A Golden Egg for Retail

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O P E R A T I O N A LE F F E C T I V E N E S S

V P I D E L I V E R S A B O O S T T O M A R G I N S

goldenegg

a

forretail

ABOUT THE RETAIL OPERATIONAL EFFECTIVENESS SERIES:

McKinsey's Retail, Apparel and Hospitality Practice

developed this series of articles to help retailers enhance

their performance by utilizing optimizing tools and novel

operations approaches. This is the first in a series of

occasional articles.

ABOUT THE AUTHORS:

The authors are leaders of McKinsey’s Retail Vendor

Performance Improvement initiative. Laura Meinke is a

consultant in McKinsey's Cleveland office, Elizabeth Mihas

is a consultant in the Chicago office, Michelle Moorehead

is a consultant in the Dallas office, and Nick Semaca is a

principal in the Chicago office.

COPYRIGHT © 2000 MCKINSEY & COMPANY.

ALL RIGHTS RESERVED.

V P I : A G O L D E N E G G F O R R E TA I L 1

Retail earnings are feeling the squeeze. The Internet, industry

consolidation and changing demographics are all applying

pressure to the top and bottom lines. Yet a powerful optimizing

tool, Vendor Performance Improvement (VPI), remains little used and

poorly understood.

VPI is a rich process that enhances retail margins by deepening buyers’

knowledge of their category’s economics. It embraces vendors as partners

in the systematic assessment of vendors’ capabilities — existing and

potential — and retailers’ opportunities to improve in category

management, buying, and logistics. The disciplines and organizational

processes that comprise VPI allow merchants to think beyond individual

buys to develop a strategic view of their business while driving dramatic

increases in growth and profitability. This article will:

• Show how VPI can lead to substantial profit improvements through

cost reduction and top-line growth

• Examine the barriers to capturing maximum value from VPI

• Define the five key practices retailers must adopt to seize the VPI

opportunity

V P I D E L I V E R S A B O O S T T O M A R G I N S

goldenegg

a

forretail

2 ©MCKI N S E Y & CO M PA N Y 2000

The size of the prize validates VPIIn the VPI process, retailers and vendors explore a comprehensive set of

opportunities to improve profits. VPI examines all aspects of the business

and all aspects of vendor relationships (Exhibit 1). A critical element of

VPI is an end-to-end analysis of the total cost of merchandise, including

the supplier’s purchase of raw materials, manufacturing processes, supply

chain, payment flows, and product merchandising and servicing on the

store shelf. VPI also requires internal, objective examination of poorly

performing elements of a business. Such a comprehensive look allows a

retailer to identify its largest and most compressible costs and provides

comparison points across vendors.

Depending on the character of the retailer’s business, VPI can vary widely

in its application. While every category requires a systematic, fact-based

approach, the levers that will most enhance profitability vary with supply-

chain and selling-cycle characteristics. Ultimately, VPI leads to the

Exhibit 1

Endproducts

Tasks Create fact base

Assess opportunities andpotential impact

Finalize recommendations

It takes 16-20 weeksto execute VPI.

Time invested varies with the category’s

complexity.

It takes 16-20 weeksto execute VPI.

Time invested varies with the category’s

complexity.

• Detailed implementation plans with actions, responsibilities, and timing

• Monitoring and tracking mechanisms

• Modified budget

• Key learnings

• Segmented vendor-sourcing strategy

• Request-for-proposal (RFP)

• RFP evaluation criteria

• Negotiated pricing terms and conditions

• Clearly articulated category strategy

• Vendor and product-spending database

• Total cost of merchandise

• End-to-end supply-chain flow

• Supply-market assessment

• Key opportunity levers

THE VPI PROCESS

Source: Team analysis


identification of vendors with capabilities and product assortments

that will maximize a retailer’s business — both bottom line and top line.

The VPI approach is equally valid for large and small, hardline- and

softline-focused retailers alike. McKinsey experience affirms that profit

improvement from VPI can be significant no matter the category. We’ve

seen overall costs as a percent of sales reduced by 7 percent, which

translates into better than 40 percent improvement in net contribution

margin. The savings range varies principally by the retail category and

skill level of the buying organization: consumables and grocery typically

yield savings of 1 to 3 percent, softlines yield 2 to 6 percent, and

hardlines yield 1 to 7 percent (Exhibit 2).

VPI also produces significant top-line revenue growth. Repositioning

product to be more on trend or to address strategic gaps in assortment

can result in a significant sales boost. It’s common to see improved

access to proprietary product, better in-stock performance, and

enhanced product features or packaging resulting from VPI.

By taking our VPI Savvy Quiz (on following page), you can determine

whether your merchant organization has room to improve its skills to

drive bottom-line improvement and top-line sales growth.

Exhibit 2

VPI DRIVES COST SAVINGS NO MATTER THE CATEGORY


Grocer –cheese

1% grossmarginincrease

• Centralized purchasing organization

• Consolidated/standardized vendors and SKUs

• Created regional distribution centers

Catalog retailer –private labelapparel 5% gross

marginincrease

• Developed and enforced standards across all apparel groups

• Developed supplier cost model to reduce purchase price

• Reduced vendor base

Mass merchant –do-it-yourself

6% grossmarginincrease

• “Unbundled” product costs to negotiate better terms

• Changed distribution flow from DSD to through DCs

• Identified product cost/quality inconsistencies

Category VPI outcomes Results


What’s your VPI SAVVY quotient?Can your merchant organization improve its skills to drive bottom-

line improvement and top-line sales growth? Take the VPI Savvy Quiz

to find out.

1 Do your merchants understand their key suppliers’ product

economics i.e., suppliers’most significant cost drivers and their

overall margin size?

2 Do your buyers understand the total cost of merchandise, from

gross sales to net contribution after store direct expense?

3 Do you conduct a full category line review, including vendor

composition assessment, each year?

4 Do your merchants have clearly defined vendor segmentations

and objectives by segment?

5 For significant categories, do your merchants develop formal

requests-for-proposal from the supply base and optimize both

top-line sales attributes and total cost of merchandise?

6 Do your merchants meet regularly with your distribution and

logistics organization to identify profit-improvement

opportunities?

7 Do your internal information systems enable merchants,

planners, and logistics to evaluate a category’s fully loaded, total

cost of merchandise?

8 Is your activity-based cost information widely used and trusted as

accurate for decision making within the organization?

SCORING: 7-8 yes responses Congratulations! You’re probably already implementing

VPI to your advantage.

5-6 yes responses You may be missing opportunities to reduce costs andincrease top-line growth. Consider VPI.

1-5 yes responses VPI will certainly help you achieve your goals.


Leap these hurdles to capture VPI value Why then haven’t more retailers seized the VPI opportunity? After all,

buying is often seen as the most important role in retail operations. And,

most retailers pride themselves on executing this role well. But it should

be no surprise that buyers fall short given the scale of the barriers they

often face. Our work with retailers suggests that five barriers impede

buyers’ ability to maximize value:

1 Incomplete knowledge of supply-market opportunities

2 Disproportionate focus on short-term performance

3 Unwillingness to switch lines and vendors

4 Misaligned incentives

5 Limited availability of information to support decision-making

BARRIER 1: Incomplete knowledge of supply-market opportunitiesBuyers rarely grasp their key suppliers’ margin structure and the profit

distribution between retailers and vendors. Few buyers have time,

resources, or experience to re-engineer the cost of their key products and

to ensure that product pricing across lines is consistent and rational.

Consequently, many buyers focus simply on bidding the business without

a structured process, and without having the knowledge needed to truly

optimize the deal.

Likewise, suppliers often do not properly understand the true cost of

serving different retail accounts. Our research indicates vendors

sometimes offer significant differences in cost and deal structures to their


multiple retail accounts. In the noise of allowances, co-ops, program fees,

and distribution costs, vendor pricing is often hugely variable. In this

environment, it is challenging for both buyers and suppliers to know if a

better structure or price exists.

VPI provides value to retailers and suppliers who work through these

issues and then share the savings discovered. For example, vendors and

retailers can fine-tune assortments by testing new product in pilot stores

before rollout to evaluate order quantities and optimal assortment mixes.

This is particularly relevant to fashion-driven businesses such as home

furnishings. Or, vendors and retailers can cooperate to optimize

specifications for private-label goods, to maximize consumer appeal at

minimum cost.

BARRIER 2:Disproportionate focus on short-term performanceMaking the week’s sales targets and constantly showing good comps are

top priorities for all buyers, but this often results in short-term planning.

The success of this month’s advertisement often overwhelms buyers’

ability to step back from day-to-day assortment management to think

strategically about overall category direction and anticipate transitions in

consumer needs. As a result, vendors often are more knowledgeable than

retailers about category and consumer trends, and frequently have a

deeper understanding of the competitive dynamics shaping an industry.

VPI provides the opportunity to step back and take a longer-term view.

This not only improves the strategic health of the business, but invariably

uncovers opportunities to improve short-term performance as well.

BARRIER 3:Unwillingness to switch lines and vendorsNew vendors can seem risky to buyers who have established vendor

relationships. Buyers prefer incumbents on the better-the-devil-you-know

principle and avoid investing time in testing and piloting new lines and

products. For hardlines businesses, especially those with slow turns,

switching product lines can be expensive and messy. Often, this deters

buyers from exploring alternate suppliers or pushing existing suppliers to

collaborate to reduce costs.


Through VPI, retailers assess these risks objectively, and often find that

vendors can help reduce or eliminate them to capture joint opportunities.

BARRIER 4:Misaligned incentives Buyers’ incentives typically are limited to sales and gross-margin

performance. So, buyers aren’t motivated to look for cost-reduction

opportunities in such areas as distribution centers, where the costs of

handling, shipping, and logistics can represent up to 20 percent of

product cost. Without incentives to optimize their products’ total cost,

buyers may not challenge themselves to investigate potential supply-chain

opportunities such as:

• Reducing cycle times to better align with emerging marketplace

trends

• Shipping direct-store-delivery versus to distribution centers

• Optimizing inbound order quantities and shipment modes to

improve trade-offs between inventory, transportation costs, and in-

stock status

By taking a look at a category’s total economics, VPI highlights where

incentives may need restructuring to enhance overall goal alignment. VPI

also provides the quantitative information needed to create a new

incentive plan.

BARRIER 5:Limited availability of information to support decision-makingBuyers rarely receive adequate external information — on consumer-

market and supply-market trends — to fully comprehend their

marketplace. Gaining a complete understanding often requires working

with multiple vendors to build a market profile. Buyers also need a good

grasp of the internal economics of their business, its strengths and its

weaknesses, and a deep understanding of their vendors’ capabilities. It’s

rare for buyers to have access to data that clarifies the true cost of

shipping and handling, in-store managing costs, and net profitability

compared across vendors. Such information would allow buyers to


identify opportunities for supply-chain savings and joint buyer-vendor

cost reductions.

The absence of user-friendly desktop systems that link activity-based-

costing logistics and distribution-cost systems, accounts-payable systems,

and different accounting methodologies for advertising allowances, also

represent significant hurdles. For many retailers, the VPI process

represents the first time they have assembled all the information needed

to optimize their merchandise strategy.


Seizing the VPI opportunity The good news is that these organizational barriers to VPI are

surmountable. High performing organizations combine smart

negotiating, collaboration with vendors, and a willingness to make tough

internal tradeoffs to drive significant bottom-line profit improvement.

Often, making the transition is a learning process; most companies start

with a handful of target categories and expand over time. We’ve seen

success with VPI when merchants adopt these five key practices:

1 Clearly articulate a category strategy

2 Rigorously develop and use external and internal information

3 Segment vendors and apply tailored sourcing strategies to each

segment

4 Aggressively coordinate all profit improvement levers in vendor

negotiations

5 Realign skills, performance metrics, and decision-making processes

to support and sustain VPI results

KEY PRACTICE 1: Clearly articulate a category strategyTo enable maximum value from VPI, merchants should establish clearly

articulated category strategies. VPI builds on and enriches a category

strategy. A clearly defined category strategy identifies the target

consumer, critical shopping occasions, and how the retailer will select

merchandise, price, and service to meet consumers’ needs. It is the

roadmap that defines the must-have strategic brands and the assortment


of branded and private-label options. It sets category sales and

contribution-margin targets. If the category strategy falls short, VPI can

be an effective way to rethink areas of weakness and fine-tune the strategy

to best leverage market opportunities.

A European catalog retailer developed its private-label-apparel strategy based

on market research and a complex review of 700 suppliers. The process led to

the identification of a clear set of preferred brands, a vendor scorecard based on

logistical and financial measures, and clear standards for size, color, and

quality. The retailer identified gross margin improvements of 2 percent from

reduced returns, a rationalized vendor base, and increased quality.

KEY PRACTICE 2:Rigorously develop and use external and internalinformation VPI’s foundation is the rigorous development and use of external market

data and internal cost-of-ownership analysis. External information

addresses the supply market — that is, competitive dynamics,

manufacturing capacity, and availability of substitute products. Even

when external information is not readily available, a picture of the

external marketplace can be developed from vendor visits, industry

reports, and global sourcing offices.

Valuable internal information includes vendor- and product-spending

performance history, as well as associated buying and supply-chain

processes. Understanding the total cost of merchandise (net category

contribution including the impact of allowances, co-ops, payment terms,

supply chain, and in-store service and display costs) can lead to insights

into cost-reduction opportunities. To evaluate opportunities for

substitution or expansion, merchants must analyze SKU and vendor

productivity to the net contribution level.


Exhibit 3 shows how a U.S. retailer used VPI in a formal request-for-proposal to

unbundle a vendor’s products from marketing services and support costs. The

retailer then assessed whether to fund each component and also eliminated

unnecessary service and support costs. Concurrently, the retailer reverse-

engineered the product with the help of independent testing laboratories. Using

both levers, savings exceeded 7 percent of total cost.

Exhibit 3

UNBUNDLING COSTS REVEALS COST-SAVING OPPORTUNITIES

75

56

2 768

Total invoicedcost (fully-loaded cost)

FreightPOP and in-storeequipment

Nationalbrandsupport

Salesforce

Cashdiscounts Advertising

allowances

Net productcost(unbundledcost)

100

Percent

DISGUISED CLIENT EXAMPLE -RETAILER


VPI revealed that bells and whistles comprised 16% of total invoiced costs to retailer

VPI revealed that bells and whistles comprised 16% of total invoiced costs to retailer


KEY PRACTICE 3:Segment vendors and apply tailored sourcing strategies toeach segmentThe third aspect of VPI combines category strategy with external and

internal information to create a high impact vendor sourcing strategy.

Vendor sourcing strategies vary along many dimensions and address the

desired number of vendors, mix of domestic and offshore sources, vendor

capabilities (lead times and supply-chain flexibility), and business-

assortment strategy (mix of promotional versus basic SKUs).

A North American department store using VPI segmented its apparel vendors

along two dimensions: logistical capabilities (fill rates, percent on time, etc.)

and financial impact (the gross margin percentage it brought the category, as

well as total cost of merchandise). Exhibit 4 shows how the retailer plotted all

vendors on two dimensions, based on performance, and then tailored a

strategy for each. The retailer sorted out profitable vendors from those that

needed to be pruned. Overall this resulted in a 2 percent improvement in net

contribution.

Exhibit 4

SEGMENTING VENDORS ACROSS TWO DIMENSIONS ALLOWED A VENDOR TO TAILOR STRATEGIES

DISGUISED CLIENT EXAMPLE -DEPARTMENT STORE


Improve financialsor trim from base

Develop partnerships

Trim or justifytesting longer

Improve logisticsor trim from base

Financial score (GM%, TCM)

Logistical score (fill rate, percent of time)

Vendor


KEY PRACTICE 4: Aggressively coordinate all profit-improvement levers invendor negotiationsThe fourth element of VPI involves using all profit improvement levers,

not just product cost. This includes improving supply-chain flows,

eliminating unnecessary middlemen, minimizing transactional costs,

and reducing the basic cost of goods.

Recent work with a discount retailer identified a 30 percent logistics savings

accomplished by shifting product delivery from direct-to-store to just-in-time

through the warehouse. Exhibit 5 shows how a softlines catalog retailer used

merchandise analysis to identify two cost elements with significant variability

across vendors: merchandise returns and payment terms. The retailer then

identified vendors with the least attractive returns and payment terms and

renegotiated higher performance standards. This initiative led to a 3 percent

increase in gross margin.

Exhibit 5

MERCHANDISE ANALYSIS REVEALS COSTS THAT VARY BY VENDOR

100.0

0.43.55.83.19.61.4

5.6

67.9

Totalmerchandise

cost

Returns Qualitycontrol

Product cost

Advertisingallowances

POPPaymentterms

InventoryShippingObsole-

scence

DISGUISED CLIENT EXAMPLE -CATALOG RETAILER

Percent

Vendor's rates varied by 50%Vendor's rates varied by 50%

21.7


KEY PRACTICE 5:Realign skills, performance metrics, and decision-makingprocesses to support and sustain VPI resultsTo maximize VPI results, merchants must realign metrics, tools, and

decision-making processes. Specifically, retailers should:

• Craft incentives that motivate buyers to take full ownership of the

cost of merchandise and ensure that VPI savings make it to the

bottom-line, rather than are shifted to other cost centers. Such

incentives encourage cooperation among merchandising, stores,

and logistics.

• Build new analytical skills and tools, such as formal vendor requests-

for-proposal, into the buying process and line review.

• Develop systems- and activity-based cost-measurement tools to

support a thorough analysis of product costs and track overall

savings.

A large home-furnishings and furniture retailer recently changed its incentive

system to one that includes the metric net-contribution-after-supply-chain costs.

This shift resulted in greater attention paid to freight costs, which reduced the

total cost of the merchandise by 1 percent.

By incorporating these five key practices into the retail

organization, buyers evolve from shepherding a transaction to managing a

strategy. With VPI, buyers manage the business proactively — instead of

reacting to supply-market fluctuations — which may make their role

more professionally rewarding.


Executive endorsement eases the way Executing VPI may seem daunting, and rightfully so. Developing a

rigorous understanding of a category requires dedicated resources and a

concerted focus on results. Senior management support is critical as the

process involves tackling traditional organizational barriers. It also

promotes buyers’ cooperation and enthusiasm for VPI. Senior

management’s involvement empowers merchants in their communications

with vendors. This may come in handy if incumbent-but-at-risk vendors

feel threatened and seek to circumvent the formal process – even

reaching to senior executives to disrupt it.

Two options exist for getting started with VPI: slow-build or immediate

commitment.

START SLOWLY If you need to build the case for changeIf your company scores low on the VPI Savvy Quiz, the scale of the

organizational development required suggests a slow-build approach to

prove the case for VPI with respected merchants in an organization.

Organizations that require significant skill building must develop a

tailored and disciplined process that establishes VPI capabilities. These

success stories can generate demand for VPI across an organization.

When selecting which aspects of a business VPI will address first, the

most promising categories are those with complex, diverse supply

markets, some brand flexibility, and turn rates that allow the merchant to

transition assortments without incurring prohibitive markdowns on

obsolete merchandise.

We suggest launching VPI with three or four pilots to prove the overall

approach and build internal skills. Merchants should consider dedicating

a VPI SWAT team to drive the process, institutionalize learning, and bring

supplemental resources to buyers. Depending on your buyers’ experience,

it also may make sense to add one or two analysts with complementary


financial and strategic skills. Once the case is built, VPI can be fine-

tuned and rolled out in broad waves every four to five months, eventually

covering all critical elements of the business. When the VPI process is

complete, the buying team should repeat it every two to three years to

confirm category knowledge and sharpen the strategy.

SPEED IT UP If you have some VPI skills in placeRetailers who score in the mid-range on the VPI Savvy Quiz and have

access to internal financial performance data and sophisticated systems

can move more rapidly with VPI. These retailers may consider a multi-

wave VPI program with five to six categories in the first phase of the

program. The faster a retailer can ramp up a VPI program the quicker

significant profit improvement will be achieved.

VPI can create both top-line growth opportunities and drive

bottom-line savings for retailers. Getting there, however, is the challenge.

VPI is a detailed and rigorous approach to developing a profitable

advantage. It requires merchants to rethink traditional attitudes to

managing vendors, build analytic skills, and take a cross-functional view

of margin opportunities. Organizationally, it requires developing cross-

functional incentives that align buyers and supply chain alike and,

usually, a dedicated SWAT team to provide analytical support to the

merchants.

When VPI is executed successfully, the size of the prize is significant. VPI

provides better strategic control of the business and can generate 5

percent or more in net margin improvements. With results like these,

can you wait?

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A Golden Egg for Retail