Is Bigger Better?

A friend of mine who operated three retail jewelry stores came to me a few years ago to see if I could help him put together a business plan for expansion of his business. He also asked if I could help him find some “growth capital.”

As part of my due diligence prior to helping with the business plan, I asked him about his profitability with the existing three stores. He replied, “They aren’t profitable yet, but if I can expand to a dozen stores, I know I can be profitable.” When I heard this, the warning bells sounded.

I asked the young merchant why he thought he could be profitable with a dozen stores, even though he was not profitable when operating just three stores. He said the extra sales volume would help leverage his fixed costs and that would lead to profitability for the business.

As we delved into his expansion plans, I found that he had not allowed for an expanded management structure. The young merchant thought that he could supervise all twelve stores himself, and he would not need any additional corporate management help, other than a manager and an assistant manager in each store. Now the warning bells and buzzers were going crazy.

As we talked about his plight – no profits, lack of corporate management, an expansion plan that was doomed to failure – we dug into his numbers in an effort to find out why he wasn’t profitable at his current level of sales.

Suddenly, it was obvious: his sales per store were well below $1 million each. In the U.S. market, a retail jewelry store needs annual sales of at least $1 million per store to eke out a profit. At $2 million in annual sales per store, profits start to become meaningful.

I tried to explain to him how greater sales per store were the secret to profitability in retailing. “It is not about adding stores; rather, it is about leveraging fixed expenses with greater sales volume per store.” I suggested that he should focus on growing sales in his existing stores, before adding new stores.

An analysis of profitability of public retailers in the U.S. market illustrates how higher sales per store can lead to superior profitability. For example, Sterling’s Kay Jewelers generates sales per store of about $1.9 million annually. Its operating profit margin is nearly 16 percent, one of the highest of any mass-market jeweler in the U.S. Further, Signet has consistently been profitable on an operating basis, even during the dark days of the 2007-2009 recession.

In contrast to Sterling’s “sterling performance,” Zale has been struggling. It has not been profitable for five years. In part, the challenge at Zale is building its sales per store. Its Zales Jewelers and Zale’s Outlet stores generate about $1.2 million in annual sales per store, while its Gordon’s generate sales of only $900,000 per unit annually. Not only are Zale’s metrics woefully short of Kay’s performance, but they are below the performance for most mid-market chain jewelry stores. Zale’s sub-standard per-store sales levels help explain its lack of profits.

I explained to my young merchant: “It is all about being better, not bigger.”

As it turns out, the youthful merchant did not heed my advice. He went on an expansion spree, opening stores helter-skelter. Eventually, the banks took him over, and his business failed.

Here’s the lesson: the route to profitability is simple – “be better, not bigger.”