A colleague of mine in Israel, Yishai Boasson, recently wrote an article analyzing the perceived and actual value of a “special promotion.” This article, available here, is only in Hebrew. As it is an interesting analysis and an excellent example of the importance of distinguishing between sales and profits, it is worth translating here for the larger English-speaking audience. It is also, in itself, an example of how numbers can trip you up.
In honour of Israel’s Independence Day, which this year was on Wednesday, April 29, 2009, the large supermarket chain Rami-Levy decided to have a special promotion of a half-kilogram (about 1 pound) of Kebab plus one kilogram (about 2 pounds) of hummous for just one New Israeli Shekel (NIS). The exchange rate has been fluctuating, but we can roughly estimate it at 4NIS=1USD, which means you could but a pound of meat and two pounds of hummous for $0.25. The apparent value of the kebab plus hummous special is around 30NIS. It is unclear from the original article Yishai quotes whether this is the retail price, i.e. the value of the gift includes foregone profit, or if this is just the variable cost, i.e. the value is just the direct cost to Rami-Levy. Either way, the supermarket chain is believed to have brought in 100,000 customers, each of whom spend about 200NIS, for total revenues of 20MM NIS.
As a general rule, supermarket chains run on very thin margins. Yishai decided to be very generous and assume they are operating at 10% margins. If so, then the profit from this little promotion was 10%*20MM NIS = 2MM NIS. Of course, Rami-Levy also gave up 100,000 customers * 30NIS per special package = 3MM NIS. The net result is that this little promotion brought in 2MM NIS in profit, at a cost of 3MM in marketing.
First rule of thumb in marketing: if your marketing costs exceed the profit generated by that marketing, it was a bad idea. Spending 3MM NIS to get 2MM NIS in profit is a good way to go out of business fast. Let’s only hope they don’t decide to “make it up in volume.”
Digging even deeper, the picture gets worse:
- It is not at all clear that the 100,000 customers are actually new. How many of them would have come to Rami-Levy anyways, even without the promotion?
- How many customers did Rami-Levy lose? While many people do come in for special promotions, many others are unwilling to deal with the mob, and are just fine paying the extra 30NIS (or $7.50) for their kebab and hummous, rather than fight the madhouse. Worse, those people who are willing to forgo the special to avoid the lines are precisely the customers that are most likely to spend more money at the supermarket.
- Rami-Levy’s margins are undoubtedly below 10%, with some analyses putting them at around 6.5% or lower.
This analysis correctly highlights that the value of any investment is not the sales return from the investment but the profit return from it. Spending 1MM to get 10MM in sales may or may not be a good idea… depending on the gross margins of those 10MM, and alternative uses of cash.
Several commenters on the original article pointed out that Rami-Levy may have had larger goals, that may have justified the net 1MM (or more) loss. These include: savings on general marketing or growth of a certain department. Additional values may have been: savings on launching costs for a new store or series of stores, and clearing out inventory. Although margins are low, inventory that might have been close to end of shelf life are worthless unless they can be cleared. A 5NIS loaf of bread is worth 0.5NIS to the bottom line at 10% gross margins… but it is worth a full 5NIS if the alternative is to completely discard it.
The Flaw in the Numbers
Last, but not least, there is one strong flaw in the analysis: the low margins are operating, not gross. While supermarkets do not normally have very high gross margins either, they tend to be much higher than 5% or 6%. We can analyze Publix, a large US-based supermarket chain, Publix, which is a public company and therefore has a publicly available 10K. In 2008, it had $24MM in revenue and $17.5MM in COGS, for an operating margin of 27%, over 4 times the 6.5% operating margins of Rami-Levy. Publix operates on even thinner operating margins than Rami-Levy, despite being a much larger chain, and thus likely has lower gross margins as well. Thus, it is not impossible that Rami-Levy actually lost quite a bit less, or broke even on the promotion, depending on what its gross margins are.
In sum, we see that numbers are very powerful but seductive. In our case study, we needed to watch for two things:
- Don’t confuse revenues with profits when calculating return on investment.
- Don’t confuse operating margins with gross margins when calculating profitability.