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Flaws In Wal-Mart’s
Produce-Procurement Thinking

The Financial Times has an article titled, Walmart Aims to Cut Supply Chain Cost, that reports on Wal-Mart’s efforts to reduce supply chain costs.

First, the piece highlights Wal-Mart’s intention to avoid third-party procurement companies:

Walmart is launching a drive this year to cut billions of dollars of costs from its supply chain by combining its store purchasing across national frontiers in a new stage in the globalization of its business.

The effort is part of plans by the world’s largest retailer to increase the proportion of goods that it buys directly from manufacturers, rather than through third-party procurement companies or suppliers.

Eduardo Castro-Wright, the head of Walmart’s US stores, has said that the retailer sees the opportunity to consolidate global sourcing as “a major source of leverage for the company in years to come”.

Second, the article speaks to Wal-Mart’s intention to use multi-national regional buying and negotiating to reduce costs:

By the end of the year, the retailer plans to be directly purchasing sheets and towels for its stores in the US, Canada and Mexico, as well as its clothing for its Faded Glory line and for licensed Disney character clothing.

It also plans to expand initial combined purchasing of fresh fruit and vegetables for its stores in the US, Canada and Mexico, after an initial pilot test with apples that it says led to a 10 per cent reduction in purchasing costs.

Third, the report explains that Wal-Mart wishes to expand direct importing:

The direct purchasing of fresh produce, using procurement offices in producing countries such as South Africa, New Zealand, Brazil and Chile, builds on the established practices of the company’s Asda subsidiary in the UK, which in turn reflects the higher use of direct sourcing in Europe.

In a piece about Wal-Mart titled, SPECIAL EDITION: Wal-Mart’s Global Food Sourcing Initiative Closes The Peterson Era And Threatens Sustainability Of Agricultural Base, we spoke of Wal-Mart’s efforts to transform procurement with a pilot project on apples in Washington State. The gist of the change was that instead of a relationship-based system, Wal-Mart would basically put its supply contract out for bid. Now this article says that Wal-Mart is claiming that the pilot project is saving it 10% on the cost of apples.

When Wal-Mart looks to create supply chain efficiencies, it not only helps itself, it helps the world. So, if there are intermediaries that are not adding value, then Wal-Mart should try to buy direct.

The produce industry is very complicated, though, and neither the top executives at Wal-Mart nor the reporters at the Financial Times are really able to assess the success or failure of the efforts to reform the produce supply chain.

Although the claim that apple procurement costs went down 10% in the Washington pilot project is mysterious — how, after all, could Wal-Mart know what its procurement costs would have been under an arrangement it never entered into? — the bigger point is that even if Wal-Mart’s number is correct, it is surely only a portion of the story.

There are so many other factors that go into successfully running a produce procurement operation. For example, very often suppliers provide product that exceeds the required quality specification. What if suppliers provided just a tiny bit lower quality product — still meeting spec — but lower than they would have provided their best customer? That tiny deviation in quality multiplied across millions of Wal-Mart shoppers results in less satisfaction with the Wal-Mart experience, and what is the cost of that?

Or what if some future day there is a shortage of a size or variety and Wal-Mart’s competitors get a slightly higher allocation than Wal-Mart would have under a relationship-based system. That means Wal-Mart stores would be out of stock and competitors in stock. What is the cost of that?

In addition, in produce you can’t look at one procurement system versus another over a couple of months. You have to look over many crops of varying conditions. The Pundit Grandfather was a major auction buyer in New York City and, for decades, the President of the Fruit Auction Buyer’s Association, and what he taught the Pundit about auctions is that they tend to go to the extremes. We wrote about the issue in Pundit sister publication, PRODUCE BUSINESS:

In times of surplus, auctions tend to depress prices. In times of shortage, auctions tend to drive prices higher. The reason is simple: Auctions remove the element of personal relationship from the transaction of a sale.

No seller ever gets more for fruit than what he asks for, and a sales organization, looking to keep its customers and maintain good relationships, will not want to seem abusive by raising prices excessively when a market is short. They will raise prices, but nothing like what an auction can do when supplies are scarce. Equally, a marketing organization anxious to keep its shippers in business is unlikely to drop prices as quickly as they would fall at an auction. In addition, buyers are likely to fight harder against rapid price increases and be more tolerant of slow price declines when dealing with the same sales organization week after week. At an auction, however, cloaks of civility fall aside. The most loyal buyer will ram a knife in the heart of his best supplier and still point out that he paid a nickel more than anyone else.

You can read the whole column here.

The point, obviously, is that if one has a relationship-based procurement system, prices tend to both rise slower and fall slower in response to market changes than in an auction system. So, during a time of surplus, an auction-based procurement system will tend to produce savings, but during times of tight supply it is going to cost more, much more.

For all kinds of reasons, Washington apples are among the easiest items to procure. As the VP of Produce at one of America’s largest chains commented to us when he read our original piece on Wal-Mart’s experiment in Washington, “Apples are not raspberries.” Put another way, even if the savings were real on Washington apples, that would say precious little about the applicability of this system to the procurement of other items.

Finally there is an obvious Achilles heel to this 10% savings claim. The producer doesn’t generally make a 10% profit if one loads in the cost of capital. So this reduction in price, if real, can’t simply come from producers agreeing to profit more modestly. It has to mean that the producers, due to supply and demand, are accepting a loss in order to avoid the bigger loss of dumping product.

To put it another way, this mode of procurement — if it produces a 10% lower cost of produce — is a violation of everything Wal-Mart purports to believe about sustainability. It goes beyond price, it doesn’t give producers the assurance they need to invest for the long run. It encourages them to do anything to beat the other bid, whatever the long term implications.

The truth is that when it comes to produce, Wal-Mart is wildly overestimating the impact of volume — at least over the long term. The Financial Times article quotes the head of Wal-Mart’s US stores:

Mr Castro-Wright has estimated that shifting to direct purchasing could reduce costs by 5-15 per cent across the supply chain within five years — suggesting potential savings of $4bn-$12bn if the retailer were to meet its long-term goal of shifting to sourcing about 80 per cent of purchases directly.

This may be so, but in produce Wal-Mart is not buying any more “direct” than it used to. It is simply negotiating with its focus now on short-term pricing rather than utilizing long-term affiliation to develop secure supply sources with desired quality and brands. Even the profit to be gained from direct importing is mostly a chimera. Typically US importers of product, such as Chilean fruit, operate on consignment so they are really just functioning as the sales force. Eliminating the US company doesn’t eliminate the function of importing and sales, so the intrinsic savings are few.

The Financial Times piece makes the case for Wal-Mart’s scale to produce great savings:

With annual sales of more than $400bn, Walmart is famously tough in negotiating with its suppliers, exploiting the scale of its buying to gain discounts.

Yet in produce the actual sustainable reductions in price one gets from increasing orders dissipate quickly as volume increases. If one goes from buying one case a day to two cases a day, there are big savings because the cost of selling — the salesman talking to the buyer, providing samples, sending an invoice, collecting the money… all get cut in half.

So there is a steep reduction in cost as one makes selling and transport more efficient by buying in larger quantities. But once one exhausts these efficiencies — the sales cost is insignificant, the transport is the most efficient, say a trailer load or a railcar full or a charter boat full in different contexts — there is no longer any savings to be gotten from higher volume.

For a while, increased volume, especially used wisely, may continue to get cheaper prices because the competition for the customer — and hope that eventually they will pay more — leads to a highly competitive market. Plus these midsize buyers have the flexibility to clear out relatively small lots of produce that, for some reason or other, vendors want to be rid off.

Think of the independent chains, some of which we talked about in this PRODUCE BUSINESS cover story. They speak to a wholesaler or a shipper and get offered an $8 price as a special deal because the wholesaler or shipper is looking to clean up a lot. The buyer asks how many they have and then offers $6 to clean up the volume. This sale may well be unprofitable for the vendor but is necessary to liquidate inventory either to make room for new product or to avoid dumping product.

As volume continues to increase, however, those unprofitable sales cannot be sustained. In the produce business, it is very helpful to have a guy who will always buy your product — even at a distressed price. We recall, as a major importer of honeydew melons, the value of having a fruit salad guy willing to buy. Though these sales can be useful for a few percentage points of one’s volume, most of the sales have to pay a price sufficient to support the business.

So, cumulatively, Wal-Mart, Kroger, Safeway, SuperValu and Costco cannot buy below the market — they are the market — and they have to pay a price sufficient to incentivize the necessary investment to sustain the companies and keep production in line with consumer needs.

The problem here is that the executive incentives at Wal-Mart are not in sync with the multi-year investment horizons on products such as apples. In the short term, the decision of Wal-Mart to engage in an auction-like procurement process may well result in buying cheaper.

Long term, however, the uncertainty as to whether a company will have a market for its products will discourage investment in orchards, packing houses, etc. This will lead to higher prices, but the connection to Wal-Mart’s policies will be too difficult to decipher and, in any case, those who made the policies at Wal-Mart will be off to other jobs.

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