Kaley's Knits: Cheating

Today, we end our month-long journey through the customer file at Kaley's Knits.

I know, some of you are dissatisfied with my conclusions.

• "You diagnosed the problem, but you didn't tell us how to fix the problem.  What are the tactics we should use to quickly fix the problem?  Should we offer 10% off instead of 20% off?  Should we offer free shipping with a hurdle instead of free shipping, no hurdle?  Should we double our email frequency?  Should we expand into mobile?  Should we connect with the "social shopper"?  Would tablet commerce help us grow new customers?  Should we rent names from co-ops at $0.06 a pop?  Should we change paid search vendors?  Why not try big data, that should help, right?"

Those who complain are looking to cheat the system.

Kaley's Knits has an expense problem.  Fixed costs are increasing, and are rapidly eroding profits.  There are only two solutions to a fixed cost problem.

1. Reduce expenses.
2. Grow sales profitably.

How do we grow sales profitably?  Pretend that marketing didn't exist, that you had to rely on merchandise productivity to grow sales profitably.  What would you do?  Well, you'd place sales growth accountability squarely on the shoulders of the merchant.  The merchant would have to find products that customers craved, and would have to find products that aren't easily knocked-off by competitors.  And if the merchant failed, the merchant would not longer be employed by the company, right?

Yes, it is terribly hard to increase merchandise productivity.

Because it is so terribly hard to increase merchandise productivity, we try to cheat, don't we?  We hire marketers.  Marketers apply magic to the problem.  Of course, all magic comes with a price.  We chase expensive items with hefty gross margins, and when growth doesn't come fast enough, we offer discounts and promotions to "tickle the buying bone".  We abandon expensive new customers, seeking instead to squeeze more juice from the loyal customer lemon.  We starve new customers, we offer sugary confections to existing customers.  We hurt the profit and loss statement.

And then we look for easy answers to problems that the marketing team created.

This is cheating.  We're cheating on top-line sales growth, we're cheating the profit and loss statement, and we're looking to cheat via easy solutions to complex problems.

The solution, of course, is to simplify.  We're going to fill the bowling alley gutters with bumpers, so that the bowling ball cannot go into the gutter - as a result, we're guaranteed to knock down a few pins.

• Goal 1 = Increase Annual New Customers from 99,120 to 115,000 per year.
• Goal 2 = Increase Gross Margin to 59% of Net Sales.
• Goal 3 = Maintain Average Price per Item Purchased, to between $33 and $36.
• Goal 4 = Increase Variable Profit to $6.0 Million.
• Goal 5 = Maintain Annual Repurchase Rate at 37%

There isn't a single tactic among the five goals.  Your job is to create tactics.  You are accountable.  

Your tactics, however, cannot cause damage to any of your goals.  If you discount heavily, you eliminate a chance to succeed at Goal 2.  If you overspend to acquire new customers, you eliminate a chance to succeed at Goal 4.  If you trim marketing expense among existing customers, you eliminate a chance to succeed at Goal 5.  If you fail to accomplish Goal 1, you make it terribly hard to to achieve Goal 4 later in the year.  If you raise prices too much (Goal 3), you might have a clearance issue, requiring discounts/promotions, making it impossible to succeed at Goal 2.

In other words, we set Goals that prevent the marketer from going off the fiscal cliff.

By doing this, we place accountability squarely in two areas.

1. The marketer must not cheat.  The marketer must be disciplined.  Cheating is not allowed.
2. The merchant must improve merchandise productivity.

We don't tell employees HOW to do something.  Instead, we make sure that success will not happen by cheating.  

Success will come from hard work.

Many employees will hate this approach (you may be one of those who hate this approach).  We are causing each employee to be accountable for success.  If the employee fails, the employee should receive a poor performance evaluation, and ultimately, not be employed by the company.  This is the start of the documentation process, folks.

I know, this isn't what 90% of you wanted to hear about.  You wanted "Six Easy Steps For Social/Mobile/Local Success", things like this:

1. Identify your target customer.
2. Create products that your target customer needs.
3. Use social media to cause your products to go viral.
4. Apply mobile strategies to be everywhere your customer is - Woodside Research says that 77% of e-commerce transactions will be on mobile devices by 2018.
5. Use big data to leverage local opportunities.
6. Reap the rewards.

Good gravy!

Instead, I spent a month sharing a forensic strategy for identifying the reasons a business is in the middle of a painful collapse.  It's your job to fix the business.  

You are accountable.  Use this methodology to identify problems.  Then you, and only you, should fix the problems.

Discuss.

Kaley's Knits: Fixing Self-Inflicted Wounds

By running a simple set of diagnostics, we quickly diagnose why a business is struggling. In the case of Kaley's Knits, some of the problems are self-inflicted.  These problems won't be solved by a "robust mobile strategy" or "three easy steps to social media success".

No, self-inflicted wounds can be healed by refocusing on fundamentals.

There's enough time to set goals for the rest of 2013.  Why not do this?

Goal #1 = Increase annual new customer counts from 99,120 to 115,000 per year.  Yes, this is an audacious goal.  But the impact on the business is substantial.  The customer file fell off the fiscal cliff once marketing dollars were taken away from customer acquisition activities.  When the customer file drops, sales drops are coming within a 6-12 month window, if not sooner.  I would immediately shift the focus of the marketing team away from a "socially engaging business that capitalizes on the burgeoning mobile opportunity" to a simple goal - "find more new customers"!  I don't care how Kaley's Knits finds more customers, that's the job of the marketing department.  Notice that I did not put a spending parameter on this goal.  If marketing can yield customers that generate profit during 2013, then marketing should be able to spend whatever marketing needs to spend to accomplish the goal.

Goal #2 = Increase gross margin percentage to 59%.  Gross margin was at or above this level from 2009 to 2011.  Of course, this is going to lead to a significant reduction in discounts/promotions, which may lead to a decline in demand.  This will be offset, in part, by the increase in new customer acquisition, which will fuel the business.

Goal #3 = Maintain average price per item purchased at between $33 and $36.  This prevents the merchandising team from artificially marking-up merchandise to artificially inflate gross margin dollars.  This will push down average order value inflation.  As we have observed, average order inflation pushes some customers out, requiring the brand to offer discounts/promotions to bring the customer back.  Why play this game?

Goal #4 = Increase variable profit to $6.0 million.  This should be achievable with a focus on new customers and a de-emphasis of discounts/promotions.  Notice that my goal has nothing to do with earnings before taxes.  99% of employees have little or no control over fixed costs.  Give employees the ability to manage metrics they control.

Goal #5 = Maintain annual repurchase rate.  I did not share data about annual repurchase rates in this project, but annual repurchase rates were 37% in 2012, 38% in 2011, and 38% in 2010.  Keeping customers is not the problem at Kaley's Knits.  So, the goal, given all of our moving parts, is to maintain repurchase rates at 37%.

I'm not telling Kaley's Knits staff HOW to do anything, am I?  I am simply setting goals that, when reviewed by smart people, eliminate all of the activities that cause a business to self-inflict wounds upon itself.  It will take a solid year of discipline for Kaley's Knits staff to adjust to the goals, make changes, and properly manage the profit and loss statement.

As staff manage to the goals I assigned, the focus can shift to the activities that cause profitable sales growth.  It is my guess that this will be a difficult transition for the staff at Katie's Knits, because through most of 2013, there won't be an easy path to sales growth.

In most cases, sales growth comes from two factors.

1. Low-cost customer acquisition programs that yield a significant increase in the number of new customers (marketing's responsibility).
2. A significant increase in merchandise productivity, yielding a significant increase in annual repurchase rates and orders per buyer per year (merchandising's responsibility).

When you look at the profit and loss statement, you see that Management at Kaley's Knits tried to artificially grow the business.  The results, predictably, were not good.

Fortunately, self-inflicted wounds can heal.  For 2013, I would ask the staff at Kaley's Knits to refocus on the basics of running a business.  In 2014, I would expect the merchandising team to step up to the plate with improvements in merchandise productivity.  In 2014, I would expect the marketing team to have a low-cost acquisition plan that could yield 125,000 new customers per year.  The combination of merchandise productivity and new customer acquisition would solve all profitability problems at Kaley's Knits, generating enough profit to offset increases in fixed costs, generating enough profit to fund future mobile developments.

Your turn - what goals would you set up for the Management Team at Kaley's Knits, and why would you create the goals you are advocating?

Kaley's Knits: The Profit Problem

Remember the profit and loss statement?

Look at the fixed costs line.  Fixed costs are increasing at a fast rate, from $3.5 million in 2010 to $3.7 million in 2011 to $4.2 million in 2012 ... a 20% increase in just two years.

The increase in fixed costs puts pressure on the entire profit and loss statement.  We know this by looking at the variable profit line.  In 2012, $5,654,610 of variable profit was generated.  In 2011, $5,616,541 of variable profit was generated.  Basically, the number is the same, right?  Kaley's Knits is generating the same amount of profit, prior to fixed costs, in 2012 as in 2011.

We have a business that has several fundamental problems.

1. Fixed costs are growing faster than top-line demand/sales are growing.
2. To partially account for this problem, Management decided to slash the marketing line in 2012.
3. Consequently, new customer acquisition dried up, putting even more pressure on top-line demand/sales.
4. Management tried to "squeeze more out of the lemon", by increasing price points.
5. Customers responded, somewhat, by buying more expensive items, at the expense of other metrics (orders per buyer per year, items per order).
6. Management responded by countering increases in price points with discounts/promotions, which caused a slight increase in orders per buyer per year.

Management had a healthy business with a satisfying mix of new and existing buyers, purchasing at reasonable price points.

Management traded this for a less healthy business, one being starved of new buyers, one of existing buyers being asked to pay more for items, then being given discounts and promotions to encourage the customer to come back.

Assuming that fixed costs remain flat, or continue to grow, what prescription would you write to fix this business?  Use the comments section to describe how you, the prospective CEO, would approach further diagnosis of business problems and ultimately how you would fix this business?

Discuss.

Kaley's Knits: Squeezing More Out of the Lemon

Let's briefly review what we already know:

1. Demand, on an annual basis, continues to grow at a modest rate.
2. The customer file began to collapse around August 1, 2012.
3. Existing buyer growth remains flat.
4. New customer acquisition began to collapse around July 1, 2012, and is down 7% from previous highs, suggesting that if this trend continues, we'll see new customer acquisition down about 13% on an annual basis by mid-2013.
5. Marketing spend is down in 2012, by about 10%.
6. Gross Margin is down to 53% of net sales in 2012, compared to 59% in 2011, and a high of 60% in 2009.
7. Orders per Buyer per Year began growing in June 2012.
8. Items per Order began to fall in October 2012.
9. Price per Item Purchased began a "race to the top" in the Fall of 2011.
10. Average Order Value is $13 higher today than two years ago.

A combination of Orders per Buyer per Year, Items per Order, and Price per Item Purchased yield Annual Demand per Buyer.

In July of 2011, the average twelve month buyer spent $102.25 per year.

In January of 2013, the average twelve month buyer spent $122.89 per year.

This metric has been increasing for eighteen months.  New customers fell off the cliff five months ago.  This tells us that new customer acquisition is not responsible for the change in this metric.

Clearly, Management is trying to "squeeze more out of the lemon".  A conscious decision was obviously made to get customers to spend more.  The focus of Kaley's Knits clearly shifted, in an 18 month window, from a balanced approach to one focused on trimming customer acquisition marketing dollars in favor of spending gross margin dollars on existing customers.

Why did I mention gross margin dollars?  Well, gross margin percentages are down from 59% in 2011 to 53% in 2012.  Discounts and promotions are frequently subtracted from the gross margin line.

Next time, we'll talk about the impact of this strategy on the total business.

Kaley's Knits: Manufacturing Growth Via AOV

We know that new customer acquisition is in the tank, while orders per buyer per year are on the rise.  It sure looks like the Management team at Kaley's Knits shifted focus from new customer acquisition to retaining existing customers.

There are two key metrics to evaluate, when considering orders per buyer per year.  The first is items per order.  Sometimes, when orders per buyer increase, items per order decreases.  What do we see here?

That's what we see here, right?  In late 2012, items per order dropped, from 2.52 to 2.47.  That's a big drop.  Customers are placing more orders per year, but are buying fewer items per order.

How expensive are the items the customer is purchasing?

Look at that!  Since late 2011, customers are buying items at ever-increasing price points. Clearly, Management is trying to encourage the customer to buy more expensive items.

If we multiply items per order by price per item, we arrive at a metric everybody looks at ... average order value!

Average order value is taking off like a rocket ship, since the middle of 2011, growing from $77 per order to $87 per order.

Next week, we'll talk about the ramifications these metrics.  We have enough information here to understand what the Management Team at Kaley's Knits is trying to do.

Kaley's Knits: Demand Up, Newbies Down. How?

If a business is growing the top line, regardless of profit, then growth can only come from a select set of tactics.

1. Increase New Customers.
2. Increase Annual Repurchase Rate.
3. Increase Orders per Buyer per Year.
4. Increase Items per Order.
5. Increase Price per Item Purchased.

We already demonstrated that there is a dramatic decline in new customers.  Let's look at orders per buyer per year.

Hey, we have good news, huh?  Around the time when new customer counts plummeted, orders per buyer per year increased.

Without having knowledge of the marketing strategies employed at Kaley's Knits, I can tell that Management made a shift from spending money on customer acquisition to spending money on customer retention.  The metrics (new customers, orders per buyer per year) move in opposite directions at about the same time (mid-2012).

By the way, it's really tough to get customers to purchase more times per year.  You accomplish this by ...

1. Having outstanding merchandise.
2. Marketing to the customer more.
3. Offering discounts and promotions, like free shipping or 20% off.

In a few days, we'll look at items per order and price per item purchased, as we continue our forensic study of Kaley's Knits.

Kaley's Knits: A Problem With New Customers

The twelve-month buyer file is in decline.  And yet, when we look at existing buyers (those with a purchase in the past twelve months, and a purchase prior to that, we see this:

If the existing buyer file is in decline, then first-time buyers (customer acquisition) must be in trouble.  Let's take a look.

Wow.

Clearly, something happened to the new customer acquisition program at Kaley's Knits in late spring 2012, or the trajectory of new customers wouldn't look this bad.

Recall our profit and loss statement?

Look at the marketing cost line.  In 2011, nearly $3.0 million was spent on marketing expense.  In 2012, the total is down to $2.7 million.

I would ask Management what happened to the marketing budget?  Did a change in strategy happen in 2012?  In late spring 2012?  Was it in programs (i.e. search) that disproportionately skew to new customers?

A question for you, dear readers.  How does this business continue to grow the top line, when fewer customers are purchasing, and fewer marketing dollars are being invested?  Are there any metrics you'd evaluate to answer this question?

Kaley's Knits: Twelve-Month Buyer File Issues

This graph shows the trajectory of the twelve-month buyer file at Kaley's Knits:

Remember, demand increased in the past year, but the housefile was in decline.  Let's look at a rolling twelve month graph of existing buyers (those with a purchase in the past year, and a purchase prior to the past twelve months).

Oh, oh.  What does this graph tell you?

Kaley's Knits: Diverging Metrics

Recall, the profit and loss statement showed top-line growth, but weak metrics below the net sales line.  Let's take a look at demand growth, on a rolling twelve month basis.

What we see is a business that was struggling, then reversed flat growth in the fall of 2011.  Since then, growth has been reasonably robust.  On the surface, things look good.

The next chart I look at is a rolling twelve month analysis of twelve-month buyers.

What do you see?

This business had marginal growth in the number of twelve-month buyers, followed by a significant drop that started in late spring 2012.

The customer file is in decline.  Top-line growth continues.  What do you think is happening at Kaley's Knits?

Kaley's Knits: Two Big Issues In The Profit/Loss Statement

Yesterday, we talked about the profit and loss statement at Kaley's Knits.  Let's briefly review the profit and loss statement one more time.

There are two lines that tell us a story.  First, look at the gross margin percentage line.  In 2009, 60.3% of every dollar sold was converted to gross margin.  In 2012, only 52.8% of every dollar sold converted to gross margin.

When I observe something like this, I ask Management what happened?!  Often, gross margin percentages decrease as discounts/promotions increase.  When promotions like 20% off are added to the marketing mix, we sometimes see the discount applied to gross margin dollars.  In other companies, the discounts/promotions are tucked into the marketing line, which actually yields a more interesting and insightful profit and loss statement.

Look at the marketing costs line, and the marketing percentage line.  Management at Kaley's Knits clearly made a strategic decision to spend less money on marketing in 2012. Sometimes, this happens when Management observes an imbalance in the profit and loss statement.  In other words, when the profit and loss statement isn't working well, Management cuts back on marketing expense, in order to balance EBT (earnings before taxes).

Every analyst/marketer/executive needs to be able to analyze a profit and loss statement, in order to understand how the business is performing.  Kaley's Knits is not performing well, in spite of reasonable top-line demand growth.

Kaley's Knits: The Profit And Loss Statement

Yesterday, we saw that top-line demand is growing, nicely.  Life is good, right?

I like to see at least four years of financial results, three years at minimum.  We get an opportunity to see just how healthy a business is.  A table, such as the table illustrated below, should be part of Analytics 101 training and Executive Management 101 training.

Oh, no.

Demand increased from $17.8 to $20.1 million over the past four years.

Earnings Before Taxes decreased, from $2.2 million four years ago to $1.5 million today.

In other words, this business is struggling, struggling badly, right?

Here's your homework assignment for today - which lines in the profit and loss statement illustrate why this business is struggling to produce profit?

Kaley's Knits: The Top-Line Looks Good

Let's take a look at what I call a "Rolling 12 Month File Analysis" of annual demand.  Take a look at the image below.

Kaley's Knits seems to have a successful trajectory, doesn't it?  Demand was at about $17.8 million three years ago, the business floundered for awhile, and then demand took off somewhere late in 2011.  Today, Kaley's Knits is a $20.1 million dollar top-line business.

This is the first piece of information I look at.  Every analyst can produce this graph, in fact, this should be part of Analyst 101 training.

Tomorrow, we'll inspect the four year profit and loss statement, which tells a story that is very different than the top-line growth this business is exhibiting.