Fred manages produce sales for a large grocery chain. Fred is a college graduate with an MBA who knows how to run Microsoft’s Excel software. The grocery chain hired Fred because they were looking for someone who could maximize profits from selling produce items like onions, carrots, potatoes and so on, and they suspected that a guy like Fred could run various sales scenarios on his computer and come up with a strategy that would expand shareholder profit.
Generating a profit in the retail grocery produce business includes certain considerations: cost of goods; transportation and warehousing efficiencies; customer value perception and ads; and doing all of this at a profit.
Let’s take Fred’s challenges one at a time:
1. Cost of goods
It is not the price that Fred must pay for goods that matters most; rather, it is that none of his competition buys cheaper or under him. Considering potatoes, whether a 10/5-pound bale costs $5 or $10 free on board (FOB) makes no difference as long as Fred is paying the same delivered price as the retail store across town. Remember that when the cost of goods is the same for all competitors, it is the store with the greatest logistical efficiencies and best consumer and management practices that accumulates the greatest profits.
2. Transportation and warehousing efficiencies
Since produce is considered on a delivered basis, this one is simple: Fred asks himself, What is my closest source? That is where I’ll pay the least for freight. If someone farther from me wishes to compete with someone closer to me, they must subsidize the freight by lowering the FOB price.
3. Customer value perception and ads
Remember that Fred’s job is to maximize profit. This means that when he puts an item on an ad and lowers the price, volume must increase to cover the margin he is giving up by lowering the price. Holiday ads are sometimes different; some holiday ads run as loss-leaders to attract customers into the store where they will purchase more items than what is being sold on ad. In both cases, ads must make sense by increasing profits; otherwise, why run them?
However, no ad or series of ads can compensate for total over-supply. As demonstrated time and again, promotions that run for weeks on end cease to be promotions, becoming instead a new and lower everyday price. The purpose of an ad is to create a temporary buying surge, and a surge, by definition, does not last month after month. In fact, A.C. Nielsen data shows for the latest available 52 weeks of 2014-15, only 23 percent of the total russet crop was actually sold in-store to consumers on promotion. The only surge that happened in 2014-15 was the one that Fred gathered up in retail profits. Over-supply significantly lowered Fred’s FOB price, and by holding his retail price at the customary level for the other 77 percent of his russet sales, Fred’s produce section made record margin and record profits.
4. Profitability
Fred absolutely loves potatoes. Nothing makes Fred look better to his boss than cheap FOB pricing due to over-supply. Fred is probably a nice guy and no doubt appreciates certain potato farmers helping him out like this. Not all produce growers are this helpful.