DISCOVERING THE PRICE-MARGIN BALANCE REMAINS DIFFICULT

David Merrefield

It might be argued that Kroger Co. is among the best managed and most successful of the large-scale supermarket operators.

Nonetheless, financial results reported in last week's SN illustrate just how difficult it is for even a company such as Kroger to achieve the delicate balance between price and margin. Those two variables, of course, define profitability to a large extent. But setting price and margin is far from simple. We'll consider that further, but first a review of Kroger's newly minted results for the second quarter that ended Aug. 12: Net income rose 6.4% and sales increased 9.2%. Sales at identical stores increased 6%, excluding fuel. There was, though, a bit of a drop in margin.

The increase in identical-store sales was no fluke. That measure has gone up for a dozen quarters now, which suggests that Kroger has found the right price formula. That's not an easy accomplishment. Pricing involves a host of factors such as how the competition prices product, which prices shoppers follow, which prices drive purchasing decisions and how prices contribute to a store's image and shopping-venue considerations.

The last consideration goes beyond the interplay between price and margin. Price points set too high will drive away business. Yet shoppers expect, and in a sense, pay for some intangibles such as store cleanliness, design and service. If prices are too low, a store may not be able to long sustain the provision of such intangibles.

And there is the margin consideration. Prices that are too low erode margins, assuming costs of operation and product acquisition have been reduced to the extent possible. Kroger has grappled with this balance for many quarters. Although identical-store sales have improved steadily, margins have gone up and down. That suggests cost reductions may not be sufficiently finessed.

Be that as it may, Kroger plans to stay the course with investing in price. David Dillon, chairman and chief executive officer, told securities analysts after issuance of the second-quarter numbers that Kroger intends to "reinvest [in price] in order to improve our sales, which is essentially how we're going to grow earnings."

Kroger's stock price dropped 5.5% shortly after that announcement because Wall Street had hoped margins and earnings would rise more than they did. Ongoing price investment suggests earnings won't rise appreciably for a time, no matter that price investment is the right course.

Finally, let's take a look at a component of profitability that goes beyond obvious aspects of the interplay among price, margin and costs: promotional allowances. This has nothing to do with Kroger at all, but, as was reported in last week's SN, Deloitte & Touche resigned as the accounting firm to Penn Traffic Co. The chain had previously disclosed it had engaged in improper practices relating to accounting for promotional allowances. Whether those events are related, the situation is a reminder that the temptation presented by allowance-allocation possibilities not only sows grief into many companies, but it also interferes with the transparency of calculating product-acquisition costs. That makes the task of finding the price and margin balance much more complex. Allowance vagaries may explain a large part of margin volatility at many companies.