Grocery Stores: The Profitability Index
Issue
The Post and Courier recently posted an article titled Super Market Central that raises more questions than it answers. The article compares the number of grocery stores in affluent Mount Pleasant, S.C., compared with North Charleston, S.C. One Mount Pleasant store owner was quoted as saying “We want to be in markets where there are households with families.” Actually, North Charleston and Mount Pleasant both have an average of 2.5 persons per household! (Source: City-data.com) After review a number of data-intensive sites such as city data and the U.S. Census, I was able to confirm many points in the article and, like the author, identify differences in these communities. Many, such as race and income, are obvious. However, this still does not explain the disparity between the numbers of grocery stores in one community versus another.
Empirical Research
It turns out this is a significant problem, not only here in the low-country, but across the United States. One source “Closing the grocery gap in low-income areas,” identifies key issues. Other research from CA Food Policy Advocates suggests:
“One promising model, among others, that has emerged involves the conversion of existing corner stores, typically depending upon sales of alcohol, tobacco and sodas, into neighborhood groceries selling healthy foods. Because so many of the necessary costs — rent, utilities, space, and management possessing some degree of both business skills and familiarity with neighborhood preferences — already are present, the conversion can be relatively inexpensive and, in fact, provide the store with additional opportunities to be profitable. A viable neighborhood grocery store represents multiple policy gains, including food access, nutrition and fitness, transportation, community development and crime reduction.”
Unfortunately, the quote describes symptoms, but not the cause of the problem. The root cause is how capital is rationed to achieve the highest return. The Post and Courier article states margins for grocery stores (a basic commodity) are around 1.5 percent. This is pretty poor even by commodity standards. In fact, one would have to wonder why anyone would go into this business, especially a small business, as suggested above. There simply are not enough retained earnings to make a living! However, to understand why Mt. Pleasant has more grocery stores than North Charleston, we must look for the answer among the financial tools used to make capital allocation strategic decisions – in other words, to build new grocery stores.
The Profitability Index
Most firms’ capital budgeting process uses some sort of discounted cash flows, the most common being net present value (NPV). Although there are other methods, such as payback or average accounting return, we assume our grocery stores use a variation of NPV. In the capital budgeting process, a project is accepted if NPV is greater than 1 and rejected if it is less than 1. That basically means if the project is accepted it will make money (hopefully). We will assume that both North Charleston and Mount Pleasant grocery projects have positive NPVs. So far so good. Unfortunately, investment capital is limited, especially when risk is factored in. We therefore can choose only one project. To do that, we run both projects back through the profitability index.
Profitability Index (PI) = Present Value (PV) of cash flows subsequent to initial investment/ Initial Investment
Again if PI is greater than 1 we accept the project, if it’s less than 1 we reject it. When using NPV, we make a go, no-go decision. However, when applying PI, projects are ranked according to the ratio of present value to initial investment. The project with the best potential return (greater than 1) is funded. It is Mount Pleasant in this case. The project is funded, as the article states, not because of corn flake sales, but because of special item sales, which less affluent customers avoid. Special items sales create a better return (profit) on capital invested in the Mount Pleasant location.
Conclusion
Both projects are in fact profitable. But one provides a slightly better return. At this point corporate culture also comes into play. For example, “what we did last week, which worked, will likely work in our next venture” … and so on. One can see this pattern in Mount Pleasant – the me too effect. This happens in part because firms generate positive NPVs because of prior investments, leveraging their current market position. An organization does need to make a profit, whether it is the small corner store or a large grocery chain. Without that profit, the store will cease to exist.
In the end a different model is needed (not currently in the domain of the typical grocery store) that incorporates social networking, transportation, specific product offerings, efficient security and product distribution. This comprehensive model leverages capital not only for the current project, but for indirect cash flows of future business ventures yet to be determined in the same locale. Extending the scope of the investment decision breaks the current boom-bust grocery store location cycle. The question is how to get business owners to adopt this perspective.
