Cost-Cutting redefined

In their desire to be efficient, companies that keep doing more for less might come to the straw that breaks the camel's back.

While Hostess Brands' products are expected to live on under new ownership, they serve as a reminder of how fragile relations with labor can put a company at risk, particularly in a treacherous economic climate. Workers will put up with only so much cost-cutting from employers before they reach their breaking point. Cutbacks in wages, benefits or labor hours might trim employer costs in the short term, but will a dent in retail service levels spur shoppers to go elsewhere for their groceries?

Those are the considerations retailers and manufacturers should weigh as they launch or renew their cost-containment strategies, experts say.

"No one has ever cut their way to prosperity. You certainly need to get costs into control so you can be competitive, but cost control in itself isn't a winning strategy," says Neil Stern, senior partner at McMillanDoolittle in Chicago.

Instead, companies need to differentiate themselves from the competition in a way that will attract and retain customers, Stern says. They need to build their business models around that distinction. For some, the model will focus on quality products or freshness, while others will find a way to sell at low prices profitably. Dollar stores and some small format discounts have done this by simplifying the conventional model and accepting secondary real estate locations. They simplify inventory and stock keeping by offering less variety, and they operate with a "bare minimum labor model," Stern says.

While these retailers could lose upper-end customers who grow frustrated with their lack of service, they'll likely keep lower-end consumers who have fewer options.

A Winning Model
Costco, which on March 12 reported a 39 percent increase in net profit and an 8 percent increase in total revenue in its second quarter from a year ago, has found a winning low-cost model while emphasizing quality products. The warehouse club has been adding organic products to attract higher-end consumers still feeling pinched by the economy. "That proposition of great, high-quality merchandise at the lowest prices you can sell it at is a very compelling one for customers, with obvious tradeoffs in package size and having to wait in line to get checked out," Stern says.

The model works because the clubs are looking for volume, not profit margin. "Costco and Sam's [Club] are running the chain to make 2 percent. The idea has never been to get 3 percent next year and 4 percent the year after that. It's 'If we keep our profits low, we're going to grow sales.' That's why they have so much goodwill with customers over time," Stern says.

For other retailers, however, differentiating on price in the face of competition from the likes of dollar stores and warehouse clubs could be a tall order, particularly if the banner doesn't have the tremendous goodwill Costco has built over time. But controlling costs can allow them to reinvest in service.

With the economy continuing to grow slowly, it's unlikely consumers will loosen their purse strings dramatically in the near future. And that's causing retailers and CPGs to continue their focus on reducing costs. "A lot of executives want to put this darn cost containment behind them and they can't," says Steve Riordan, retail practice leader at Kalypso in Beechwood, Ohio.

According to PricewaterhouseCoopers' "2013 US CEO Survey," 81 percent of CEOs surveyed said they had reduced expenses in 2012, and 71 percent said they were planning cuts in 2013.

Many are continuing to pressure suppliers to reduce costs, yet that strategy could have unintended consequences if it leads to unsafe or unscrupulous behavior on a supplier's part. Many food contamination crises stem from suppliers' efforts to reduce costs by lowering their standards. Even when the public's health isn't at risk, as in the case of the horse meat scandal in Europe this year, retailers and manufacturers can face a loss of consumer confidence when shoppers feel duped by suppliers taking shortcuts to save money.

"At PricewaterhouseCoopers, we work with a lot of clients on supply chain efficiency...and really understanding who their suppliers are. We've seen it over and over again in the food industry with contamination," says Sue McPartlin, U.S. retail and consumer leader for PricewaterhouseCoopers in Cincinnati.

To that end, more companies are treating their suppliers as partners. About 53 percent of CEOs in the PwC survey said they planned to improve engagement with suppliers "to both minimize costs and maximize supply chain flexibility and delivery performance."

While retailers often get caught in the middle of food safety incidents, they also face their own pressures to reduce overhead in their stores. "The one word of caution I would put out there is that often retailers cut staffing first and all too often sacrifice service," says Garrick Brown, director of research at Cassidy Turley in San Francisco. "Now this might not be too horrible when consumers are in deal mode and more willing to sacrifice service for cheap prices, but it is a dangerous game even in a down economy. Service still matters even in the worst economies and gutting staff can have direct consequences not only in terms of losing sales and hurting retailers' reputation, but also on shortage and negatively impacting employee morale and motivation."

Ethical considerations to cost-cutting also are gaining credence. The PwC survey indicates fully half of U.S. CEOs said they planned to support a culture of ethical behavior this year by creating or improving a framework to guide behavior. As one part of this, about a third of companies said they will expand their nonfinancial reporting, providing more information about ethical guidelines or the company's role as a corporate citizen.

Matching Customer Needs
Most companies look first at cutting costs by automating their back offices or warehouses, but many have already done that and are now looking at ways to take costs out of the store itself. But that strategy can backfire if done ruthlessly, Riordan says. "If you are redesigning the store and are just trying to do a cheaper version of category shopping, you might not be on the right track," he says. "It ought to be driven by the consumer, not by operations and execution people internally."

Getting closer to the customer is a popular goal this year, according to the PwC survey, which indicates 90 percent of CEOs surveyed said they were bolstering their customer engagement programs in one form or another.

Retailers should be planning their store designs to match customer needs, experts say. Regional supermarkets often can better serve local customers than national competitors, Stern suggests. "There are still great regional chains all around the country who just simply know the local customer better and are willing to be part of the community, localizing the assortments to the neighborhoods and being generally faster to react than the big chains."

Mariano's Fresh Market, which is owned by Milwaukee-based Roundy's, where former Dominick's CEO Bob Mariano is CEO, is an example of a regional chain with expertise in the markets it serves, Stern says. Mariano's has successfully entered the Chicago market with nine locations at a time when the Supervalu and Safeway banners in the area were struggling. "Mariano's has been able to come into Chicago and be very successful, while Safeway is running Dominick's from California and Supervalu is going through management changes," Stern says. Jewel-Osco was recently sold by Supervalu, while Dominick's has declined in market share since Safeway purchased it.

Mariano's offers fresh produce and specialty foods at lower prices than high-end specialty retailers, while offering the branded staples sold in conventional supermarkets at the same competitive prices. The concept is designed to encourage shoppers to do all of their shopping at Mariano's, instead of buying routine items at Walmart, Target or their neighborhood supermarket.

Understanding local customers can build loyalty. In Milton, Mass., Fruit Center Marketplace's 14,000-square-foot stores have thrived despite competition from nearby Whole Foods Market and Fresh Market stores. "When there's a recession, a lot of people shut the lights off. We do the opposite," says Michael Mignosa, store manager and son of owner Don Mignosa, who opened the stores in 1973. The company remodeled its Hingham store three years ago, despite the poor economy.

At the same time, Mignosa says, "When things started to turn, we tried to get closer to distributors and put more pressure on them. We've changed how we buy in grocery and produce."

Vendors were responsive in part because most had done business with Fruit Center Marketplace for years. "It works in their favor to be able to work with us," Mignosa says.

The company, which says it has the longest salad bar south of Boston, has positioned its extensive produce department in the center of the store, which is a point of differentiation. It also has opened a full-service Marketplace Cafe where shoppers can enjoy breakfast or lunch, and area chefs demonstrate recipes.

"We take very, very good care of [our customers] as they do us. Anything they need, we go above and beyond," Mignosa says.

Journalist Ann Meyer, who serves as senior editor of Retail Leader, is also president of L3C Chicago.