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

It’s time for everyone in thegrocery retail business to ask: How dohard discounters make money? The answer sheds light on hard discounters’strengths, so that competitors and suppliers get the insights they need todevelop responses to this growing threat.

After extensive study – and compiling the thinking for this blog – BillBolton and I believe that competitors and product suppliers will need to makesignificant changes in the way they work together to be able to neutralize thispowerful new way of doing business. To do this, you have to understand why theyare so successful and what it means for the future.

Price is a big reason for the  appealof hard discounters – specifically Aldi and Lidl – but you need to dig deeper.

Their core competitive strength comes from the way they have changed almostevery aspect of how they do “food retailing.”  They have created what Ivo Petroff astutely describedas an entirely new business ecosystem when we had a recent email exchange.

This ecosystem makes it hard tobeat hard discounters on just a single dimension, and their value propositionis gaining traction with consumers worldwide. As of Q2 2017, Kantardata shows that UK supermarket sales are up 4.0% year over year, but the hard discountersare 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 modelsuccessfully combines the traffic-building power of low grocery prices with twokey things:

• Higher product profits
• Lower operating costs

Now, the long answer

(This iswhat you really need to know.)

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

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

Exceptionally low prices attractcustomers to hard discounters, but how they present these prices also makes a bigdifference.

• They know how to “shock” customers with a smallnumber of items in the weekly circular, i.e., mangos that regularly sell at 99cents are promoted at 39 cents each in the circular.
• They maintain exceptionally low non-advertisedprices on a small number of popular items; i.e. “known value items” such as agallon 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 labelproducts with similar national brands in TV ads that call out savings of 50% ormore along with a “double guarantee” to refund the price and replace theproduct if the customer isn’t satisfied.

Beyond low prices, the harddiscounters’ small-sized stores and faster checkout add to the appeal. Shopperscan get in and out quickly.

2) Strong PRODUCT Profits

Even with these low prices, harddiscounters can generate higher than expected profitability from the productsthey sell because of the unique interplay between how they buy and what theysell.

>  PRODUCT PURCHASING. Sincehard discounters mainly sell their own controlled private label brand, they caninfluence how the products are manufactured and packaged.  As a result, they have a lot of influence overwhat they pay for the product, and they have broken the usual connectionbetween low price and low quality. They consistently “surprise and satisfy”with products priced lower than the advertised brands, but of equal quality. Bycomparison, prices for advertised brands sold in supermarkets are not easilyinfluenced by retailers. This is a big advantage for hard discounters.

>  PRODUCT MIX. The unique mixof products sold by hard discounters lets them sell at low prices whilemaintaining higher profit margins.

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

3) Low-cost Operations

Hard discounters are built from theground up as high efficiency, low cost operations. Some of this traces to theirbeginnings as bare-bone operators when they occupied only low rent, second-usebuildings and sold less than 500 items, many directly off of full-palletdisplays. The same emphasis is evident today, even though they have “softened”some aspects of the shopping experience.

>  VARIABLE COSTS. Like mostother retailers, the hard discounters’ biggest variable cost is labor, and theirentire business system is designed for high labor productivity.

It starts in the warehouse, where theproductivity of selecting an order is higher because they frequently put two toas many as five different products, each with their own UPC, in the sameshipping case. This reduces the number of warehouse slots the selector has to visitwhen building an order, which translates into less time to pick the entireorder.

At the store, most products flow directlyto the display floor, with minimum time in the back room. Groceries and generalmerchandise are sold from display-ready shipping cases which lets storepersonnel move entire cases of product to the shelf instead of stocking eachitem. This efficiency is further amplified in the perimeter departments.

• Frozen products are sold from gravity feeddisplays which automatically keep the product in front of consumers without additionallabor.
• Most of the refrigerated products like milk arestocked from the rear of the case which is more efficient than stocking fromthe front.

Labor productivity is also boostedat the checkout, where cashiers typically work seated and rapidly scan productsinto a shopping cart; the customers do the bagging at a separate counter sothey don’t slow down the cashiers.

Other variable costs that hard discounterstightly control include:

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

>  FIXED COSTS. One of thebiggest fixed cost is occupancy. Hard discounters successfully leverage this fixedcost by driving higher sales per store, but with significantly fewer items –at boththe store level (2,000 – 4,000 SKUs vs 30,000 to 40,000 in a typicalsupermarket) and at the category level, like in peanut butter (4 to 6 SKUs vs the30 – 40 separate SKUs in a typical supermarket).

The average product at a hard discounter sells more units per week thanthe average product in the supermarket. This positive impact is furthermultiplied with the introduction of smaller premium products and otherassortment changes that increase sales per square foot.

Evolution in progress

Since first appearing in NorthAmerica, the hard discount business model has evolved, and that evolutioncontinues with a focus on increasing sales per store without a significant lossin efficiency.  This isn’t easy to do,and there are occasional indications that this pressure has caused some loss ofefficiency (e.g., occasional stock-outs).

At the same time, however, the harddiscounters are finding more ways to improve the shopping experience while stillmaintaining much lower prices, and the results indicate that the hard discountvalue proposition is gaining traction with US shoppers.

The Power of Simplicity

As shown above, the effectivenessof this business model hinges in large part on the simplicity that comes fromoffering only a limited number of different items. With a limited assortment,hard discounters benefit from higher sales per item, which translates intofaster inventory turns, higher sales per square foot, and lower cost ofinventory per unit sold, and all of these lead to strong, solid financialperformance.

A lot can be learned from this, butthe role of positive synergies coming from other aspects of their unique retailecosystem also needs to be acknowledged. These synergies produce new forms ofcollaboration between players in the supply chain – such as lower producthandling 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 totheir advantage.”

What This Means for the Future

The full impact of hard discounterswon’t be felt across US food distribution and retailing for years, but now isthe time to start reimagining current businesses and begin testing theeffectiveness of response strategies.

> Even though hard discounters will likely neverbecome the dominant form of grocery retailing, they – along with increases inonline grocery shopping – are causing a major disruption in the entire retail grocerybusiness.

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

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

• Expect that the survivingbrands (and new ones, too), will move away from trade practices that fail to yielda return on investment.
• These brandswill focus business efforts on retailers that represent efficient andproductive marketing channels for their products, and who are open to replacingtraditional business practices with ones shaped by new forms of collaboration.