Target’s Margins Improve Even As Digital Sales Explode: How Is That Even Possible?

On November 18^th, Target TGT Corporation reported its third quarter earnings. Not surprisingly, because of  COVID-19, ecommerce sales are surging. What is surprising is that even as ecommerce becomes a bigger percentage of their sales, their gross margin continues to increase! In one article from a few years ago a pundit said, “The dirty little secret about omnichannel that is not getting nearly enough attention – omnichannel can cost a lot more than simply running stores.” That was the accepted wisdom. Target is making us rethink that.

Omni-channel, or what Target calls digital sales, is based on providing consumers with a more seamless shopping experience across different channels. Target’s digital channels including picking orders up in the store, curbside delivery, or same day shipments from Shipt.

Target’s gross margin rate was 28.4%in 2018 but has steadily grown to 30.6% in the third quarter of this year. Third quarter comparable sales grew by 20.7%. But digital comparable sales grew an astounding 155%! For the fiscal year 2019, digital sales were 8.8% of total sales. By the second quarter of this year, they had almost doubled to 17.2% of sales.

More than 95% of Target's third quarter sales were fulfilled by its stores; fulfilling orders in stores is more expensive because in-store customers do their own picking, but fulfilling digital orders requires store labor.

Other issues with omni-channel fulfillment include last mile delivery. The last mile is far more expensive than delivering goods by truckload or less-than-truckload to stores. Target charges $9.99 for same day deliveries. But they charge $99 for an annual membership. For a frequent online shopper, that $99 can in no way cover Target’s last mile delivery costs.

Finally, inventory accuracy can never be as high in a store as in a warehouse. Poor accuracy leads to rework, returns, and lost sales.

So how can Target’s margin be increasing? Shouldn’t logistics expenses be scaling in a way that would decrease margins?

Target admits logistics costs are increasing. The gross margin improvement reflects “the benefit of merchandising actions, primarily from exceptionally low markdown rates.” That margin improvement is “partially offset by the impact of higher digital fulfillment and supply chain costs.”

But Target has invested billions of dollars over the past three years to help ensure that growing digital sales would not be cannibalized by skyrocketing logistics costs.

Arthur Valdez, Executive Vice President and Chief Supply Chain and Logistics Officer at Target, spoke about the mega-retailer’s supply chain transformation at the Council of Supply Chain Management Professionals (CSCMP) online forum in September. According to Mr. Valdez, there were four critical improvement initiatives spanning inventory management, transportation, automation, and operational excellence.  

“The anchor and catalyst for our transformation” was moving to using one pool of inventory to fulfill all digital and in-store purchases. Though not mentioned, this almost certainly required implementing a distributed order management (DOM) system. Legacy order management systems can’t handle the complexity associated with omnichannel fulfillment.

But it also required changes in buyer’s duties. Target used to have one set of buyers and merchandisers focused on the in-store experience and other buyers focused on digital. “We don’t have that anymore, Mr. Valdez explained. A buyer now “purchases for one business.” The buyer’s roles and responsibilities were combined. Making that cultural transition “was a tough problem.”

Inventory management improvements also included better forecasting and a better understanding of where inventory needed to be stored based on channel and geography. Modern forecasting and inventory optimization solutions reduce the manual labor surrounding forecasting, rely on machine learning to improve forecast accuracy, and automate much of the purchasing.   

Target also needed to change the way they thought about transportation. Traditionally, Mr. Valdez explained, supply chain executives focus on ways to reduce their supply chain costs by reducing transportation spend. But Target was focused on the customer experience. Inventory needs to be available for all channels when consumers want it. Thus, their transportation investments were focused on increasing speed and gaining real-time visibility to where shipments are. Getting a vendor shipment into their network “matters more than holding up a truck somewhere to make sure it is full.” This focus on speed also means more frequent but smaller loads moving from Target’s distribution centers to their stores.

When it comes to transportation spend, it has been helpful to Target that curbside delivery pickups grew twice as fast in the second quarter as same day deliveries.

In a February 2018 meeting with financial analysts Target CEO Brian Cornell said, "Fundamentally, we are changing how we move product. In the future, we know we’ll still have to move cases. But to move product faster, and to manage the growing digital demand, we have to start moving individual items."

That is why warehouse automation has been a critical part of the retailer’s transformation. In the past, the minimum order quantity for a product delivered to a store was a case. Now, warehouse automation is allowing stores to order less than case level. Mr. Valdez refers to this as “replenishment at the correct unit of measure.” Essentially, a tote for an individual store is conveyed through different zones and workstations at a distribution center and pickers select just the needed inventory for that store into a store tote. Meanwhile, backrooms at the stores were shrunk so stores could not rely on the crutch of ordering in full cases unless necessary. This automation also saves money on store labor as picking into the boxes at the warehouse is done at a store aisle level so team members in stores can unpack a much greater proportion of the product directly onto the shelf. In contrast, their legacy break-pack solution required store associates to resort and touch product multiple times.  

The fourth pillar that Mr. Valdez spoke about was operational excellence – “how we manage the metrics of the business.” What analytics were important, what variances are acceptable, which are too big. In Targets 2019 annual SEC financial filing, the company stated, “we have redesigned our store operating model – redefining roles for hundreds of thousands of team members to deliver better guest service.” A large proportion of many store associate’s activities now involves fulfillment and inventory management.

One critical problem for using the store as a fulfillment node has been the poor inventory accuracy. In a warehouse, inventory accuracy can be 99.9 percent and above. Stores inventory accuracy is usually at 90 percent or less; this is because inventory can be in a shopper’s cart, left in dressing rooms, stolen, or returned by shoppers to the wrong aisle. For these reasons, some supply chain experts believe store inventory accuracy can never go above 96 percent.

But if you go to YouTube and watch “day in the life” videos of Target associates, you will see that a large part of an associate’s duties now includes inventory management and fulfillment. As you view these videos you will see the ubiquitous use of barcode scanners for inventory accuracy, that associate’s jobs involves moving inventory from returns to the department they work in, that team members are expected to move inventory that is misplaced by customers to a collection point in the store where it could be sorted before being returned to store shelves, and that workers help fulfill orders for curbside pickup. And you will see that much of the worker’s inventory management labor is directed by the intelligent application on their scanner.

Mr. Valdez describes these four initiatives as all combining in a form of “orchestration” that allows their customers to purchase whatever they want through whatever channel they desire.