SKU Rat vs. Cat Man

Thursday 03 May 2018

Article

News this month of UK grocery retailer Tesco's positive results show the benefits of (amongst other things) SKU rationalisation - aka SKU Rat - with some of their categories having had a 25% reduction in the number of SKUs.

The SKU Rat playbook is a well-proven driver of margin growth. Typically you can achieve a 2% cash margin improvement from very modest actions.

The SKU Rat playbook generally comprises 3 elements:

• Cut the tail of worst performing low margin and high cannibalisation SKUs
• Stretch the price ladder of the remaining SKUs
• Further switch out national brand SKUs with private label SKUs for margin improvement and reinforcement of your distinctness

This is a fantastic playbook I've seen played out at CVS in the US, Rewe in Germany, Boots and Sainsbury, and now Tesco in the UK. I myself have worked through the SKU Rat plays at multiple global retailers and helped create billions of dollars of enterprise value for my clients with these tools.

The game plan of SKU Rat plays out something like this:

• Modest SKU rat of 10% of SKUs in a category
• Creates -1% loss in sales volume and value
• But +1.5% increase in cash margin
• Furthermore: Including SKU Rat and additionally stretching the price ladder up/ down will typically give flat volume, +1% sales value, and a whopping +2.5% increase in cash margin

I use quite sophisticated models to delist on the basis of an optimisation but basically you can think of it as a scorecard of SKU sales value, % margin, and 1-cannablisation, where we de-list the bottom SKUs of the scorecard. You can also control for SKUs associated with high value baskets, certain customer targets, or trip types.

How the maths works will generally look something like this:

• Taking out 10% of SKUs is maybe 5% of volume
• There is perhaps 80% cannibalisation for these worst SKUs, i.e.: only 20% of their sales is lost from the category when they are de-listed
• So we only lose 1% of volume
• But the margin of the de-listed SKUs is perhaps 50% lower than the category average (so 5% of volume makes up 2.5% margin), so if the volume flows to average margin SKUs (after the flows, this is now 4% margin), therefore overall cash margin increases by 1.5%

Typically an optimisation model will say to delist something like 20% of SKUs, but after workshops and so on with a retail client, they'll say 'this SKU is important' for reasons of choice or distinctiveness, so you end up at a 10% reduction.

We can take comfort from additional benefits, e.g.: supplier leverage might mean lower costs of goods, and also reduced incidences of out-of-stock.

Throw in a stretched price ladder, taking advantage of more air gaps in your price tiers, and another couple points of margin is easy.

Add in some private label substitution for national brands (rinse and repeat the SKU optimisation) and bingo you're easily at a 2% or bigger cash margin improvement. For a US grocery retailer with $5bn of gross margin, a 2% improvement is an easy $100m, and likely a billion dollars of enterprise value - just from a dose of SKU Rat.

It would take $400m of capex at 25% to buy an extra $100m of profit, so this seems like a bargain.

But, then there's SKU Rat's arch nemesis... Cat Man. Does a Cat triumph over a Rat?

Cat Man, short for Category Management is the more subtle cigar and cognac solution versus SKU Rat's bottle of Buckfast quick magic to create a billion dollars of value.

Being the Bob Ross of retail consulting, here's how it works...

Category management juggles the different dimensions of pricing, promotion, assortment, and innovation as a portfolio question. Where do I place my scarce monies within a category? Is it in more innovation or more promotion? Should you invest in pricing (reductions) or increased customer choice in your assortment? A bit like adjusting the different controls of your aeroplane, for throttle, pitch, yaw and so on, category management is a sophisticated solution to achieve greater sales and margin performance.

The problem with category management is that it's a somewhat baroque process when you're looking to create shareholder value quickly. Also, like any portfolio allocation question, you become challenged to make decisions when the gradient of response to innovation versus price of promo versus increased assortment is often quite flat. There are many combinations of price, promotion, innovation and assortment that give about the same answer.

You can use category management tools to also prioritise between categories: who gets more or less space; who gets the gondola ends for promotion? Where is the best category to place from our innovation joker?

In conclusion, I'd say a rat's cunning beats a cat's skills. SKU Rat triumphs over Cat Man.