Short vs. Long View for the Grocery Market

McKinsey routinely publishes studies that show companies with a long-term view outperform those companies with a short view. Most supermarkets have been focused on the short term for decades and it worked fine until Walmart, Costco, Trader Joes, Amazon, and Aldi started to enter the market in the early 2000’s.

Supermarkets have recently focused on the short term to deliver margin and profit targets.  Doing this year over year has allowed them to approach these targets but has slowly resulted in higher gross margin rates, higher prices, and fewer units.  Each year the changes are small but looking over the last 15 years and the gaps have become meaningful.

Amazon Flywheel

The Amazon flywheel, which has also been adopted by Walmart aggressively focuses on unit growth, which makes the wheel turn. The key is the realization that increasing units can be self reinforcing if fixed costs increase at a slower rate. Amazon and Walmart keep the lid on fixed costs with productivity improvements, coming largely from data and technology. The result as highlighted in the image above, is lower prices, a better customer experience, more traffic, more sellers, and a lower cost structure. And this process is self reinforcing because more units continue to keep unit costs and unit prices lower, which drives more units, which keeps units costs lower, etc.

So what happens when the flywheel turns in the opposite direction?

When units are declining and fixed costs remain largely the same, fixed costs are allocated across fewer units so the fixed cost per unit increases. This generally results in higher prices which in turn lead to fewer units. This process is self reinforcing but in the wrong direction. This example is not sustainable because it will continue to put pressure on GM rate and the gap to the market will continue to get bigger until the supermarket is no longer competitive. 

The chart below shows the actual GM rate (red line) from the U.S. Census Annual Retail Trade Survey. The dotted trend line and blue GM rate forecast are derived from my analysis. As we move away from Covid, I expect GM's to fall once again, in large part because of the aggressive push by Walmart, Amazon, and Costco to drive units. If supermarkets do not respond to this trend, their GM rate gap and price gap will grow, which will feed into the negative units and a negative flywheel. 

As stated above, if you view the gap through the short term lens, one year at a time, the gap does not seem that large, but if you view it from the Great Recession, which is when the national players began to aggressively grab share, the cumulative gap is large and likely growing.

Evercore ISI pricing Study

Evercore ISI is a Wall Street Research firm.  They track and make recommendations on several grocery companies. In May 2024 they completed a pricing study to better understand the price gaps between the different channels – Warehouse, Mass, and Supermarkets. Evercore concluded that supermarket prices were 50-70% higher than Warehouse and 20-25% higher than Walmart. 

These price gaps, like Gross Margin rates were not always this big. These gaps are making it increasingly difficult for supermarkets to compete, particularly on commodity items, like paper, hygiene, HH goods, and center store branded items.

A little math

Sorry for the math but I figured if you made it this far, you might be up for some algebra? Probably not but let's give it a go. I think it helps to solidify how the flywheel works.

The formula above is a simplified formula that shows the high level elements of price per unit. One can easily add more detail but these are the big rocks.

• The fixed cost - these are costs that do not move as units increase or decrease. They are typically the costs associated with the HQ, computer systems, and sometime rent or building expenses

• Net margin - This is profit and is the difference between revenue and costs

• COGS - these are what the grocery retailers pay for their products and is the biggest piece of the variable cost. If you sell more units, you need to buy more units. 

• The gross margin covers all of the fixed costs and the profit. Gross Margin is Revenue less COGS. Gross margin dollars are the gross margin rate times revenue.

From this formula, we can see how a unit decline increases PPU. If fixed costs, net margin, and COGS are constant, a decline in units must be met with an increase in price. If fixed costs fall at the same rate as units then the equality can be maintained without increasing prices. This also holds if the company lowers profit targets or COGs fall. 

What we have seen for the last 15 years, is supermarkets are fighting hard to keep their net margin dollars each year. It is how most executives are evaluated. Most supermarkets, who don't have the scale of a Walmart or Kroger, are also price takers. Their COGS are largely out of their control. What is in the supermarket's control is fixed costs and Price Per Unit, and if units are falling and fixed costs are not falling as fast or perhaps not at all, then price increases are needed to hit net margin targets. 

What does this mean?

To hit the short term net margin target, many supermarkets are willing to raise prices. After all it is just a little bit when viewing it over a year or two. But when doing it year after year, these small changes become a significant gap, and that is where we stand for many supermarkets. Which ironically makes it harder for supermarkets to hit net income targets, which requires bigger price increases, reduces units even more, and the negative flywheel spins even faster in the wrong direction. There becomes a tipping point, which is why we have seen so much consolidation over this same 15 year period.

Supermarkets must be dialed in on costs and prices or the gap to Amazon, Walmart, and Costco will become too large. To amplify the situation, grocery retailers profit margins are typically around 2-3% which compares to 8% for most companies in the U.S. There is little room for error, and every year units decline, the harder it will be to rectify. The current reality is many shoppers are dialed on on price and many supermarkets simply cannot compete on price. Moreover, supermarkets are also not delivering the incremental quality, convenience, and store experience to justify the higher prices. They are simply losing the value game, which is key in driving customers to your store.

The supermarket flywheel must be reversed. Supermarkets must ask themselves what price will deliver flat units over the longer run. This is the baseline price. If prices are higher than this, units will be likely be negative, yada yada. 

So how does the flywheel turn in the right direction for supermarkets? Most of these solutions are longer term and will likely reduce net margin in the short term but will increase the chances of success in the long run.

1. Data, analytics, AI and a deep understanding of your customers is essential when navigating the choppy waters ahead

2. Costs, particularly fixed costs must be carefully managed and must adjust with unit declines

3. Grocery tech and AI will be needed to drive productivity and reduce costs per unit

4. Personalization and loyalty program allow supermarkets to get the most out of their pricing strategy. If supermarket unit costs do fall, personalization allows supermarket to identify those departments, like perishables, where they can begin to lower prices and drive trips and units. This of course will vary for each retailer, their customer base, and their competition. This is where a strategy that carefully aligns the key customer targets with price/promo, products, store placement, and store experience is needed

5. Understanding price elasticities for all 20-30k items in the store. What are the optimal prices across these categories and products. How can we decrease prices in some categories and increase prices in other to help drive trips, units and margin. There is software and analytics available that can provide these answer. My current employer, dunnhumby, is one of them

6. Understanding where you can differentiate your banner from the big national players. This requires a deep understanding of consumers, how they perceive the different grocery retailers across price, quality, experence, etc. , and a critical assessment of your strengths and weaknesses. This is often hard to do internally because we are human, but there are many companies that specialize in helping organizations objectively evaluate themselves

7. Private brands. We did a study in 2017 and have done it every year since and it consistently shows the connection between private brands and supermarket financial and emotional performance. The best way for a supermarket to compete on price AND quality is with a solid private brand program. The link to the latest study is 

https://www.dunnhumby.com/resources/reports/retail-trends/en/eighth-annual-retailer-preference-index-rpi-for-u-s-grocery/

Turning it around will require a deep understanding of customer, competitors, and a longer term view. The current short term focus may lead to another year of hitting margin targets, but the cost is typically less competitiveness in the future and there will be a point when the hole is simply too deep.