Harnessing Operational Efficiency: Achieving Sustainable ... · rather than consumer centric. In order to hold ground, department store operators need flexibility in their operating

www.pwccn.com

Harnessing Operational Efficiency: Achieving Sustainable Retail SuccessSummary of 2016 working capital management study for retailers in China

Summary of 2016 working capital management study for retailers in China PwC 12

Acknowledgment

Special thanks to the below interviewees for their sharing and contributions to the development for this report.

Professor Stuart Gilson Steven R. Fenster Professor of Business Administration Harvard Business School

Professor Ananth Raman UPS Foundation Professor of Business Logistics Harvard Business School

Sun Weimin Vice Chairman Suning Commerce Group

Yuki Habu Chairman & CEO AEON (China)

Gao Shulin President Rainbow Department Store

Chopinter Wang Group VP, Food BU GM Better Life Commercial Chain

Sam Guo Food & Supplies Division General Manager Yonghui Superstores

Peter Yu GMM of HL Dept., National Commercial Center China Resources Vanguard

Hang Yan Chain Store Education Foundation

Project committee

Expert advisory boardChina Chain Store & Franchise Association: Guo Geping, Pei Liang, Chu Dong, Zhu Fang

PwC: Carrie Yu, Michael Cheng, Kevin Wang

Renmin University of China: Professor Liu Xiangdong

Beijing College of Finance and Commerce: Professor Wang Chengrong

Editorial boardChina Chain Store & Franchise Association: Wang Ruida, Guo Yujin

PwC: Mark Gilbraith, Ken Zhang, Michael Gildea, Steven Zhong, Susan Eggleton, Kurt Xu, Joan-na Chen, Veronica Zheng, Esther Mak


Foreword

In the 2016 Report on the Work of Government, Li Keqiang, Premier of the People’s Republic of China, discussed China’s emphasis on supply side structural reform in order to drive sustained growth. Retail, as the intermediate link between manufacturing and end consumers, its development progress directly reflects the efficiency of supply-side in meeting consumers' demands. Thus, understanding the relationship among all retail stakeholders - including shareholders, community, government, and consumers - will enhance cooperation and help drive the healthy development.

In this context, the Ministry of Commerce delegated China Chain Store & Franchise Association (CCFA) to conduct a study on 2016 Commercial Relationship Survey under the context of Supply-side Reform which covers the emerging retail trends, relationship between retailers and suppliers, retail price ‘mark-up’ and working capital management.

CCFA enlisted PwC to help conduct the study on retailers working capital management. PwC has many years of experience with working capital management solutions in the retail sector. The report delivers insights to corporate executives, the academic community, and various institutions. It also delivers findings, makes comparisons of listed companies’ key indicators and suggests recommendations for effectively optimizing working capital.

The report will allow retail operators to compare industry indicators with their company’s own results, providing a solid benchmark against the industry.

China Chain Store & Franchise Association April 2017


Retailers’ path to business transformationThe retail industry in China has witnessed rapid growth during the past two decades, and that growth has tended to cover up many inherent problems in the retail industry itself. However, given the more recent slowdown of growth, changes in consumption patterns and the rise of e-commerce, challenges in all aspects of operations management have become more critical. Today, against the backdrop of the government’s supply-side reform, retailers have begun to explore a path to business transformation in order to increase their overall competitiveness and drive sustainable development. This is necessary as some Chinese retailers have started to experience decreases in sales, and certain companies are in financial difficulty. For retailers in China, topics such as cash flow and working capital management no longer remain only within the finance department, but have gradually become part of the CEO agenda.

China’s retail sales and profit growth have declined In China, supermarket sales growth is at single-digit levels. Some larger department stores and multi-format retailers are even recording decreased revenue. Supermarkets registered a net profit ratio of 1.3% in 2015, compared to 2.1% in 2014. The net profit ratio of department stores also declined from 4.8% in 2014 to 3.8% in 2015. An exception is apparel retail, which reported a net profit ratio of 11.2%. Home appliance chains only registered net profit of 0.8%(Figure 1).

Chinese retailers have always relied on credit from suppliers as an important source of external funding. In recent years, suppliers’ credit terms have been continuously stretched, and any room for retailers to alleviate working capital pressure by further deferring payments to suppliers is limited(Figure 2). Supermarket chains and apparel retailers have faced especially great challenges as cash is locked up with the slowing down of inventory turnover.

Understanding the value of working capital A company’s working capital not only reveals whether resources are wisely utilised but also affects the company’s profitability and risks. It is a critical building block for business growth. Executive management must understand the value of working capital as well as the underlying operational issues and risks, while seeking to improve efficiency.

Inventory turnover is a key performance indicator (KPI) in Europe and United States – but not in ChinaInventory turnover measures the number of days it takes to pay for and generate cash from the sales of a company’s products. The retail industry in Europe and the United States uses this to measure inventory performance, as well as the overall health of the company and the performance of management. Retailers in China typically do not

Executive summary


focus on working capital management. In most cases, operating revenue and profit margin are taken as the important and only measures for evaluating retailer performance. This reflects a common style in which top management focuses on results but not on the process and neglects the significant lost opportunities from improving operational management to generate new business and improve financial results.With unsustainable business fundamentals and broad geographic coverage, supply chain management including inventory management has become a common challenge for retailers in China. Supermarkets in the United States maintained an average 30 day inventory turnover rate, as compared to China’s 50-day rate from 2013 to 2015(Figure 3). The average supplier payment term for the retail industry in China is as long as two to four months, while in the United States it is just 1.5 months(Figure 4). It’s clear that there is room for improvement here. Through this report we hope to encourage retailers to begin to focus on the concept of working capital management and its tools, as these are building blocks of successful performance.

Inventory management criticalFor supermarkets, improving their ability to quickly respond to change in demand is critical. Management has to reduce the gap between the frequent changes in market demands and corresponding response to meet these demands(Figure 5). If the forecasting mechanism is insufficient, retailers will have a difficult time addressing changes in consumer behaviour and seasonality demand factors. Likewise, lack of inventory planning and pre-warning mechanisms will hinder effectiveness in inventory management(Figure 6).Department stores often operate jointly with suppliers, and suppliers have designated concessionary counters for their merchandise. This can reduce inventory risk and increase turnover, but such traditional operating models

can cause stores to lose market appeal since the products are supplier centric rather than consumer centric. In order to hold ground, department store operators need flexibility in their operating models in order to meet the increasingly diversified needs of consumers. However, this is a step change as it requires strengthening procurement capabilities, category management and inventory planning.

Better inventory management yields better resultsMany proactive retailers are focusing on inventory management, especially category management and inventory planning. We believe better inventory management processes are key to thriving in this competitive market.

Harnessing operational efficiency: Achieving sustainable retail success Effective working capital management is essential to financial and operational success. It requires driving collaboration across the value chain, building a portfolio of quality suppliers, integrating resources and strategically managing suppliers. It also means focusing on inventory planning and category management and continuously driving improvement in inventory turnover performance. By doing so, Chinese retailers will transform from the traditional model that places high reliance on suppliers rebates and credit terms to an operating model that drives profitability from revenue growth and savings from operating effectiveness. In this report, we offer these recommendations:• Optimise working capital to

drive business growth Collaborate across the retail chain to optimise working capital and drive business growth

• Enhance forecasting of future demand Work with business partners to enhance forecasting and collaborative planning of future demand

• Get win-win solutions by managing strategic supplier relationships Encourage resource sharing and achieve win-win by managing strategic supplier relationships

• Increase inventory turnover using category-based planning Strengthen merchandising and category-based inventory planning to proactively manage business changes and inventory turnover

• Support better inventory decisions with IT and data analytics Strengthen IT system and data analytics capabilities to support better inventory decisions

Research methodologyThis report is based upon research conducted jointly by China Chain Store & Franchise Association and PricewaterhouseCoopers (PwC). It summarises our views on operational management for Chinese retailers and provides insights on improving operational efficiency. Our research included information from three major sources:Interviews: We interviewed professors at Harvard Business School, as well as senior executives of the Top 100 retail chain stores in China.Questionnaires: We conducted a survey with 21 Chinese retailers, most of them in the Top 100 retail chain stores in China.Listed company data: Our quantitative analysis, including financial indicators, was based on publicly available data for retailers listed in Mainland China and Hong Kong. The sample consisted of 86 companies, and the formats included department stores, supermarkets, multi-format stores and specialty stores.

Interview with Professor Stuart GilsonSteven R. Fenster Professor of Business AdministrationHarvard Business School

PwC4

Q: Can you please tell us about your financial management background and research focus?

I joined the Harvard Business School faculty in 1991, following three years as a professor at the University of Texas at Austin. My teaching, research and consulting activities are centered around how companies can create value through better financial management, with a particular focus on value creation through corporate restructuring. For almost 20 years I taught my course “Creating Value Through Corporate Restructuring” in the MBA program. Since then I’ve been teaching the Financial Management course full time in the school’s Advanced Management Program (AMP), which is our flagship long executive program.

My research has been published in leading academic and management journals, and I have written over 60 case studies and teaching notes. I published a number of my case studies in my book, “Creating Value Through Corporate Restructuring: Case Studies in Bankruptcies, Buyouts, and Breakups” (John-Wiley), now in its second edition. I currently serve on the board of directors of Advanced Alloy Processing. I also provide expert testimony on valuation, restructuring, and financial analysis in business litigation, and have taught custom executive education programs for a variety of companies and organisations around the world.

Q: How important is it for a CEO to look at financial ratios?

I think it is extremely important for senior executives to consider financial ratios and metrics – of both their own companies and their competitors – in making capital expenditure and allocation decisions, and managing their businesses. Finance provides CEOs with a set of tools and concepts that can be used to evaluate opportunities, measure performance, and make better business

decisions. Finance brings discipline to decision making, and helps managers understand when a decision or choice will create real long-term value.

But that said, I think it is really important to assess investment opportunities and challenges from multiple business perspectives – to look at every situation through “multiple lenses.” I always teach my students that while finance can be critically important in driving good business decisions, it is also important to evaluate any opportunity through the lenses of strategy, operations, marketing, etc. When an executive evaluates a problem or opportunity from multiple perspectives, he or she will be in a better position to make the most informed choice that leads to the greatest creation of value.

Q: What are the biggest mistakes you see that companies are making when managing their business, as a Professor in Finance?

I think one of the biggest challenges that companies can face is in managing their “net working capital,” which is the difference between a company’s short-term assets and its short-term liabilities used in its operations. Excessive growth in net working capital can be a significant drain on a company’s cash flow. For example, increases in customer receivables or inventories represent a use of the company’s cash. Managers who have the direct responsibility for the profit and loss statement of their businesses can be at risk of becoming too narrowly focused on profits, and losing sight of how their decisions can impact the company’s balance sheet, which can materially impact its cash flows. From a financial perspective, value creation is ultimately determined by a company’s ability to generate cash flows.

A related issue is that sometimes there is a disconnect between a business’s profits and its cash flows. Reported profits are based on the application of accounting

rules that affect the measurement and recognition of revenues and expenses. Often times these do not directly translate into cash flows – and sometimes the gap can be quite large. Growth in the net working capital can be a big contributor to this gap. So it is really critical as a manager of a business that you focus not only on how the business generates earnings, but also on how your decisions in managing the business impact your balance sheet (and the use of short term assets and liabilities).

Q: What is the most effective role that a CFO can do?

The most effective CFOs that I have encountered are effective partners with the non-finance areas of the business. They don’t just deal with budgets, forecasts, and treasury functions, but they “burn shoe leather” and get out of their offices to meet and interact with people outside of Finance. They also visit the factory floor; they meet with important customers and suppliers; they engage with and understand the company’s corporate strategy, and how the strategy drives value creation.

The most effective CFOs often make very good CEOs because of this deep understanding of and appreciation for what drives superior performance in a business. It’s not just about managing data, setting budgets, and monitoring compliance, but also connecting and communicating with the rest of the organisation, including operations, strategy, and marketing. The ability to communicate here is key. This means being able to speak in plain simple terms, free of jargons, and not overwhelming the listener with spreadsheets and numbers, which can be intimidating to those for whom finance is not their primary language. It also means being able to listen and understand the speaker’s perspective. Ultimately, effective CFOs are those who are able to build bridges that lead to greater transparency, collaboration, and sharing of information.

Summary of 2016 working capital management study for retailers in China 5

PwC6

Interview with Professor Ananth RamanUPS Foundation Professor of Business LogisticsHarvard Business School

Q: Can you please tell us a little about yourself and your interest in retail?

I joined the faculty of the Harvard Business School in 1993. My teaching and research focuses on operations management. I currently teach in the Owner/President Management Program, one of the school’s comprehensive leadership programs for executives. I started studying retail supply chains in my doctoral thesis. Over time, this interest transitioned into a more systematic research program, and an industry-academia partnership consortium, the Consortium for Operational Excellence in Retailing. I have written many articles, case-studies, and a book on retail operations. I work closely with multiple retailers in different continents, and serve on the board of directors of Cumberland Farms, a large convenience store chain in the US. I am also co-founder and director of 4R Systems, a firm that helps retailers plan their inventory better.

Q: How do you see the retail sector evolving in China?

Retail in China has been incredibly successful during the last few decades, reflecting the success of the Chinese economy more broadly. We have witnessed tremendous growth in the sector, and some very innovative and successful retailers have emerged. My sense, from reading and listening to other people, is that in the next few years retailing in China will probably not grow as rapidly as it did in the last few decades. Moreover, many retail firms that were startups a couple of decades ago, have now become substantially larger firms. Under such circumstances – when firms become larger, or when the economy slows down – firms have to become more mature. They have to demonstrate that not only can they deliver top-line growth, they can also operate efficiently. To operate more efficiently, retailers will have to improve both planning and execution of their operations. The words of a successful, serial entrepreneur probably sum it up in my mind, “Out of chaos comes revenue, out of discipline comes profit.” Retailers in China have to ask themselves: Are you ready to become more operationally efficient? Can you do so without compromising your organisation’s entrepreneurial capabilities? In other words, can you integrate “chaos” and “discipline” in your organisation?

Q: Inventory management is an important aspect of being

operationally efficient. What opportunities do you see for Chinese retailers in managing their inventory better?

The financial costs of carrying excess inventory are considerable. Inventory imposes additional financing costs and also drives other costs, such as the cost of storage, handling and shrinkage. Most retailers have discovered that they can make a number of small and large changes that collectively enable the retailer to operate with less inventory. There is reason to suspect that Chinese retailers can increase their inventory turns. In PwC’s sample of Chinese retailers for example, the average supermarket operated with 53 days of inventory. Contrast this with what would be fairly typical in the US; Albertsons (Albertsons LLC.), operated with 38 days of inventory. Moreover, note that the slower inventory turns for Chinese retailers cannot be explained by higher gross margins. Supermarkets in the PwC sample operated with 18% gross margin, significantly lower than the 28% gross margin that Albertsons. While the costs of carrying too much inventory is considerable, retailers should also be wary of carrying too little inventory. Every year, I get calls from multiple retailers, who ask for help because they have “an inventory problem,” a euphemism for “we have too much inventory.” In almost all these case, the costs of excess inventory is swamped by the cost of stockouts. Most retailers that I know do a very poor job of tracking the sales lost due to stockouts, even though stockouts are rampant in retailing. In fact, I think retailers should not think of inventory management as an “inventory reduction problem” but as a problem of matching supply with demand!

Q: What can Chinese retailers do to better match supply with demand?

Summary of 2016 working capital management study for retailers in China 7


There are a few levers that managers have available. I will list them briefly here because I have discussed these in considerable detail elsewhere, including in my co-authored book, The New Science of Retailing. One, is to improve demand forecasting. Another is to rely on responsiveness in your supply chain; your business is less dependent on accurate forecasts if your supply chain can respond quickly with new or additional product. A third lever for managers is to invest in better inventory planning tools. Changes in information technology have enabled retailers to make substantial progress in using each of these levers more effectively.In addition, retailers should also focus on two other aspects that affect inventory management. One, they should look for perverse incentive misalignment within their firms (especially across different functions) and with their supply chain partners. Two, they should focus on superior execution of their plans and strategies.

Q: What should a Chinese retail CEO focus on, under the circumstances?

The CEO needs to enable his or her

firm to be more disciplined without significantly sacrificing the entrepreneurship and “chaos” that enabled his or her firm to be successful in the past. This will require many changes. The transition will require injection of new kinds of talent, for example, in areas such as supply chain management and information technology. The challenge for the CEO is not the injection of new talent per se but, ensuring that the new talent is integrated with the organisation’s old talent. In the short-term, CEOs should start tracking stockout, days of inventory, and inventory spoilage or obsolescence at a micro level. Inventory – too much or too little – is a symptom of underlying problems in the organisation. CEOs should also invest in multiple experiments to produce a few small “miracles” that can motivate and point the way forward for their organisation.Most important, in my mind, is for the CEO to recognise that the path to operational discipline is a “marathon,” not a “sprint.” CEOs have to be patient and ensure that their organisations, including the board and investors, stay patient and do not lose faith. Once the long-term (e.g., 3-5 year) goal is established, the CEO should then translate those to short-term (e. g., monthly) targets.


Appendix


The retail industry still faces cost and profit challenges. Rising rent and labour costs are increasing operating costs and further reducing profit margins. In the meantime, e-commerce is impacting physical retail businesses, squeezing their profit margins.

Figure: 1 Analysis of net profit margin of the retail industry

2013 2014 20150%

5%

10%

20%

15%

3.6% 3.7% 3.2%

SupermarketsDepartment stores

Household appliances stores

Apparel and footwear stores

Aggregate

Multi format stores

Figure: 2 Composition of funding sources of retail companies

Inner circle: 2013Centre circle: 2014Outer circle: 2015

Financing from financial institutions

Other liabilities

Accounts payable

Advance receipts

Share capital and capital reserve

Operating surplus

12.0%

13.0%

13.9%

26.5%

26.0%

25.3%

16.8%17.8%

18.5%8.6%

7.3%

6.6%

21.4%

19.9%

19.4%

14.7%15.9%16.3%


Figure: 3 Days inventory-Supermarkets

2013 2014 20150%

20%

40%

60%

80%

100%

56

52.4 52.3

50

52

54

56

58

60

30-60 days 60-90 days Average

Figure: 4 Days payables outstanding

2013 to 2015 average

55.2

77.6 84.8

127.4

61.5

0

30

60

90

120

150

Department stores Supermarkets Apparel and footwear stores

Household appliance stores Multi format stores


Main causes of challenge in inventory turnover management as perceived by respondents (%)

Figure: 6 Causes of challenge in inventory turnover

Figure: 5 Challenge in inventory turnover management

Supermarkets Department stores

Incompetence of managers

Delivery by suppliers

not timely

Increaseddifference in thedemand in low

and high seasons

Changes in thebuying habitsof consumers

Lack of planning in inventory

management

Overstock causedby upgrade of

merchanise

Obstructed communication

of inventory information

80%

88%

60%

50%

50%

63%

40%

63%

30%

0%

20%

13%

20%

13%

Supermarkets Department stores

90%

75%

1

75%

60%

2

38%

40%

4

13%

30%

5

75%

50%

3

13%

10%

6

Lack of effective demand forecast

mechanism

Lack of planning and early warning

for inventory

Delivery not timelyin procurement

and supply

Unreasonabledeployment of

warehouseand logistics

Lack ofcollaboration in inventory

management

Low visibility of inventory

management


Please visit www.pwccn.com for the "Harnessing Operational Efficiency: Achieving Sustainable Retail Success - Summary of 2016 working capital management study for retailers in China" full report (available in Simplified Chinese only).

Contact us

Carrie Yu

Retail and Consumer Assurance Partner+852 2289 [email protected]

Michael Cheng

Asia Pacific & Hong Kong/China Retail and Consumer Leader+852 2289 [email protected]

Ken Zhang

Advisory PartnerDeals-Transaction Services+86 (21) 2323 [email protected]

Kevin Wang

China Retail and Consumer Leader+86 (21) 2323 [email protected]

Steven Zhong

Consulting Director Operations+86 (21) 2323 [email protected]

Mark Gilbraith

China and Hong Kong Retail and Consumer Consulting Leader +86 (21) 2323 [email protected]

Michael Gildea

Advisory Partner +852 2289 [email protected]

www.pwccn.comThis content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.

© 2017 PwC. All rights reserved. PwC refers to the PwC network and/or one or more of its member firms, each of which is a separate legal entity. Please see www.pwc.com/structure for further details. CN-20170302-7-C1

Documents

Harnessing Operational Efficiency: Achieving Sustainable ... · rather than consumer centric. In order to hold ground, department store operators need flexibility in their operating