FIRST IN A SERIES ON RETAIL OPERATIONAL EFFECTIVENESS

O P E R AT
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IONAL
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golden egg forretail

VPI DELIVERS A BOOST TO MARGINS

ABOUT THE RETAIL OPERATIONAL EFFECTIVENESS SERIES: McKinsey's Retail, Apparel and Hospitality Practice developed this series of articles to help retailers enhance their performance by utilizing optimizing tools and novel operations approaches. This is the rst in a series of occasional articles.

ABOUT THE AUTHORS: The authors are leaders of McKinseys Retail Vendor Performance Improvement initiative. Laura Meinke is a consultant in McKinsey's Cleveland ofce, Elizabeth Mihas is a consultant in the Chicago ofce, Michelle Moorehead is a consultant in the Dallas ofce, and Nick Semaca is a principal in the Chicago ofce.

COPYRIGHT 2000 MCKINSEY & COMPANY. ALL RIGHTS RESERVED.

golden egg forretail

etail earnings are feeling the squeeze. The Internet, industry consolidation and changing demographics are all applying pressure to the top and bottom lines. Yet a powerful optimizing tool, Vendor Performance Improvement (VPI), remains little used and poorly understood.

VPI DELIVERS A BOOST TO MARGINS

VPI is a rich process that enhances retail margins by deepening buyers knowledge of their categorys economics. It embraces vendors as partners in the systematic assessment of vendors capabilities existing and potential and retailers opportunities to improve in category management, buying, and logistics. The disciplines and organizational processes that comprise VPI allow merchants to think beyond individual buys to develop a strategic view of their business while driving dramatic increases in growth and profitability. This article will: Show how VPI can lead to substantial profit improvements through cost reduction and top-line growth Examine the barriers to capturing maximum value from VPI Define the five key practices retailers must adopt to seize the VPI opportunity

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The size of the prize validates VPI

In the VPI process, retailers and vendors explore a comprehensive set of opportunities to improve profits. VPI examines all aspects of the business and all aspects of vendor relationships (Exhibit 1). A critical element of VPI is an end-to-end analysis of the total cost of merchandise, including the suppliers purchase of raw materials, manufacturing processes, supply chain, payment flows, and product merchandising and servicing on the store shelf. VPI also requires internal, objective examination of poorly performing elements of a business. Such a comprehensive look allows a retailer to identify its largest and most compressible costs and provides comparison points across vendors. Depending on the character of the retailers business, VPI can vary widely in its application. While every category requires a systematic, fact-based approach, the levers that will most enhance profitability vary with supplychain and selling-cycle characteristics. Ultimately, VPI leads to the
Exhibit 1

THE VPI PROCESS

Tasks

Create fact base

Assess opportunities and potential impact

Finalize recommendations

End products

Clearly articulated category strategy Vendor and productspending database Total cost of merchandise End-to-end supplychain flow Supply-market assessment Key opportunity levers

Segmented vendorsourcing strategy Request-for-proposal (RFP) RFP evaluation criteria Negotiated pricing terms and conditions

Detailed implementation plans with actions, responsibilities, and timing Monitoring and tracking mechanisms Modified budget Key learnings

It takes 16-20 weeks to execute VPI. Time invested varies with the categorys complexity.

Source: Team analysis

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identification of vendors with capabilities and product assortments that will maximize a retailers business both bottom line and top line. The VPI approach is equally valid for large and small, hardline- and softline-focused retailers alike. McKinsey experience affirms that profit improvement from VPI can be significant no matter the category. Weve seen overall costs as a percent of sales reduced by 7 percent, which translates into better than 40 percent improvement in net contribution margin. The savings range varies principally by the retail category and skill level of the buying organization: consumables and grocery typically yield savings of 1 to 3 percent, softlines yield 2 to 6 percent, and hardlines yield 1 to 7 percent (Exhibit 2).
Exhibit 2

VPI DRIVES COST SAVINGS NO MATTER THE CATEGORY

Category VPI outcomes Results

Grocer cheese

Centralized purchasing organization Consolidated/standardized vendors and SKUs Created regional distribution centers 1% gross margin increase

Catalog retailer Developed and enforced standards across all apparel groups private label apparel Developed supplier cost model to reduce purchase price Reduced vendor base

5% gross margin increase

Mass merchant Unbundled product costs to negotiate better terms do-it-yourself Changed distribution flow from DSD to through DCs
Source: Team analysis

Identified product cost/quality inconsistencies

6% gross margin increase

VPI also produces significant top-line revenue growth. Repositioning product to be more on trend or to address strategic gaps in assortment can result in a significant sales boost. Its common to see improved access to proprietary product, better in-stock performance, and enhanced product features or packaging resulting from VPI. By taking our VPI Savvy Quiz (on following page), you can determine whether your merchant organization has room to improve its skills to drive bottom-line improvement and top-line sales growth.
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Whats your VPI SAVVY quotient?

Can your merchant organization improve its skills to drive bottomline improvement and top-line sales growth? Take the VPI Savvy Quiz to find out.

1 2 3 4 5 6 7 8

Do your merchants understand their key suppliers product economics i.e., suppliersmost significant cost drivers and their overall margin size? Do your buyers understand the total cost of merchandise, from gross sales to net contribution after store direct expense? Do you conduct a full category line review, including vendor composition assessment, each year? Do your merchants have clearly defined vendor segmentations and objectives by segment? For significant categories, do your merchants develop formal requests-for-proposal from the supply base and optimize both top-line sales attributes and total cost of merchandise? Do your merchants meet regularly with your distribution and logistics organization to identify profit-improvement opportunities? Do your internal information systems enable merchants, planners, and logistics to evaluate a categorys fully loaded, total cost of merchandise? Is your activity-based cost information widely used and trusted as accurate for decision making within the organization?

SCORING:
7-8 yes responses 5-6 yes responses 1-5 yes responses Congratulations! Youre probably already implementing VPI to your advantage. You may be missing opportunities to reduce costs and increase top-line growth. Consider VPI. VPI will certainly help you achieve your goals.

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Leap these hurdles to capture VPI value

Why then havent more retailers seized the VPI opportunity? After all, buying is often seen as the most important role in retail operations. And, most retailers pride themselves on executing this role well. But it should be no surprise that buyers fall short given the scale of the barriers they often face. Our work with retailers suggests that five barriers impede buyers ability to maximize value:

1 2 3 4 5

Incomplete knowledge of supply-market opportunities

Disproportionate focus on short-term performance

Unwillingness to switch lines and vendors

Misaligned incentives

Limited availability of information to support decision-making

BARRIER 1:
Incomplete knowledge of supply-market opportunities
Buyers rarely grasp their key suppliers margin structure and the profit distribution between retailers and vendors. Few buyers have time, resources, or experience to re-engineer the cost of their key products and to ensure that product pricing across lines is consistent and rational. Consequently, many buyers focus simply on bidding the business without a structured process, and without having the knowledge needed to truly optimize the deal. Likewise, suppliers often do not properly understand the true cost of serving different retail accounts. Our research indicates vendors sometimes offer significant differences in cost and deal structures to their

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multiple retail accounts. In the noise of allowances, co-ops, program fees, and distribution costs, vendor pricing is often hugely variable. In this environment, it is challenging for both buyers and suppliers to know if a better structure or price exists. VPI provides value to retailers and suppliers who work through these issues and then share the savings discovered. For example, vendors and retailers can fine-tune assortments by testing new product in pilot stores before rollout to evaluate order quantities and optimal assortment mixes. This is particularly relevant to fashion-driven businesses such as home furnishings. Or, vendors and retailers can cooperate to optimize specifications for private-label goods, to maximize consumer appeal at minimum cost.

BARRIER 2:
Disproportionate focus on short-term performance
Making the weeks sales targets and constantly showing good comps are top priorities for all buyers, but this often results in short-term planning. The success of this months advertisement often overwhelms buyers ability to step back from day-to-day assortment management to think strategically about overall category direction and anticipate transitions in consumer needs. As a result, vendors often are more knowledgeable than retailers about category and consumer trends, and frequently have a deeper understanding of the competitive dynamics shaping an industry. VPI provides the opportunity to step back and take a longer-term view. This not only improves the strategic health of the business, but invariably uncovers opportunities to improve short-term performance as well.

BARRIER 3:
Unwillingness to switch lines and vendors
New vendors can seem risky to buyers who have established vendor relationships. Buyers prefer incumbents on the better-the-devil-you-know principle and avoid investing time in testing and piloting new lines and products. For hardlines businesses, especially those with slow turns, switching product lines can be expensive and messy. Often, this deters buyers from exploring alternate suppliers or pushing existing suppliers to collaborate to reduce costs.

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Through VPI, retailers assess these risks objectively, and often find that vendors can help reduce or eliminate them to capture joint opportunities.

BARRIER 4:
Misaligned incentives
Buyers incentives typically are limited to sales and gross-margin performance. So, buyers arent motivated to look for cost-reduction opportunities in such areas as distribution centers, where the costs of handling, shipping, and logistics can represent up to 20 percent of product cost. Without incentives to optimize their products total cost, buyers may not challenge themselves to investigate potential supply-chain opportunities such as: Reducing cycle times to better align with emerging marketplace trends Shipping direct-store-delivery versus to distribution centers Optimizing inbound order quantities and shipment modes to improve trade-offs between inventory, transportation costs, and instock status

By taking a look at a categorys total economics, VPI highlights where incentives may need restructuring to enhance overall goal alignment. VPI also provides the quantitative information needed to create a new incentive plan.

BARRIER 5:
Limited availability of information to support decision-making
Buyers rarely receive adequate external information on consumermarket and supply-market trends to fully comprehend their marketplace. Gaining a complete understanding often requires working with multiple vendors to build a market profile. Buyers also need a good grasp of the internal economics of their business, its strengths and its weaknesses, and a deep understanding of their vendors capabilities. Its rare for buyers to have access to data that clarifies the true cost of shipping and handling, in-store managing costs, and net profitability compared across vendors. Such information would allow buyers to

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identify opportunities for supply-chain savings and joint buyer-vendor cost reductions. The absence of user-friendly desktop systems that link activity-basedcosting logistics and distribution-cost systems, accounts-payable systems, and different accounting methodologies for advertising allowances, also represent significant hurdles. For many retailers, the VPI process represents the first time they have assembled all the information needed to optimize their merchandise strategy.

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Seizing the VPI opportunity

The good news is that these organizational barriers to VPI are surmountable. High performing organizations combine smart negotiating, collaboration with vendors, and a willingness to make tough internal tradeoffs to drive significant bottom-line profit improvement. Often, making the transition is a learning process; most companies start with a handful of target categories and expand over time. Weve seen success with VPI when merchants adopt these five key practices:

1 2 3 4 5

Clearly articulate a category strategy

Rigorously develop and use external and internal information

Segment vendors and apply tailored sourcing strategies to each segment

Aggressively coordinate all profit improvement levers in vendor negotiations

Realign skills, performance metrics, and decision-making processes to support and sustain VPI results

K E Y P R AC T I C E 1 :
Clearly articulate a category strategy
To enable maximum value from VPI, merchants should establish clearly articulated category strategies. VPI builds on and enriches a category strategy. A clearly defined category strategy identifies the target consumer, critical shopping occasions, and how the retailer will select merchandise, price, and service to meet consumers needs. It is the roadmap that defines the must-have strategic brands and the assortment

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of branded and private-label options. It sets category sales and contribution-margin targets. If the category strategy falls short, VPI can be an effective way to rethink areas of weakness and fine-tune the strategy to best leverage market opportunities.
A European catalog retailer developed its private-label-apparel strategy based on market research and a complex review of 700 suppliers. The process led to the identication of a clear set of preferred brands, a vendor scorecard based on logistical and nancial measures, and clear standards for size, color, and quality. The retailer identied gross margin improvements of 2 percent from reduced returns, a rationalized vendor base, and increased quality.

K E Y P R AC T I C E 2 :
Rigorously develop and use external and internal information
VPIs foundation is the rigorous development and use of external market data and internal cost-of-ownership analysis. External information addresses the supply market that is, competitive dynamics, manufacturing capacity, and availability of substitute products. Even when external information is not readily available, a picture of the external marketplace can be developed from vendor visits, industry reports, and global sourcing offices. Valuable internal information includes vendor- and product-spending performance history, as well as associated buying and supply-chain processes. Understanding the total cost of merchandise (net category contribution including the impact of allowances, co-ops, payment terms, supply chain, and in-store service and display costs) can lead to insights into cost-reduction opportunities. To evaluate opportunities for substitution or expansion, merchants must analyze SKU and vendor productivity to the net contribution level.

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Exhibit 3 shows how a U.S. retailer used VPI in a formal request-for-proposal to unbundle a vendors products from marketing services and support costs. The retailer then assessed whether to fund each component and also eliminated unnecessary service and support costs. Concurrently, the retailer reverseengineered the product with the help of independent testing laboratories. Using both levers, savings exceeded 7 percent of total cost.

Exhibit 3

UNBUNDLING COSTS REVEALS COST-SAVING OPPORTUNITIES

DISGUISED CLIENT EXAMPLE RETAILER

Percent

100

7 Freight 5 POP and National in-store equipment brand support 5 6 2 Sales force Cash discounts 7 68 Advertising allowances

VPI revealed that bells and whistles comprised 16% of total invoiced costs to retailer

Total invoiced cost (fullyloaded cost)

Source: Team analysis

Net product cost (unbundled cost)

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K E Y P R AC T I C E 3 :
Segment vendors and apply tailored sourcing strategies to each segment
The third aspect of VPI combines category strategy with external and internal information to create a high impact vendor sourcing strategy. Vendor sourcing strategies vary along many dimensions and address the desired number of vendors, mix of domestic and offshore sources, vendor capabilities (lead times and supply-chain flexibility), and businessassortment strategy (mix of promotional versus basic SKUs).
A North American department store using VPI segmented its apparel vendors along two dimensions: logistical capabilities (ll rates, percent on time, etc.) and nancial impact (the gross margin percentage it brought the category, as well as total cost of merchandise). Exhibit 4 shows how the retailer plotted all vendors on two dimensions, based on performance, and then tailored a strategy for each. The retailer sorted out protable vendors from those that needed to be pruned. Overall this resulted in a 2 percent improvement in net contribution.

Exhibit 4

SEGMENTING VENDORS ACROSS TWO DIMENSIONS ALLOWED A VENDOR TO TAILOR STRATEGIES

DISGUISED CLIENT EXAMPLE DEPARTMENT STORE Vendor

Improve financials or trim from base

Develop partnerships

Logistical score (fill rate, percent of time)

Trim or justify testing longer

Improve logistics or trim from base

Financial score (GM%, TCM)

Source: Team analysis

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K E Y P R AC T I C E 4 :
Aggressively coordinate all prot-improvement levers in vendor negotiations
The fourth element of VPI involves using all profit improvement levers, not just product cost. This includes improving supply-chain flows, eliminating unnecessary middlemen, minimizing transactional costs, and reducing the basic cost of goods.
Recent work with a discount retailer identied a 30 percent logistics savings accomplished by shifting product delivery from direct-to-store to just-in-time through the warehouse. Exhibit 5 shows how a softlines catalog retailer used merchandise analysis to identify two cost elements with signicant variability across vendors: merchandise returns and payment terms. The retailer then identied vendors with the least attractive returns and payment terms and renegotiated higher performance standards. This initiative led to a 3 percent increase in gross margin.

Exhibit 5

MERCHANDISE ANALYSIS REVEALS COSTS THAT VARY BY VENDOR

DISGUISED CLIENT EXAMPLE CATALOG RETAILER

Percent 21.7 3.1 5.6 5.8 3.5 POP 100.0

9.6 67.9 1.4

0.4 Quality Advertising control allowances

Inventory Returns Payment terms Obsole- Shipping scence

Vendor's rates varied by 50%

Product cost

Total merchandise cost

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K E Y P R AC T I C E 5 :
Realign skills, performance metrics, and decision-making processes to support and sustain VPI results
To maximize VPI results, merchants must realign metrics, tools, and decision-making processes. Specifically, retailers should: Craft incentives that motivate buyers to take full ownership of the cost of merchandise and ensure that VPI savings make it to the bottom-line, rather than are shifted to other cost centers. Such incentives encourage cooperation among merchandising, stores, and logistics. Build new analytical skills and tools, such as formal vendor requestsfor-proposal, into the buying process and line review. Develop systems- and activity-based cost-measurement tools to support a thorough analysis of product costs and track overall savings.
A large home-furnishings and furniture retailer recently changed its incentive system to one that includes the metric net-contribution-after-supply-chain costs. This shift resulted in greater attention paid to freight costs, which reduced the total cost of the merchandise by 1 percent.

By incorporating these five key practices into the retail

organization, buyers evolve from shepherding a transaction to managing a strategy. With VPI, buyers manage the business proactively instead of reacting to supply-market fluctuations which may make their role more professionally rewarding.

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Executive endorsement eases the way

Executing VPI may seem daunting, and rightfully so. Developing a rigorous understanding of a category requires dedicated resources and a concerted focus on results. Senior management support is critical as the process involves tackling traditional organizational barriers. It also promotes buyers cooperation and enthusiasm for VPI. Senior managements involvement empowers merchants in their communications with vendors. This may come in handy if incumbent-but-at-risk vendors feel threatened and seek to circumvent the formal process even reaching to senior executives to disrupt it. Two options exist for getting started with VPI: slow-build or immediate commitment.

S TA RT S LO W LY
If you need to build the case for change
If your company scores low on the VPI Savvy Quiz, the scale of the organizational development required suggests a slow-build approach to prove the case for VPI with respected merchants in an organization. Organizations that require significant skill building must develop a tailored and disciplined process that establishes VPI capabilities. These success stories can generate demand for VPI across an organization. When selecting which aspects of a business VPI will address first, the most promising categories are those with complex, diverse supply markets, some brand flexibility, and turn rates that allow the merchant to transition assortments without incurring prohibitive markdowns on obsolete merchandise. We suggest launching VPI with three or four pilots to prove the overall approach and build internal skills. Merchants should consider dedicating a VPI SWAT team to drive the process, institutionalize learning, and bring supplemental resources to buyers. Depending on your buyers experience, it also may make sense to add one or two analysts with complementary

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financial and strategic skills. Once the case is built, VPI can be finetuned and rolled out in broad waves every four to five months, eventually covering all critical elements of the business. When the VPI process is complete, the buying team should repeat it every two to three years to confirm category knowledge and sharpen the strategy.

SPEED IT UP
If you have some VPI skills in place
Retailers who score in the mid-range on the VPI Savvy Quiz and have access to internal financial performance data and sophisticated systems can move more rapidly with VPI. These retailers may consider a multiwave VPI program with five to six categories in the first phase of the program. The faster a retailer can ramp up a VPI program the quicker significant profit improvement will be achieved.

both top-line growth opportunities and drive bottom-line savings for retailers. Getting there, however, is the challenge. VPI is a detailed and rigorous approach to developing a profitable advantage. It requires merchants to rethink traditional attitudes to managing vendors, build analytic skills, and take a cross-functional view of margin opportunities. Organizationally, it requires developing crossfunctional incentives that align buyers and supply chain alike and, usually, a dedicated SWAT team to provide analytical support to the merchants. When VPI is executed successfully, the size of the prize is significant. VPI provides better strategic control of the business and can generate 5 percent or more in net margin improvements. With results like these, can you wait?

VPI can create

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