3 essential pieces of the supermarket business model

A short while ago, I posted “10 strategies for SME’s to beat the supermarket gorillas at their own game”  which generated quite a bit of comment and feedback. Amongst the feedback were a number of requests to go into more detail on each of the strategies,  and so this is the first of the series, focussed on understanding the business  model of the supermarkets.

I deliberately used the word “Gorillas” because of the extraordinarily concentrated nature of Australia’s supermarket retailers, with Coles and Woolworths between them holding over  70% of FMCG sales depending on the category, and whose numbers you believe.

You know the old question: “where do the 500kg gorillas sleep?”

Answer: “anywhere they bloody like”

That was the way it was, a comfy duopoly, however, more recently there have been some major strategy alterations by Coles which has dramatically lifted their financial performance, and Aldi has successfully carved out a growing niche as a third retail presence. In addition, there are still some very good independent retailers around operating out of the wholesaler Metcash, who also competes with some of  their own and franchised retail outlets.

This mix, combined with the opportunities suppliers have to sell into food service and institutional markets and increasingly direct to consumers via the net and other means makes for an environment where the agile and insightful suppliers can be very successful despite the obstacles, but it is a very challenging environment.

The concept of business models is well known, in summary, it is the expression of how a business makes money. It always involves a matrix of revenue generated, the fixed and variable costs of generating that revenue, and the choices that the business makes about its customers and how they will be serviced, and the way they incur the costs of that servicing.

Supermarkets are a great example of a number of seemingly similar competitors that have slightly differing business models. At a macro level they have strong similarities, relying on volume, price, and shopper numbers to succeed, but everyone who shops knows that Woolworths is not Coles, is not Aldi.

However, they do have some common building blocks.

1. 1. Revenue generation. Supermarkets generate revenue on both sides of the equation.
      • Shoppers buy products, paying at the checkout.
      • Suppliers “pay” for shelf space via a range of charges levied for every variable the retailers can dream up. Volume discounts, payment terms, promotional levies, preferred shelf positioning, promotional slots, access to sales information, and a host of others. Some are items for which suppliers receive an invoice, others are taken as discounts off the invoice price, increasingly applied automatically as a part of the trading term package.
   2. Cost management. Supermarkets work on very low percentage margins, relying on the volume to generate the cash margins.
      • Fixed costs are a significant part of retailers total costs, made up of the provision of the retail floor space, the logistics infrastructure and personnel. Supermarkets attack their fixed cost base aggressively using their scale as negotiation tools with landlords and logistics suppliers, while keeping a very substantial proportion of front line retail staff as casuals rather than permanent employees so they can better adjust staff levels to match activity. The sorts of choices retailers make are between high density shopping centre locations Vs stand alone locations. There are costs and benefits to each which are considered as a part of their strategic decision making.
      • The biggest variable cost is the cost of good sold, and they similarly use their scale to manage those costs downward. Tactics vary between retailers, but the core game is to maximise their margins while keeping prices as low as possible to attract the volume buyers. This is an extremely delicate balance.
      • Transaction costs are usually pretty well hidden in most businesses, but are really significant in the case of supermarkets simply due to the number of transactions they make.  For example, there is a cost to managing the buying relationship with a supplier, but  the larger the supplier, the less is the total costs/unit of sale of managing that relationship. This has led to a dramatic reduction of the number of suppliers supermarkets have in any category over the last 15 years or so a trend further accelerated by the increasingly common strategy of limiting the number of proprietary brands in any category  substituting house-branded products, and reducing the number of relationships to be managed. This has made negotiating shelf space increasingly hard, and because of scarcity, increasingly expensive for suppliers, in turn putting extreme pressure on small suppliers.
   3. Customer service and relationships.   The retailers have each made choices about  the pricing, location, ranging, and service strategies that sets them apart from each other, and more subtly, they have back office strategies that differ. However, their common aim is to have as much market share ass possible, as volume is the profit generator.
      • As in any market, no retailer can be all things to all people, so each makes the choice of the “ideal” customer, and markets towards them, grateful for any overlap. Increasingly the marketing is being supported by customer loyalty cards and the data mining and personalised promotional opportunities that technology is delivering, but the fundamental measures of success remain unchanged: number of shoppers, share of wallet, and basket size.
      • The two major retailers have very large marketing budgets which they spend in a wide  variety of ways, across all channels of communication with customers and potential customers, and often in joint activity with their suppliers, which inevitably, the suppliers end up funding in return  for volume.  The smaller the retailer, the less “mass market” they are, so the tactics tend to differ, although strategically, finding willing supplier partners is a core part of every retailers marketing mix.
      • Consumers generally want choice when they are in a supermarket, the more the better, in any category. Woolworths and Coles stores carry 12-20,000 Sku’s  (Stock keeping unit) depending on the size and location of the store, a typical IGA might carry 8-10,000, while Aldi carry just over 1,000. The sku’s carried in any store also reflect of the demographic and cultural mix. The Woolworths store in Auburn in Sydney has a significantly different product mix to the Woolworths of a similar size in Double Bay.
      • Every retailer uses some form of category management disciplines as a means  to monitor, adjust and locate their inventory onto the sales face in the way that best meets their customers needs and maximises impulse pick-up. This is always a data intensive mix of the volume and margin of the individual Sku, (such as Ski strawberry yoghurt 200gm) group of similar Sku’s (all strawberry 200gm yoghurt) subcategory (all strawberry yoghurt) and category (all yoghurt) and between categories. They make choices about how many brands and types to keep in stock, where they put them, on shelf and in relation to other yogurts, and indeed other chilled products. A facing of yoghurt added is a facing of some other product gone, as the sides of the stores are not elastic. At the core of the category management activities is the need to best satisfy consumers, whilst competing effectively and delivering maximised margins.

Being agile, persistent,  and prepared to experiment are about the best qualities a supplier to supermarkets can have.

Related posts:

The evolving Push & Pull of the supermarket business model. The ever evolving supermarket business model Is the supermarket business model developing terminal cracks? 10 strategies for SME’s to beat the supermarket gorillas at their own game.