“Act Vertical” vs. “Go Extinct” Retailers - Part 2

Part 1 of this blog series set the historical background for the supply chain management (SCM) evolution and presented the advantages and shortcomings of vertical vs. horizontal integration. The analysis then moved onto the generally embattled retail sector, where a select group of innovative retailers has found a “happy medium” approach to stay well above the fray. Retailers such as PetSmart Inc., Aéropostale Inc., Coach Inc., Trader Joe’s, Walgreens, and Target have realized the need to become serious product innovators and not just merchants of national product brands or sellers of their own knockoffs.

Kurt Salmon Associated (KSA), the leading global management consulting firm specializing in the retail and consumer goods industries, dubbed this strategy “Act Vertical” in its seminal research study. The firm presented the highlights of the study at the National Retail Federation (NRF) Annual Convention & EXPO 2009 (also known as the "Retail Big Show") in January 2009 in New York City. The accompanying slide deck can be downloaded here.

The gist of the matter is that these avant-garde merchants no longer see the division of labor between suppliers and retailers as the customary one of “they invent and make it, and we sell it.” In fact, the retailers control (without owning per se) every piece of the value chain, from creating new product concepts to getting finished goods into the hands of consumers.

The retailer is thus in charge of processes such as “design & develop,” “source,” “plan & manage,” “move,” “sell,” and “buy & flow.” As a result, these companies are able to more quickly discern emerging consumer trends. They are also better at creating products to meet those needs and are critically faster at bringing the resulting “hot” and “cool” products to market.

In contrast to "acting vertical" (i.e., controling the components of the product development and supply chain operations required to create products without necessarily owning them), "being vertical" means owning all the supply chain nodes, a strategy that hardly anyone recommends or pursues today (as mentioned in Part 1). The downside of owning such assets is getting locked into high costs and capital investments, with potentially inflexible capacity. Even many consumer goods manufacturers have been increasingly shedding their plants.

Acting vertical, on the other hand, does not require retailers to own inflexible and costly manufacturing and other supply chain assets
—yet it enables them to operate as though they do. This advantage comes in part from striking strong and mutually beneficial working relationships with approved and certified supplying manufacturers.

In addition to the retailers mentioned earlier, other retailers that act vertical include Abercrombie & Fitch, Ann Taylor, H&M, Macy’s, and VF Corporation (a branded lifestyle apparel manufacturer that also turned into a retailer). They have all increased their private-label business significantly, working more closely with manufacturers to create products expressly and exclusively for their supply chains.

The Drivers for "Acting Vertical"

While the practice of “acting vertical” has been in place for many years (e.g., Gap Inc., The Limited [LTD], and Talbots adopted vertical business models 40 years ago, as described in Part 1), it has accelerated over the last decade. Why? From KSA’s consulting experience, the following five factors are the cause:

1) The consolidation of retail brands
As said in Part 1, over the last 10 years the number of department store chains has shrunken more than threefold. The survivors wield greater clout over suppliers to create distinct products for their stores and expand their private-label business. To try to differentiate their products and customer experiences, many retailers have been selling a larger number of private-label or exclusively distributed items, as well as providing more store and Web site information on what they sell.

Private-label sales in grocery stores in the US are now about 18 percent of total revenue, and growing nearly 10 percent annually, according to the Nielsen Company's research. Drug stores generate 13 percent of revenue from private labels, and that number is growing 15 percent a year. And although private labels account for only 1.5 percent of convenience-store sales, this business has still been climbing 18 percent annually.

However, these retailers have had mixed success in their private label forays. About one third of retailers KSA surveyed generated the majority of their revenue from products unique to their chains. By 2013, 41 percent plan to generate the majority of revenue from their own products. However, only a minority (43 percent) said they had been highly or very highly effective at getting customers to embrace and purchase products that were unique to their chains.

And less than one third said they were highly or very highly effective at helping store customers secure the right products. Even fewer (20 percent) said their websites were highly effective at this game. An earlier TEC article sheds more light on the promise and complexities of dealing with private labels.

2) The proliferation of product brands
— While the number of retail brands (at least in general merchandise stores) is diminishing, the number of product brands has mushroomed. For example, consider the sevenfold increase in the number of branded jeans over the last 20 years, from 8 to 57 (not including another 940 niche jeans brands).

This is the case in many retail product categories, and as a result consumers have many more choices and much less loyalty to any one of them. They are much less willing to pay more for brand names. In fact, according to the US Department of Labor (DoL) and MBG Information Services, apparel pricing over the last 10 years has declined when adjusted for inflation.

Finally, consumers are much less forgiving of retailers that have popular items that are out of stock. For more information, see TEC’s article entitled “Yes, We Have No Bananas: Consumer Goods Manufacturers Serve Demanding Customers.”

3) The emergence of Internet-based retailing and the channel conflicts it has created
— These online trends have also increased the need for merchants to focus on their own (private-label) products. Many wholesalers are not willing to let retailers sell their products on the retailers’ Web sites because it can create conflicts with competing retailers about who should be allowed to sell the products in a given territory. Avoiding such conflicts encourages retailers to instead create product offerings that no other retailer can sell.

4) The need to accelerate time-to-market of both new and existing products
— Hitting ever-smaller fashion windows has also become critical, since speed is of the essence here (i.e., from the time a consumer need is identified to the time a product hits the stores’ shelves). That, in turn, requires much greater coordination and control over each piece of the product development and supply chain. For more information, see TEC’s article “Zooming into the Clothing Retailer Conundrum.”

5) Finally, investor expectations of publicly held retailers are intense
— There is an enormous pressure from investors and Wall Street for year-over-year improvement of financial results. One of the best ways to boost profitability is through differentiated products: the gross margins from selling a private-label product are reportedly 10 to 15 points higher than they are on a wholesale brand.

Furthermore, Wall Street rewards retailers that balance growth and profitability, and penalizes those that increase the top line at the expense of the bottom line. The Act Vertical business model can help retailers achieve that coveted balance.

How to Act Vertical, then?

The five factors outlined above force retailers to create much stronger product offerings and keep them in stock accordingly. In turn, this capability requires more control over the ideation, design, manufacture, and distribution of those offerings, which is what the “Act Vertical” model is all about.

To put all this into perspective, retailers have traditionally competed either on customer experience or product uniqueness. Strategies have ranged from the extreme of competing on price (or convenience) via ubiquitous products (where the customer experience is a mere transaction) to the other extreme of differentiating on a breakthrough offering that engages customers’ lifestyle experience.

The Act Vertical territory encompasses the ability to compete on both a distinct, compelling offering and on superior customer experience. But acting vertical has to entail the following three capabilities, starting with product conception:

1) Working With Consumers to Co-create Demand

A successful Act Vertical business model begins with creating products that delight consumers. These products are developed by conducting extensive research with consumers. The evidence shows that many retailers suffer from an excess of poor product decisions, and the excessive use of markdowns is one sign.

KSA’s research finds that US apparel retailers alone lose US$64 billion annually on markdowns. Some of them spend half of their planning resources on managing markdowns. Yet, markdowns are not the only sign of poor product decisions. In the apparel industry, retailers shift 5 percent of their excess product to the off-price channel, which has become a $10 billion industry.

Shorter selling seasons and cycle times are making this situation even worse, since retailers have much less time to make good assortment decisions. The Act Vertical model calls for retailers to get consumers more involved in key product decisions (i.e., more extensive testing of new products, colors, and patterns before retailers make commitments to suppliers, as well as more frequent testing of the entire consumer experience).

Getting consumers involved in co-creating demand means collecting data not only beforehand (in the early idea phase), but throughout the entire life of the consumer. This means taking input from every consumer interaction (in the store, online, via the catalog, etc.) and analyzing and acting on it. Retailers that do this well gain a deeper understanding of how their products fit within consumers’ lifestyles and belief systems.

Catalog retailers have done this for years, and now more bricks-and-mortar retailers such as American Eagle Outfitters and Payless ShoeSource are doing it too. Yet, in spite of the findings of the previous TEC article entitled “Consumers Shop Everywhere: Understanding Multichannel Sales,” most retailers still have, at best, only one point of contact with consumers during product design and development.

Brick-and-mortar retailers are also accelerating their consumer research and product development processes. Some have drastically reduced their concept-to-market process duration, e.g., from 10 months to 10 weeks. Such product “fast tracking” has become a key advantage, and leading retailers are managing 40 to 60 percent of their assortments with only 10 to 20 weeks allowed for the “from concept to shelf” cycle time.

Still, speed isn’t all that matters in Act Vertical retailing. Without proper research, many retailers simply get more of the wrong products to their stores, albeit faster. Retailers leveraging the Act Vertical model also gather more extensive consumer feedback on their products. Some use their stores as laboratories to test products.

They often bring merchandising and product design personnel in to hear consumers’ input directly. These retailers limit merchandising managers from relying on personal preferences and historical data. They let the science of retail count as much as the art. In other words, they do not let merchants “fall in love” with products or base their decisions on a hunch (i.e., what they thought looked great and what they needed to fill the slots in their catalog).

With more consumer input to use in product buying decisions, “vertically acting” retailers can begin to see easy-to-overlook nuances of different consumer segments. This is critical because most consumer segmentations use broad demographic and psychographic categories.

Leading retailers use focus groups, web-based consumer panels, product surveys, social networking Web sites such as MySpace or Facebook, and other means to ferret out fine-grained differences in consumer attitudes, emotions, lifestyles, behaviors, aspirations, and self-perceptions. As an idea, see TEC’s earlier article/podcast entitled “Social Networks: How They’re Turning CRM Upside Down.”

The above initiatives enable retailers to create finer-grained “micro segments” of consumers (e.g., “affluent moms in their 30s in Boston” rather than “affluent women from 20 to 35 nation-wide”). With much smaller and sharper focused consumer segments, these retailers can create much more appropriate products, assortments, and marketing campaigns.

Because consumer tastes change quickly today, Act Vertical retailers conduct consumer research and segmentation more frequently as well. While most retailers do such research and segmentation every two to three years, Act Vertical retailers do it every season. This frequency is part of their product development and merchandising processes.

In addition, these retailers ensure that their employees have the same mental image of their chain’s target consumer. In these companies, the merchant’s role shifts from picking products to managing projects (i.e., executing the plans that define how the retailer will meet the needs of each major consumer segment). With shortened cycle times, many assortment planning processes must be executed in parallel and much closer to the selling season (to meet the latest consumer needs).

Leading retailers now make assortment decisions 20 weeks out from in-store delivery (rather than 30 weeks in the past), and with much greater amounts of consumer information. They rank styles and items based on consumer-generated “confidence levels,” with the result being major increases in comp-store sales and margins.

Personal Example

I, personally, can go on and on (as an unpaid passionate advocate) about my experiences in the local Trader Joe’s grocery store. Namely, I have caught myself finding excuses to go to the store many times a week, in anticipation of the food and wine testing and cooking suggestions (combination of the in-store items) I might experience that day. Often I end up buying many items I had no intention of buying before I entered the store.

The company’s offering is indeed unique, not exactly pretentiously overpriced organic stuff (a la Whole Foods Market) but with many organic or close-to-organic (e.g., natural) products. The store’s choice of reasonably priced private label items (in addition to the “three buck Chuck” wines from the Charles Shaw brand) in the frozen food or dairy sections cannot really be found elsewhere.

The same goes for many domestic and imported beers or seasonal items like pumpkin butter. Not to mention the imported cheeses from Europe, lamb from New Zealand, and so on. The store staff is receptive to any suggestions, flexible in reacting to relieving long lines at cashiers (on demand), and on several occasions I did not need a receipt to either replace a defective item or to be reimbursed on the spot.

2) Delivering a Consistent and Immersive Consumer Experience

With more appropriate products to offer, Act Vertical retailers are far more likely to dazzle consumers who visit their stores. Still, great products isn’t the only thing that differentiates these retailers. Their store experience is also superior, and this immersive experience (not only in the store, but also online and via other channels) means how well consumers can test products before purchase, maximize their use after purchase, and fulfill other needs directly and indirectly related to the products.

PetSmart, for example, has opened up hotels for pets and runs dog obedience classes in its stores. Both value-add services create tighter bonds with the consumers that typically come to shop for their pets’ food. The regional grocery supermarket store chain Wegmans lavishes attention and services on its consumers, providing everything from recipes to catering services.

Since 2006, Best Buy has been offering customized "store-within-a-store" experiences and services at selected locations for small business owners and home theater enthusiasts. At these Best Buy For Business locations, trained specialists provide business solutions and services to businesses with up to 20 employees. To meet the expectations of convenient, personal service from specialized advisors, and technical support whenever and wherever they need it, Best Buy For Business offers a broader selection of technology products, such as servers and professional notebooks, professional advice and 24/7 IT support via the Geek Squad service.

These services generate much higher product sales because they help customers satisfy their larger emotional needs, lifestyle demands and aspirations. Such services also enable a retailer to gain a much richer understanding of its customers’ needs--insights it can use to continually create new and compelling products and services.

These retailers ensure that consumers can go to the store for everything they will need to use the product (i.e., one-stop shopping). Apple’s stores are great at this. At the Genius Bar in-store spot, a team of specialists instructs consumers on a variety of topics without pressuring them to buy.

Consumers who need one-on-one advice on how to operate Apple’s devices can pay $99 a year for appointment-based training (under the "No pain, all gain" slogan), from basic advice on how to set up a Mac personal computer (PC) or iPhone to editing digital videos and running graphic design software. Again on the personal note, my 20-month-old daughter, whose attention span can be measured in milliseconds, spends umpteen minutes (punching the keyboard and chasing the mouse) at the local Apple store’s video games spot for children.

Such services have helped make Apple a huge retailing success. Apple’s retail revenue has nearly doubled in the last two years. With about 200 stores to date, Apple generates an average $23 million a store, according to the company’s 2007 annual report. Revenue per square foot (about $2,500) was two-and-one-half times greater than Best Buy’s, according to a New York Times article in 2006.

These retailers also make sure that their store employees are as passionate about the company’s products as their consumers are--not just more knowledgeable. For example, outdoor gear retailer Recreational Equipment Inc. (REI) hires associates who love the outdoors. When the consumer looks for the right sleeping bag or tent at REI, store employees can speak from personal experience about what he/she will need.

By hiring employees who share consumers’ product passions, retailers that act vertical use their stores to create strong relationships. They ensure their salespeople are part of the consumer’s “community” of others with similar interests. Apple uses its retail stores to encourage consumers to bond with other consumers by hosting social events like the “Midnight Mix” concerts, where the hottest local DJ's play songs from midnight to 2 a.m. As another example, Best Buy For Business encourages networking among local small business professionals in exclusive events with business leaders, local professional organizations, and the US Small Business Administration (SBA).

By providing compelling products and services through engaging customer experiences, the best act vertical retailers create a virtuous circle that continually strengthens their bonds with their customers. They have converted their casual customers into passionate advocates--people who not only like shopping at those retailers but also enjoy congregating with one another in and outside the stores. In this way, these savvy retailers have created a “tribe” of people with common passions, values, and aspirations.

3) Tailoring Supply Chains

After improving the way they interact with consumers both before and during their store visits, act vertical retailers have quite different ways of interacting on the back end of their business as well. They might even create more than one supply chain to accommodate different types of products. In other words, they tailor and fine tune their supply chains as required.

The final part of this blog series will conclude with how these retailers handle (with care) their “act vertical” supply chains. To my mind, this flexibility and agility of supply chains and using different supply approaches to meet the distinct needs of different products is where the “Act Vertical rubber hits the road.”

Till then, what are your thoughts and comments in this regard? What are your experiences in dealing with the abovementioned retailers? What software applications do you think can help these companies in their “Act Vertical” efforts?
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