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Managing inflation risk in retail Leveraging advanced analytics to weather the storm

Retailers are increasingly feeling the pain of inflation. 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, retailers 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 to retailers.
Figure 1. Food Price, Cotton and Crude Oil Indices (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-11

Feeling the pressures of inflation Within the last two years, oil prices have risen over 110%1 an increase which impacts virtually every segment of the economy. Other commodities and critical retail inputs, such as cotton, food, leather, silk, and other textiles have experienced significant price jumps as well (see Figure 1). Cotton prices have almost tripled in the past two years, driven largely by a supply shortage. Additional price increases are anticipated, with many analysts expecting cotton prices to hit $3 a pound after trading for decades around $0.40 to $0.50. Food prices have risen at similarly 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 may trigger inflation in grain, which could trickle down to the overall food market. These rising prices in crude oil, food, and retail raw materials have significantly outpaced core inflation, which was only 1.29% in 2010. This trend is anticipated to continue, and will likely impact retailers in two critical ways: reduced consumer discretionary spend and diminishing product margins.

International Monetary Fund, January 2011. Ibid. Cotton Price Forecast. Seeking Alpha. 4 March 2011. OECD Statistics. 18 March 2011.
1

Month Food Price Index (2002-2004 =100) Cotton A Index US cents per pound (lb) Crude Oil Index (2005 = 100)

Managing inflation risk in retail Leveraging advanced analytics to weather the storm

Dampened consumer discretionary spend While retailers may hope to offset higher input costs by raising prices, inflation will have a significant impact on consumers ability to spend. When food price increases are paired with steadily increasing gasoline prices, one would expect that the discretionary spend of the average consumer will likely trend downward. Consumer shopping patterns will likely reflect tighter pocketbooks in a variety of ways, including fewer shopping trips, accelerated migration to the Internet, a shift to neighborhood shopping locations and one-stop centers, and an increased focus on low-cost options, such as private-label goods and discounted merchandise. Fewer shopping trips will likely mean a reduction in impulse purchases and may drive overall unit decreases. Additionally, the new Internetsavvy customer is much more equipped to bargain shop, avoid price hikes, and buy more with less, which will limit retailers ability to pass along price increases and force them to be more scientific in their approach. Recent actions During the recent economic recession, retailers were forced to aggressively reduce costs and pull the typical downturn levers. They cut capital spending, closed underperforming stores, pared back labor, and slashed inventory levels. The result has been improved cash positions and lower

selling, general, and administrative (SG&A) costs. With retailers already running relatively lean operations, the convergence of rising input costs and declining consumer spend will require new strategies to stay ahead of the game this time around. Retailers will continue to turn to historical go-to levers, such as sourcing, design, and private brands. These tried-and-true tactics should help them combat inflation to some degree. With inventory to sales ratios at the lowest levels in the last 10 years, a new art meets science approach can help to address the inventory investment (see Figure 2). To execute this approach successfully, retailers should focus on precision and leverage new analytical tools to impact levers, such as pricing, assortment, and inventory. 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 SG&A 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.

Figure 2. Non-Auto Retail Inventories to Sales Ratio 1.80 1.70 1.60 1.50 1.40 1.30 1.20 1.10 1.00 1992 1995 1998 2001 2004 2007 2010

Source: U.S. Department of Commerce

Traditional go-to levers: sourcing, design and private brands Sourcing Retailers have historically been fairly nimble in shifting production to lower-cost countries. While there may continue to be some marginal benefit to moving and consolidating production, the bigger sourcing plays may be around raw materials. For retailers and manufacturers who continue to use raw materials, such as cotton, that have experienced volatile price changes, there will likely be tremendous risk in the timing of purchases. Whether a company locks in a price a year before production or buys product at the last minute, prices and margins will either reap the rewards of a favorable buy or pay the penalty for an ill-fated purchase. Even hedging in the futures market does not fully eliminate commodity purchasing risks as buyers have increasingly been left on the wrong side of the contract. In addition to managing the cost of raw materials, retailers and manufacturers will likely

Go-to levers to combat inflation: Sourcing Design Private Label New advanced analytics levers: Pricing Assortment Inventory

explore alternative fabrics, including synthetics and other non-cotton or non-petro-based blends. Some clothing manufacturers have already begun incorporating rayon into their offerings to save on input costs. However, alternative fabrics are not a panacea as increased demand is pushing prices higher. 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

Private brands The third traditional lever retailers will pull to combat inflation is increasing the mix of private brand products. Both private brand share in existing spaces and entry into new categories will continue to grow as they have over the past couple of decades, accelerating in the recent recession. The extra margin private brand products provide, usually 400500 basis points, gives retailers the incremental margin to absorb some of the cost of inflation if the consumer reacts negatively to increases in unit prices. Some retailers have already begun implementing private brands in their sales mix as a margin-protection strategy. These tried-and-true levers will help retailers pinch pennies to stave off diminished margins, but many retailers have already made these moves and are unsure of what to do next. They also fear fallout from pushing too far, and may struggle to predict the effects of their actions, which is where a new advanced analytics approach comes into play. Advanced analytic levers: pricing optimization, assortment analytics, and inventory productivity Retailers have long been awash in data, but the emergence of advanced analytics has made generating insights from it more feasible. Advancements in technology have enabled retailers to run more sophisticated analyses, using massive sets of transactional data, to provide precise answers to questions once left up to gut instinct. While there will always be an element of art to merchandising, it is the science that underpins new tools now available that have the immediate potential to help merchants make more informed, data-driven decisions. Pricing optimization Pricing is the lever that will likely get the most attention as inflationary pressures intensify. However, retailers ability to pass along pricing increases will likely vary depending on the companys market position and value proposition. Market leading retailers, with solid and consistent foot traffic, are well positioned to hold retail prices flat. However, secondary competitors, perhaps more desperate to maintain current levels of profitability, will likely be

forced to increase overall prices and leverage other levers to drive traffic into their stores. Dollar and value-driven formats will be under tremendous pricing pressure as their lower-income shoppers, who are traditionally more price sensitive, will be increasingly forced to make fewer and more selective purchases. The rapid adoption of mobile commerce is likely to have a significant impact on retailers ability to pass along price increases to customers. Consumers ability to price shop competitors instantaneously will handcuff retailers ability to significantly raise prices on comparable items. With declining brand loyalty among Generation X and Y consumers, the premium placed on brand will be under further attack and product substitution will become a greater threat.

These influencing market factors will force retailers to be more strategic and scientific in price execution, and more agile in adapting to changes in the market. Retailers will have to closely monitor competitors pricing moves and determine how to rapidly adjust accordingly. Price optimization solutions will continue to provide the key to unlocking this level of knowledge, allowing retailers to analyze price elasticity and make smarter, more confident pricing decisions. These sophisticated analyses will help pinpoint price elasticity down to the SKU x location level, measuring price sensitivity by attribute or a set of attributes. Similarly, the importance of promotional effectiveness is likely to be magnified. As retailers seek to generate foot traffic from people who are making fewer shopping trips, knowing which offers will activate consumers to buy will become critically important. More retailers may look to start or expand a high-low pricing program using deep promotional discounts to drive store traffic and mask price increases elsewhere. By employing analyses to consider product attributes of importance, consumer spending patterns, and pricing tolerances, retailers can identify product combination promotions that will motivate different customer segments. Introducing this level of sophistication to pricing and promotional decisions will allow retailers to avoid risking fallout from the gut-instinct tactics employed in the past and ensure that pricing and promotional plays generate the intended results. Assortment analytics Back when most retailers only had a few dozen stores and were heavily concentrated in one region, localizing an assortment was easy. The buyer knew each store, each neighborhood, and many of the shoppers. He or she was able to use this intimate knowledge of the market to customize the assortment based on the nuances of the local demand. As retailers continued to grow, they began to cluster stores based on market characteristics and develop uniform assortments based on broadbrush customer and store segmentations. Even today,

this approach is largely utilized by many retailers, as a localization strategy based on demand patterns has historically been too difficult and time-consuming to develop. However, the advent of advanced analytics is changing the game. Leading retailers are making groundbreaking strides in using attribute-based analyses to maximizing product mix. Product- (color, fabric, size, brand, price), store- (space, productivity, assortment), and/or consumerbased (shopping behavior, demographic, psychographic, geographic) attribute analyses provide insights beyond the traditional ranking reports used by merchants. It allows merchants to more accurately determine local demand patterns and decide on how best to optimize their assortment at the local level. In addition, there are some software companies that are able to provide sustainable solutions to analyze both consumer and transactional data to model local demand and help retailers determine which items should be included in the mix, by store or store cluster. Assortment localization is a powerful tool in fighting the pressures of inflation. The insights derived from these analyses will help merchants be more selective in shaping their buys, choosing relevant products in better quantities and more accurate size scales, and allocating them more efficiently. Given the convergence of rising cost of goods and flat inventory dollars, this enhanced confidence in defining a core assortment and adding localized layers will be critical for developing a sustainable competitive advantage. Inventory productivity Many retailers continuously swing between eras of high inventory, when customer service concerns top the priority list, and low inventories, when business slows down and leadership looks at the cost of holding all that inventory. The Great Recession may be over, but the long-term inflationary environment will pressure retailers to generate 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

Additionally, other factors will emphasize the importance of managing inventory productivity: The rise in transportation costs may lead to decisions resulting in increased inventory levels to manage logistics spend. The rise in commodity prices can also cause retailers to overbuy, particularly on imports, to avoid future price increases. Most retailers house and manage e-commerce inventories separately from their brick-and-mortar counterparts. However, as e-commerce continues to become a greater portion of many retailers business, it will be imperative for retailers to adopt a cross-channel approach to inventory management. Given all that, retailers may want to evaluate the effectiveness of the entire inventory life cycle, across channels and, for global retailers, across countries and regions. Using advanced analytics, retailers may be better prepared to deconstruct the entire life cycle in four primary ways: Evaluate the impact every planning, particularly assortment and space, forecasting, and management decision has on other upstream or downstream functions. Most retailers look at this problem in functional silos, in effect optimizing inventories within each function without considering the big picture. Build visibility and flexibility into the life cycle, including supply chain, to rapidly identify and react to market changes. Take into better account the impact of variability in demand or supply plans before recommending inventory levels. As with many things in the supply chain, use of averages in planning inventories can lead to problems. valuate opportunities to merge inventory into a E common pool that feed demand across channels or geographic areas, maximizing sales and margin performance.

Advanced inventory optimization tools are now able to zero in on the right amount of inventory, in just the right places, to meet customer service and revenue goals. This level of accuracy in demand forecasts allows for timephased purchasing; decreased safety stock levels, stockouts, and overbuys; optimal replenishment parameters; and enhanced stock balancing. With inflation compressing margins across the retail industry, leveraging advanced analytics to manage a lean and productive inventory may just be the answer to coming out of this period on top. Building a new capability To come out of this inflationary period ahead, retailers will likely need to develop an advanced analytics capability that is a step removed from day-to-day operations and enables proactive improvement of the business. Across the industry, merchants are overwhelmed with the operational tasks of running their businesses. Buyers are under constant pressure to make their numbers, maximize the current assortment, and identify the next got-to-have-it product. Planners are scrambling to manage their open-to-buy dollars, receipt flow, and inventory position. Meanwhile, replenishment and allocation is often bogged down by reactionary and last-minute changes. Organizationally, no one has the time or mandate to perform the deep-dive (SKU/Store/Week), holistic (companywide) analyses that allow for sustainable gains in inventory productivity. Additionally, advanced analytics require deep quantitative skills that do not traditionally reside inside most retail organizations. To fully benefit from the advanced analytics available today, retailers should address this capability gap by developing new skills, structures, and tools. From a skills perspective, while buyers core competency is picking product and planners excel at managing the money, few have a sophisticated understanding of statistical analysis. Given the differentiated skills required to perform advanced analytics, it logically follows that these resources should be structured as a center of excellence. As a centralized

group, they can more efficiently and effectively evaluate business performance. Finally, though many retailers have sophisticated software tools to help merchants plan and manage their buys, few use these tools to drive the leading edge, detailed, and expansive analyses that would allow for proactive optimization of the business. The good news is that retailers have the option to build this capability and unlock opportunities to impact lever, such as assortment, inventory, and pricing. Merchants can effectively localize assortments based on multiple product, consumer, and store attributes. Pricing can use optimization tools to read demand and selectively pass along price increases. Impacting each of these levers will allow retailers who move swiftly and smartly to stay ahead of inflation, but it will not be easy.

Retailers will want to start small to build the capability. Select a department or two and build the analytics. Determine what attributes really matter. Prove to the organization that this knowledge translates into market power. Once you have proven to the organization the value of these advanced techniques, attack the other departments systematically. Take the time to learn from each wave, constantly refining the models and analytics to get more precise. There will never be a model or set analyses that will be able to replace the importance of the merchants feel for the market. However, arming the merchant with the latest and best possible insights will provide additional leverage, especially in an inflationary environment. The time to act 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

Authors Rod Sides Principal Deloitte Consulting LLP +1 704 887 1505 rsides@deloitte.com

Jean-Emmanuel Biondi Principal Deloitte Consulting LLP +1 404 631 2503 jebiondi@deloitte.com

Kyle Vahle Senior Manager Deloitte Consulting LLP +1 212 618 4537 kvahle@deloitte.com

For more information about Deloitte LLPs Retail & Distribution services, contact: Alison Paul Vice Chairman & U.S. Retail Leader Principal Deloitte Consulting LLP +1 312 486 4457 alpaul@deloitte.com Keith Dorris U.S. Tax Leader, Retail Partner Deloitte Tax LLP +1 214 840 7361 kdorris@deloitte.com Ramesh Swamy U.S. Financial Advisory Services (FAS) Leader, Retail Senior Manager Deloitte FAS LLP +1 213 688 3356 rswamy@deloitte.com Lawrence Hutter Global Consumer Business Leader Partner Deloitte Touche Tohmatsu +44 20 7303 8648 lhutter@deloitte.com John Rooney U.S. Consulting Leader, Retail Principal Deloitte Consulting LLP +1 215 446 3600 jrooney@deloitte.com John Scheffler U.S. Assurance Leader, Retail Partner Deloitte & Touche LLP +1 415 783 6827 jscheffler@deloitte.com John Little U.S. Financial Advisory Services (FAS) Leader, Retail Principal Deloitte FAS LLP +1 214 840 7383 jolittle@deloitte.com

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Managing inflation risk in retail Leveraging advanced analytics to weather the storm

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