Digging into why Aldi & Lidl are so successful and what this means for the future

September 11, 2017; 00:01 am by Bill Bishop 

 

It’s time for everyone in the grocery retail business to ask:  How do hard discounters make money? The answer sheds light on hard discounters’ strengths, so that competitors and suppliers get the insights they need to develop responses to this growing threat.
After extensive study – and compiling the thinking for this blog – Bill Bolton and I believe that competitors and product suppliers will need to make significant changes in the way they work together to be able to neutralize this powerful new way of doing business. To do this, you have to understand why they are so successful and what it means for the future.
Price is a big reason for the appeal of hard discounters – specifically Aldi and Lidl – but you need to dig deeper.
Their core competitive strength comes from the way they have changed almost every aspect of how they do “food retailing.”  They have created what Ivo Petroff astutely described as an entirely new business ecosystem when we had a recent email exchange.
This ecosystem makes it hard to beat hard discounters on just a single dimension, and their value proposition is gaining traction with consumers worldwide. As of Q2 2017, Kantar data showsthat UK supermarket sales are up 4.0% year over year, but the hard discounters are growing much more – sales are up 18.9% at Aldi and 17.2% at Lidl.

So back to the question: How do hard discounters make money?

First, the short answer

The hard discount business model successfully combines the traffic-building power of low grocery prices with two key things:

• Higher product profits
• Lower operating costs

Now, the long answer (This is what you really need to know.)

Let's explore each of the three big factors that drive the success of the hard discount business model.

1) Strong Customer Attraction- from better prices and more speed/ease

Exceptionally low prices attract customers to hard discounters, but how they present these prices also makes a big difference.

• They know how to “shock” customers with a small number of items in the weekly circular, i.e., mangos that regularly sell at 99 cents are promoted at 39 cents each in the circular.
• They maintain exceptionally low non-advertised prices on a small number of popular items; i.e. “known value items” such as a gallon of milk at $1.69 and a dozen eggs for 65 cents at the time of this writing. (These prices do change week to week, but they stay exceptionally low.)
• They compare the prices of their private label products with similar national brands in TV ads that call out savings of 50% or more along with a “double guarantee” to refund the price and replace the product if the customer isn’t satisfied.

Beyond low prices, the hard discounters’ small-sized stores and faster checkout add to the appeal. Shoppers can get in and out quickly.

2) Strong PRODUCT Profits

Even with these low prices, hard discounters can generate higher than expected profitability from the products they sell because of the unique interplay between how they buy and what they sell.
>  PRODUCT PURCHASING. Since hard discounters mainly sell their own controlled private label brand, they can influence how the products are manufactured and packaged.  As a result, they have a lot of influence over what they pay for the product, and they have broken the usual connection between low price and low quality. They consistently “surprise and satisfy” with products priced lower than the advertised brands, but of equal quality. By comparison, prices for advertised brands sold in supermarkets are not easily influenced by retailers. This is a big advantage for hard discounters.
>  PRODUCT MIX.  The unique mix of products sold by hard discounters lets them sell at low prices while maintaining higher profit margins.

• The biggest contributor is general merchandise. General merchandise can occupy 20% to 25% of display space, and hard discounters have developed methods to turn it over quickly. Since general merchandise typically carries higher profit margins than grocery along with higher price points – frequently above $10 – this generates a strong flow of profit dollars that helps to offset the low prices on other key items.
• The other contributors are premium quality products and multiple differentiated brands.
  • Premium quality products not only give customers the opportunity to trade up or indulge (like dark chocolate coated biscotti), they also sell at higher prices, frequently twice the price per ounce of the more popular form of the same product. This translates into both higher profit margins and more pennies of profit for each item sold.
  • The introduction of multiple, differentiated private label brands targeted at different customer segments contributes to a more profitable product mix. 

3) Low-cost Operations

Hard discounters are built from the ground up as high efficiency, low cost operations. Some of this traces to their beginnings as bare-bone operators when they occupied only low rent, second-use buildings and sold less than 500 items, many directly off of full-pallet displays. The same emphasis is evident today, even though they have “softened” some aspects of the shopping experience.
>  VARIABLE COSTS. Like most other retailers, the hard discounters’ biggest variable cost is labor, and their entire business system is designed for high labor productivity.
It starts in the warehouse, where the productivity of selecting an order is higher because they frequently put two to as many as five different products, each with their own UPC, in the same shipping case. This reduces the number of warehouse slots the selector has to visit when building an order, which translates into less time to pick the entire order.
At the store, most products flow directly to the display floor, with minimum time in the back room. Groceries and general merchandise are sold from display-ready shipping cases which lets store personnel move entire cases of product to the shelf instead of stocking each item. This efficiency is further amplified in the perimeter departments.

• Frozen products are sold from gravity feed displays which automatically keep the product in front of consumers without additional labor.
• Most of the refrigerated products like milk are stocked from the rear of the case which is more efficient than stocking from the front.

Labor productivity is also boosted at the checkout, where cashiers typically work seated and rapidly scan products into a shopping cart; the customers do the bagging at a separate counter so they don’t slow down the cashiers.
 Other variable costs that hard discounters tightly control include:

• Energy costs – by using LED lights and doors/covers on frozen displays
• Maintenance costs – by investing in quality display fixtures and durable low-maintenance tile floors.
• Shopping cart expenses – by requiring customers to make a 25 cent deposit.
• Shopping bag expense – by requiring the shopper to bring his or her own bags or buy them from the store.

>  FIXED COSTS. One of the biggest fixed cost is occupancy. Hard discounters successfully leverage this fixed cost by driving higher sales per store, but with significantly fewer items –at both the store level (2,000 – 4,000 SKUs vs 30,000 to 40,000 in a typical supermarket) and at the category level, like in peanut butter (4 to 6 SKUs vs the 30 – 40 separate SKUs in a typical supermarket).
The average product at a hard discounter sells more units per week than the average product in the supermarket. This positive impact is further multiplied with the introduction of smaller premium products and other assortment changes that increase sales per square foot.

Evolution in progress

Since first appearing in North America, the hard discount business model has evolved, and that evolution continues with a focus on increasing sales per store without a significant loss in efficiency.  This isn’t easy to do, and there are occasional indications that this pressure has caused some loss of efficiency (e.g., occasional stock-outs).
At the same time, however, the hard discounters are finding more ways to improve the shopping experience while still maintaining much lower prices, and the results indicate that the hard discount value proposition is gaining traction with US shoppers.

The Power of Simplicity

As shown above, the effectiveness of this business model hinges in large part on the simplicity that comes from offering only a limited number of different items. With a limited assortment, hard discounters benefit from higher sales per item, which translates into faster inventory turns, higher sales per square foot, and lower cost of inventory per unit sold, and all of these lead to strong, solid financial performance.
A lot can be learned from this, but the role of positive synergies coming from other aspects of their unique retail ecosystem also needs to be acknowledged. These synergies produce new forms of collaboration between players in the supply chain – such as lower product handling costs that come from the smooth flow of inventory from truck to shelf, and the way customers are encouraged to do some of the work “because it’s to their advantage.”

What This Means for the Future

The full impact of hard discounters won’t be felt across US food distribution and retailing for years, but now is the time to start reimagining current businesses and begin testing the effectiveness of response strategies.
>  Even though hard discounters will likely never become the dominant form of grocery retailing, they – along with increases in online grocery shopping – are causing a major disruption in the entire retail grocery business.

• Many of the supermarkets open today will lose enough sales to move them from modest profitability to “economically impaired” and unsustainable. These will eventually close.
• The surviving supermarkets will need to be highly differentiated based on their fresh and prepared food offerings. Packaged grocery will be a relatively smaller part of the business.
• Most of the surviving stores will use technology to do two things:
  • Increase labor, inventory, and display space productivity to reduce costs.
  • Improve the speed and convenience of shopping to attract and retain customers.

>  Pressure will also increase on CPG brands, especially those that don’t “connect” effectively with today’s consumers, and some of them will disappear from the shelves.

• Expect that the surviving brands (and new ones, too), will move away from trade practices that fail to yield a return on investment. 
• These brands will focus business efforts on retailers that represent efficient and productive marketing channels for their products, and who are open to replacing traditional business practices with ones shaped by new forms of collaboration.