter 22.

Which KPI?

The obvious challenge for manufacturers and supermarkets in a high inflation environment is how to price items to meet shopper expectations. These decisions are often driven by KPIs so which KPI is more important?

If category average margin is important then in a high inflation market shoppers could have a negative perception of retailers pricing. This was shown by Australian shoppers’ reaction to iceberg lettuce at $12. This could lead to a situation of shoppers switching brands / retailers / decreasing loyalty.  

If shopper led pricing is more important category average margin could decrease. This could improve shopper loyalty / sales by ensuring a competitive offer in a high inflation market but may also decrease % margin in the short term.

A potential solution is to focus on other measures, such as $ margin. $ margin is simply category $ sales minus nett purchases for supermarkets and COGS for manufacturers. By using $ margin manufacturers and supermarkets can then have more flexibility to better manage prices to meet shopper expectations. This can help maximise long-term financial results including shopper loyalty. Secondly by focusing on $ margin manufacturers and supermarkets can generate sufficient cash flow to manage their own increasing CODB (cost of doing business). Some financial measures, e.g. EBIT to sales %, may decrease but topline numbers ($ sales, $ profit etc) could be maximised.    

Industry structure – supermarkets

During the last 10 years the level of competition in the Australian supermarket industry has increased. Since 2012 Aldi Australia has doubled their number of stores from approx. 280 to 570. Costco Australia has increased their store (warehouse) numbers from 3 to 13. In 2018 Amazon Australia launched their Amazon Pantry Food and Drinks category for Australian shoppers. These larger international retailers are now offering Australian supermarket shoppers more options of where to shop.

Partly due to increasing levels of competition Woolworths Australian Food and Liquor EBIT as a % of sales has decreased from 7.5% in 2012 to 5.5% in 2021 (2012 Annual Report p91, 2021 Annual Report p26, 36). So, whilst topline sales for Australian Food and Liquor (includes Endeavour) grew 45% from $37.5B in 2012 to $54.6B in 2021, EBIT grew 10% from $2.8B to $3.1B (including Endeavour). IMHO (in my humble opinion) this long-term trend will continue for the foreseeable future. New entrants are prepared to operate on lower EBIT %. For example, Costco works on approx. 3.4% EBIT (2021 Annual Report p40). Amazon International business (includes Australia) reported a loss last year (2021 Annual Report p75). NB US accounting standards may be different to Australia.

The challenge for supermarkets today is that they require substantial positive cash flow to invest in services shoppers now demand, e.g. click and collect and home delivery, to maintain sales and share. To deliver these services requires major investments in infrastructure including automated warehouses, updated stores and digital to name a few. This is a reason why I suggest measures, such as $ margin, will become more important in the future.  

Industry structure – brands

“The last thing we want to do is increase the price of goods to consumers, but part of our products, especially the tin can with iron ore prices up and freight costs, it goes to the position that we need to move prices.”

Robert Giles, CEO SPC

Source: news

Due to a number of factors manufacturers are working on reduced margins due to increasing COGS. Many external costs, such as raw materials and freight, plus internal costs, such as labour and electricity, have increased significantly in the last few years. This has led to a situation where numerous manufacturers are now requesting price increases to cover increases in CODB (cost of doing business).

Much has already been written about the increasing sales of P/L (private label) globally. IRI estimates that P/L (private label) accounts for 16.5% of global FMCG sales value. The long-term increasing sales of P/L (private label) has led to downward pressure on manufacturer sell prices for many years.

Analysis by Morgan Stanley highlighted that there was a profit transfer from Australian grocery suppliers to major supermarkets in the 7 years to 2014 (foodanddrink). This profit transfer also led to downward pressure on manufacturer sell prices.

So, like major supermarkets many manufacturers, particularly of branded ranges, have been operating on lower % margins. As an example, Nestle global trading operating profit has decreased from 15.2% in 2012 to 14.0% in 2021 (Annual Report 2012 p3, Annual Report 2021 p49).  

The challenge for manufacturers today is that they require substantial positive cash flow to invest in their brands. In addition to above the line marketing campaigns this investment includes innovation / NPD to differentiate their offer vs P/L (private label) plus developing new channels to better serve shoppers such as D2C (direct to consumer). This is a reason why I suggest measures, such as $ margin, will become more important in the future.  

Future shopper demands

As the economy transitions to a high inflation economy it is logical that shoppers will demand more ‘value’. Historically ‘value’ was simply having ‘the best product at the best price’. Today ‘value’ is about delivering a better overall experience. For manufacturers and supermarkets the focus is now on how best to serve shoppers. For example, Woolworths is launching a new app (Metro60) that can deliver small orders ($20+) to shoppers in 60 minutes (inside FMCG). Also, many manufacturers and supermarkets are changing their products / operations to meet shopper demands for a more sustainable / ESG / circular economy offer. To meet future shopper demands manufacturers and supermarkets will require substantial positive cash flow to change their supply chain. Again, this is a reason I suggest measures, such as $ margin, will become more important in the future.  

Summation

Disruption is the new normal in supermarkets. Numerous factors such as COVID and adverse weather have already disrupted the supply chain including CODB (cost of doing business). As the Australian economy moves from a low inflation to a high inflation environment sell prices will increase. Using some measures, e.g. category average margin, to determine sell prices is not apt in a high inflation market. . Simply put shoppers will switch to other brands / supermarkets plus P/L (private label) manufacturers and international supermarkets are prepared to operate on lower margins.

The increasing level of competition in the Australian supermarket industry, for both brands and supermarkets, will continue to create margin pressure for both manufacturers and supermarkets. Trying to achieve KPIs that focus on increasing margin as a % of sell price is questionable.

The industry needs to review KPIs to ensure they are aligned with shopper expectations to deliver long-term financial results. I suggest to ensure the long-term financial success of manufacturers and supermarkets the KPIs need to focus on maximising positive cash flow in an ever increasing competitive marketplace.

The information provided in this blog post was general in nature. If you require more information I offer a free initial consultation by completing a contact us form.