Margin Squeeze and Globalization in the Food and Beverage Industry
Written By: Predrag Jakovljevic
Published On: November 1 2006
Fastidious Food Service Channel
Many food distributors act as commodity brokers, negotiating annual supply contracts for the major retail chains for a range of food products. Often, these are "private-label" products sourced from different growers or food processors around the world to guarantee supply year-round. The logistics planning and documentation must be precise if costs are to be kept under control. Furthermore, if the quality is sub-standard and the consignment is rejected, the food distributor has the prospect of replacing, re-labeling and disposing the product on a secondary market, which is almost surely a losing proposition.
Part Three of the series Food and Beverage "Delights."
For background and a definition of the industry see Food and Beverage "Delights". For information about trends in the sector, see Food and Beverage Industry Trends and Issues.
The situation is not much mitigated when it comes to the food service channel, which is the second largest food distribution channel. This channel sells fresh and fully- or semi-prepared food produce for consumption in restaurants and eating establishments outside of the home. Products include canned foods, meats, poultry, seafood, dairy, fruits, vegetables, beverages, and other ancillary products such as napkins, paper towels, detergents, and cleaning materials. Food service customers, especially owner-run restaurants, rely on a more personalized approach from their suppliers, which often employ a field sales force to generate new business and take customers orders. This can be an expensive sales channel, and more food service distributors are encouraging their customers to order over the Internet or use customized personal digital assistant (PDA) devices, which store product information and instructions on how to log orders. This suits many restaurateurs, who can check their stock at the end of the evening, and transmit orders electronically for next-day delivery.
Chain restaurants or public food outlets—such as hotels, hospitals, and school canteens—also have the buying power to negotiate national and regional contracts with special ordering, billing, and fulfillment needs. Quotation, price, and cost management are common requirements, as are personalized menu management and menu guides based on order structures. This means that suppliers can, for example, deliver on Monday everything required to prepare Tuesday's menu, or all the menus for the week.
What can a food manufacturer do about the decrease in margin per unit? Sure, the manufacturer can accept it as a cost of doing business. But continued pressure from the channel master towards lower prices and greater service means that margins will eventually go to negative levels. For a discussion of channel masters, see Food and Beverage Industry Trends and Issues.
The manufacturer can attempt to address margin erosion; however, this effort is hampered by the fact that the manufacturer does not control many of the determinants of the profit margin. The manufacturer can attempt to increase volume by using promotional measures, but only within limits—and then only by sacrificing margins. When consumers go to the grocery store, they see items on sale all the time, in addition to coupons in newspapers, magazines and other places. These are called promotions, and are a driving force in the industry. For example, approximately 60 percent of all chocolate candy is sold on promotion. Even for such stable items as rice and peanut butter, approximately 30 percent of volume is sold on promotion. For seasonal items, such as holiday season candy or stuffing mixes, 80 percent of fourth calendar quarter sales are sold on promotion. Promotional spending now consumes 54 percent of food company marketing budgets, and represents an average of 17.3 percent of gross sales.
Therefore, in the complex sales channels of food and beverage, small adjustments to pricing and promotional incentives (such as ad hoc deals) can have significant impacts on sales volumes and revenues. On one hand, raising prices can increase profits per unit, but it can also drive demand to a competitor; on the other hand, offering larger rebates can motivate brokers and distributors, but cut into already thin profit margins. Promotional activity drives complexity for the food manufacturer, but is an absolute requirement to compete, since retailers and consumers expect it. Promotions, however, lead to complexity in packaging, pricing, distribution, and even accounts receivable (AR) and accounts payable (AP). Sophisticated systems are thus needed to fine-tune pricing and promotions to achieve the ideal balance, and ensure that company objectives are achieved.
Food producing and distribution is a bulk low-margin business with linked customer and supply contracts, and contract pricing and discounting in the food industry can be extremely complex. Most prices are volume-based, with various chain discounts based on almost any variable, from product line to manner of transport. Suppliers are constantly inventing new products or repackaging old ones with special pricing, promotional offers, and marketing campaigns. Customers demand rebates, overrides, and retro adjustments, which are commonplace in the food industry. This practice leaves food distributors hard-pressed to figure out overall gross and net margins on their products. An accurate identification of the most profitable product lines is thus quite critical for companies seeking to focus on their most valuable products, and considering dropping their unprofitable products. To do so requires visibility into all material and production costs, including indirect costs or value resulting from co-products and by-products. Visibility is also needed into actual profits that account for promotional deductions such as rebates, discounts, and adjustments to orders and payment terms.
The channel master makes the final volume decision, and mostly controls the unit price, with the manufacturer having limited power to increase or maintain prices. The only real variable the manufacturer does control is the cost side of the equation. As a result, maintaining margins is the result of lowering cost. Along with market share growth, lowering operating costs is a key way in which consumer goods manufacturers generate profits. This has been quite complicated recently (with rising fuel costs translating into higher transportation costs), and has added an extra burden on consumer goods manufacturers, as they must try to pass on this added cost in their very competitive markets.
Finding the right level of inventory to meet both production requirements and customer service is always a challenge. As indicated earlier, sales forecasting (and ultimately the estimation of demand) in the food and beverage industries is highly dynamic, affected by price changes, promotions, seasonality, and many external factors. Effective demand planning is necessary to optimize manufacturing and distribution asset utilization; reduce the cost of finished goods inventory; and promote high customer service levels by minimizing stock-outs.
The food industry long thought it was safe from the impacts of globalization. It reasoned that the barriers of transportation cost, shelf life, and consumer taste would protect its local markets. These assumptions have proven false. Incredibly, a food processor on the US West Coast tells us that its Chinese competitor can deliver product to the US West Coast at a lower cost than even the domestic manufactures can. Fresh products are now always available in most markets, imported from countries once considered to be too far away to compete. Since consumers now expect a year-round supply of seasonal products, it is an extremely complicated process involving everyone in the food supply chain from the grower to the retailer.
Is globalization an opportunity or a threat? Looking at the entire food industry, the answer is "both." Looking at individual categories, it can be an opportunity, a threat, or even a combination. Globalization clearly provides the opportunity to sell to new markets. But any discussion of globalization must begin with the impact of China. As a market for food products, the Chinese economy has been doubling in size roughly every six years. By some estimates, China could become the world's largest economy by as early as 2015. China's huge population base of 1.3 billion consumers thus represents a very large opportunity, although the challenge is to gain access to this very large market and provide products that the Chinese consumer wants (and at a viable price, given the buying power of the average Chinese consumer). As other countries expand their middle class, the demand for imported products also grows.
Globalization also means the opportunity to source ingredients at a lower price. With control over quality, shelf life, and forward-looking planning systems, global sourcing can lead to lower cost (see The Gain and Pain of Global Retail Sourcing).
However, globalization presents the threat of new competitors with cost advantages. Logistics differentials still exist, but the lower costs of production and processing in other countries more than makes up the difference. Today, food and beverage companies are seeing competition for commodity-driven products, but the future is likely to see competition for value-added products.
Another complexity stemming from guaranteed year-round availability is that suppliers are spread around the world and are invoiced in different currencies. Commodity traders are well aware that contracts to supply over a twelve-month period can severely erode profit margins if currency exchange rates fluctuate significantly, so they buy or sell their currencies forward to protect their margins. Some retail chains share the risk in exchange for lower shelf prices by negotiating sales contracts with built-in currency clauses. If the exchange rate fluctuates outside predefined tolerances, the food distributor can adjust the customer's pricing to maintain margins.
About the Authors
Predrag Jakovljevic is a principal analyst with Technology Evaluation Centers (TEC), with a focus on the enterprise applications market. He has nearly twenty years of manufacturing industry experience, including several years as a power user of IT/ERP and related applications, as well as being a consultant/implementer and market analyst. He holds a bachelor's degree in mechanical engineering from the University of Belgrade (Serbia [the former Yugoslavia]), and has also been certified in production and inventory management (CPIM) and integrated resources management (CIRM) by APICS.
Olin Thompson is Lawson's vice-president of industry strategy. He has over twenty-five years of experience as an executive in the software industry, and has been called the "father of process ERP." Thompson is a frequent author and award-winning speaker on such topics as gaining value from ERP, supply chain planning (SCP), e-commerce, and the impact of technology on industry. He can be reached at firstname.lastname@example.org.