Department stores in China merchandise direct sales

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1 Department stores in China merchandise direct sales January 2013 I. Introduction In general, department store operators in China generate revenue primarily from commissions on concessionaire sales; other sources of income include merchandise direct sales, rental income from store tenants, agency fees earned by serving as agents as well as management fees, etc. Nowadays, more and more operators realize the drawbacks of the profit model of relying on commissions low profit margins, poor differentiation of brands and products, weak customer loyalty, etc. They are now trying to adopt a differentiated business model by engaging in merchandise direct sales and launching private labels. Hoping to shed light on the latest developments of merchandise direct sales in China, the Fung Business Intelligence Centre, together with the China Chain Store and Franchise Association (CCFA), conducted a survey in late 2012 to understand the developments of merchandise direct sales in major department stores in China. Apart from the survey, face-to-face interviews with some of the major department store operators were conducted. This English version summarizes the key takeaways of the Chinese report. For more details of the Chinese report, please kindly visit 13c8a &publishcid=402881e91c59dbcb011c59e15ca P a g e

2 Merchandise direct sales model refers to? - Under merchandise direct sales arrangements, department store operators source and sell their own directly purchased merchandise or private labels/proprietary brands. Department store operators own the title to the goods; they profit from merchandise mark-ups. Most of the merchandise in supermarkets, home appliances and electronics, and cosmetic products with high brand recognition are covered by direct sales arrangements. Why merchandise direct sales? - Most of the department store operators we interviewed admitted that merchandise direct sales could help them enhance core competencies, reap higher profit margins, improve customer loyalty, offer differentiated products to customers, ensure product quality and lower transaction costs. (See Exhibit 1) Exhibit 1: Advantages of merchandise direct sales model Advantages Rank (Highest score: 5) Enhance core competencies 4.4 Reap higher profit margins 3.9 Improve customer loyalty 3.8 Offer differentiated products to customers 3.7 Ensure product quality 3.5 Lower transaction costs 3.3 Source: China Chain Store and Franchise Association and Fung Business Intelligence Centre 2 P a g e

3 II. Overview Merchandise direct sales model is not prevalent Currently, department store operators in China generate the bulk of their revenue from commissions on concessionaire sales, while that from merchandise direct sales is little. According to our survey and interviews, revenue generated from merchandise direct sales accounted for only 7.0% of the total revenue among the department store operators. It is noteworthy that the larger scale the department store, the smaller contribution of merchandise direct sales to the total revenue. The adoption of direct merchandise sales varies largely by category of products Nature of products is one of the factors affecting whether the department store operators will directly purchase the products. For instance, department store operators tend to directly purchase products with longer product cycle such as home appliances and electronics, which carry lower inventory risks. By contrast, the merchandise direct sales for apparel and accessories are not common. One of the possible reasons may be that the operators lack the knowledge to keep pace with the fashion trends. Regional department store operators tend to engage more in merchandise direct sales than the national players Our survey results show that regional department store operators engaged more heavily in merchandise direct sales than the national operators. In some cases, the proportion of merchandise direct sales can reach as high as almost 100%. Hebei Xinyulou Department Store is a case in point. Leveraging their strong local networks and long-standing relationship with suppliers, Xinyulou Department Store directly purchased all products from suppliers except the catering services. For operators who are engaging in merchandise direct sales, over 50% of their products were directly sourced from regional distributors 3 P a g e

4 Usually, department store operators directly purchase products from three channels 1) brand owners or manufacturers; 2) national distributors or agents; and 3) regional distributors or agents. Among the surveyed department store operators who have engaged in merchandise direct sales, over half of their products were directly purchased from regional distributors or agents. Development of private labels is still in its nascent stage Though an increasing number of department store operators are interested in merchandise direct sales and private labels, the development of private labels is still in its nascent stage. According to the survey, private labels accounted for less than 2% of the revenue of the surveyed department store operators, much lower than 30-50% for retailers in the developed markets. Snapshot: Characteristics of successful operators engaging in merchandise direct sales - Possess a strong team of buyers Experienced buyers with strong business sense and profound understanding of the latest market developments are hired to ensure the products purchased suit the tastes of the customers. - Buy out the products from manufacturers directly Reduction of distribution costs is observed since layers of distributors are cut out. Better differentiation of products can also be guaranteed. - Develop private labels Owning a private label allows operators to improve profitability and strengthen core competencies. Uniqueness and exclusiveness of products can also be offered. - Provide differentiated services Creation of detailed customer database. Range of merchandise, visual merchandising and other services will be adjusted according to the data collected. Loyal customers are identified and tailor-made services will be offered. Source: Fung Business Intelligence Centre 4 P a g e

5 III. Challenges In our survey, we also attempt to find out the challenges department store operators face when adopting the merchandise direct sales model. When asked about the biggest challenge for switching to merchandise direct sales model, most surveyed department store operators named the huge capital outlay involved. Lack of experienced in-house buyers presents another enormous challenge to them. Please see Exhibit 2 for more details. Exhibit 2: Challenges facing department store operators Challenges Rank (Highest score: 5) Huge capital outlay involved 4.6 Lack of experienced in-house buyers 3.4 Inexperienced management 2.8 Resistance from leasing staff 2.8 Weak control over distribution channels 2.5 Source: China Chain Store and Franchise Association and Fung Business Intelligence Centre Huge capital outlay involved Unlike charging commissions on concessionaire sales, the merchandise direct sales model requires department store operators to buy out the products, which involves huge capital outlay. Warehousing and logistics arrangements for the products also involve substantial cash expenditures. Lack of experienced in-house buyers The lack of experienced in-house buyers with strong business sense and profound understanding of the latest market developments is the common challenge facing many Chinese department stores. According to industry watchers, it has to take at least three years to nurture a professional buyer with practical experience and knowledge of a target market. Inexperienced management The management of most department stores has been acting like landlords under the current business model for over two decades. The merchandise direct sales 5 P a g e

6 model requires a different type of management skills to succeed. Meanwhile, the management has to acquire a better understanding of the retail market and consumer tastes so as to tap the market. Weak control over distribution channels The distribution network of many renowned brands is very well-established. The brand owners either have set up their own direct-operated stores or have developed stable relationships with reliable distributors for distribution of their products. The department store operators have little control over the distribution channels for many of these renowned brands. It is difficult for them to buy out products directly from the brand owners. Resistance from leasing staff The leasing staff will be affected if the operators switched from the concessionaire model to the merchandise direct sales model. Under the merchandise direct sales model, the department store operators usually adopt centralized sourcing, which the leasing staff will only have little say in the choice of tenants. Therefore, they may not be willing to embrace the change. 6 P a g e

7 IV. Outlook The proportion of merchandise direct sales is expected to increase As mentioned before, a growing number of department store operators realize the drawbacks of the concessionaire model and have tried to adopt a differentiated business model by engaging in merchandise direct sales and launching private labels. Currently, on average, sales revenue generated from merchandise direct sales accounted for only 7.0% of the total revenue among the department store operators surveyed. They wish to push the number to 15.0% by Certain categories of products are likely to take the lead in merchandise direct sales Among the major product categories sold in department stores, the operators foresee that the proportion of merchandise direct sales for home appliances and electronic products and cosmetic products will be the highest. More details can be found in Exhibit 3. Exhibit 3: Proportion of merchandise direct sales by category by 2015 Category Proportion in 2012 Proportion by 2015 Apparel and accessories 1.9% 8.0% Cosmetic products 11.6% 18.0% Home appliances & electronics 15.3% 20.0% Home products 3.1% 10.3% Stationery 3.8% 12.0% Source: China Chain Store and Franchise Association and Fung Business Intelligence Centre 7 P a g e

8 It takes time to see impressive progress in launching private labels Many department store operators expressed interests in developing private labels. Having said that, they understand that it takes time to develop their own labels due to financial and human capital constraints. For instance, at least three to five years may be required to nurture a strong team of in-house buyers. Concessionaire model still prevails in the near future; while merchandise direct sales model is gaining popularity Since the current concessionaire model has been established for over two decades and that it takes time for the department store operators to develop the merchandise direct sales model, it is expected that concessionaire sales will continue to be the major source of income for most department store operators. At the same time, the merchandise direct sales model will gradually gain market share from the concessionaire model. 8 P a g e

9 V. Recommendations To promote the development of merchandise direct sales, the government should consider providing designated funds such as subsidies for research and development for private labels for the enterprises. Other innovative means of financing, such as issuing corporate bonds, should be considered as merchandise direct sales involve huge capital outlay. Meanwhile, tax reductions and strengthening the provision of training for talents will surely be welcomed by the enterprises. As for the operators, to engage in merchandise direct sales, they should consider acquiring a better understanding of customers tastes, developing unique market positioning, launching private labels on a trial basis and, last but not least, nurturing in-house buyers. 9 P a g e

10 About the Organizations The China Chain Store and Franchise Association Founded in 1997, the China Chain Store & Franchise Association (CCFA) is an official representative of the retailing and franchise industry in China. Currently, there are 1,000 enterprise members with 200,000 outlets, including domestic and overseas retailers, franchisers, suppliers, and relevant organizations. The total sales of China s Top 100 retail chain operators, which are part of the members of the CCFA, amounted to about RMB 1.7 trillion in 2011, with more than 57,000 stores in total. CCFA participates in policy making and coordination, safeguards the interests of industry and members, provides a series of professional training and industry information and data for its members and establishes platforms for exchange and cooperation. The Fung Group The Fung Group is a privately held multinational group of companies headquartered in Hong Kong whose core businesses are trading, logistics, distribution and retailing. The Fung Group employs over 41,000 people across 40 economies worldwide, generating total revenue of more than US$21.1 billion in Fung Holdings (1937) Limited, a privately held business entity headquartered in Hong Kong, is the major shareholder of the Fung group of companies. The Fung Business Intelligence Centre Through exceptional relationships and deep networks, the Fung Business Intelligence Centre (formerly known as the Li & Fung Research Centre) collects and analyses market data on China's economy, with special reference to sourcing, supply chains, distribution and retail. It also produces reports on sourcing and trading in other Asian countries. Serving as a knowledge bank for the Fung Group, the Centre makes its market data and analysis available to businesses, scholars and governments around the world. It has become an impartial thought leader on issues shaping the future of manufacturing, distribution, logistics and retailing in China, and regularly provides advice and consultancy services to internal and external clients. Copyright 2013 The Fung Business Intelligence Centre and the China Chain Store and Franchise Association (CCFA). All rights reserved. Though the Fung Business Intelligence Centre and CCFA endeavour to ensure the information provided in this publication is accurate and updated, no legal liability can be attached as to the contents hereof. Reproduction or redistribution of this material without prior written consent of the Fung Business Intelligence Centre and CCFA is prohibited. 10 P a g e

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