Retail viewpoint: Don’t let your margins get trampled by tariff costs

August 28, 2018

U.S. core retail sales rose a healthy 0.4% in July after a downwardly revised 0.1% dip in June,1 with clothing stores and restaurants posting a 1.3% increase in sales to lead the way2. Online and mail-order retail sales increased 0.8%, likely boosted by Amazon's "Prime Day" promotion3. But receipts at furniture stores fell 0.5% and spending at hobby, musical instrument, and book stores dropped 1.7%. July's increase in core retail sales indicates that the economy is in a healthy state, showing its best second-quarter performance in nearly four years4.

This momentum bodes well for back-to-school season. But even as consumers shell out cash for backpacks, sneakers, and new clothes, the average buyer isn't aware of the growing expenses retailers face in getting these products into their shopping carts. Looming tariffs could potentially add a tricky component to the mix.

Not all items will be affected similarly, as import tariffs vary across product categories, source country of raw material, and manufacturing location. However, several retailers are bracing for impact. When it comes to back-to-school items, shoes, sneakers, and boots are likely to be deepest hit, according to data from Footwear Distributors and Retailers of America. In some cases, almost 50%5 of the cost of kids' shoes may be attributed to tariffs and other duties (see figure 1).

The U.S. has already approved tariffs on around $50 billion6 worth of Chinese imports. Duties on goods worth another $100 billion could be on their way. In response, China is imposing 25% tariffs on hundreds of American products. While a lot of apparel and shoe production is moving to Vietnam, Cambodia, and Ethiopia, China continues to claim the lion's share of production of these items. Almost 73% of footwear and more than 41% of apparel imports still come to the U.S. from China.7

These tariffs could result in a hit of between 5-10% on the average retailer's margins on impacted products. Not only are raw material prices likely to go up, supply chain underlying costs for container shippers will rise, too.8

As a first step, retailers should already be working with trade lawyers and other in-house experts to chart which duties might impact business.

Should costs get passed to consumers? Think about this: Consumer power is strong. Online shopping and frequent sales events have led to lasting expectation of both lower prices and transparency in pricing structures. It is unlikely that consumers will suddenly be willing to pay more.

Retailers need to think systematically about their competitive response – and shouldn't be left holding the bag. At the highest level, retailers should try to explore ways to absorb only between 10-20% of the burden, while passing off 70% of it to suppliers and the rest to consumers.

Mitigating impact: What can you do?

  • Evaluate the supply chain: Retailers must map their end-to-end supply chain. Relocating some raw material sources and operations to countries other than China could proactively lower part of the tariff impact. Some of the increase in product costs can also be compensated by reducing overall operational costs associated with product development and sourcing.
  • Negotiate contracts with suppliers and vendors: Consolidate production to a few key vendors. Retailers can negotiate and refine contracts using long-term agreements, indexing, hedging strategies, and by building strategic partnerships with key suppliers. Other key leverages include favorable exchange rates and supplier options outside of China.
  • Redesign the product: By implementing robust Design-to-Cost or Design-to-Value programs, changes can be made to absorb some of the costs at the product design stage. Changing the product composition can have an impact on duties charged. For example, currently tariffs on footwear with a rubber outsole are 37.5%, but tariffs on textile outsole shoes are only 12.5%.9
  • Develop a tariffs-efficient operation: Retailers that use components with a complex supply chain involving multiple countries can explore strategies such as the substantial transformation rule, transfer pricing, Foreign Trade Zone, First Sale for Export, etc.
  • Set up a joint-venture relationship: Retailers can set up joint ventures in low-cost sourcing countries and leverage these relationships to partner with strategic suppliers through long-term manufacturing agreements.
  • Evaluate how much consumers will take on: A good way to gauge which products consumers are willing to pay more for is to run a price-elasticity analysis. For products that are price elastic, retailers can increase prices with little expected impact on demand.

Are you getting schooled?

Both specialty and multi-brand retailers should evaluate moving as much as possible into private brands to more easily execute on recommendations 1-4, above. However, if retailers sell mostly national brands, they need to ask suppliers whether they are following all six suggestions above, and, if so, eventually claw back price increases. If suppliers have not yet implemented these suggestions, retailers must refuse price increases in their entirety, ask suppliers to take the above actions, and then share benefits.

Back-to-school season is, of course, a precursor to holiday season. Since the new tariffs are likely to cause customs delays around the peak of holiday shopping, retailers will need to plan now.

How's that for homework?


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