July 28, 2017

There's a significant cost associated with taking the backroom for granted. Taking the time to re-evaluate a variety of relevant factors can help companies operate a more efficient, cost-effective backroom.

When designing the layout of their stores, retailers understandably pay close attention to the front spaces—the places where consumers purchase goods and interact with staff. The dynamics of these customer-facing areas are relatively well understood. Backroom spaces, on the other hand, tend to attract less attention and are not as well understood, especially in the context of their impact on store performance.

However, our research shows that retailers have a substantial opportunity to increase revenue and improve customer service by increasing the efficiency of backroom operations—especially at a time when the rise of online sales and omnichannel business models is redefining the functionality of retail outlets.

This makes sense, as the backroom is the vital link between the store and the complex supply chain that supports it. Consequently, it's important that retailers allocate the optimum amount of space to meet a store's needs and manage that space as efficiently as possible. Neglecting these demands can exact a high price in terms of store profitability and service levels.

Space and profitability

Backroom spaces make a major contribution to store profitability. If the amount of inventory held in the backroom is too low, the retailer can lose sales because product is not available when customers wish to make a purchase. Too much inventory in the backroom, however, loads the store with excessive costs and waste, which eats into profit margins.

A clear picture of the relationship between backroom space and store profitability is depicted in Figure 1. The chart shows how the annual profit achieved in a 1,500-square-foot retail store changes as the available backroom space changes.

Initially, increasing the backroom space allocation increases product-related profit because the larger space carries more inventory (a 1,500-square-foot store can reap nearly $300,000 more profit annually when the backroom space is increased to 150 square feet from 75 square feet, or from 5 percent to 10 percent of the total store space). A smaller and hence a more congested backroom space could also potentially lead to larger in-store logistics cost (for example, labor costs), which have not been included here.

However, these gains disappear when the backroom reaches a certain size threshold. At this point, the amount of revenue that the store can earn is limited by the demand observed at the store. Additionally, too much backroom space cuts into the amount of square footage devoted to the front room—the demand-generating part of the store that has a direct impact on maximum revenue potential.

Previous research indicates that backroom operations can have a significant impact on a store's costs. In-store operations can account for up to 50 percent of total costs in a retail supply chain,1 and the backroom is responsible for a major portion of those costs. For example, organizing and managing the backroom—especially a smaller, and hence a more congested, space—incurs labor costs, and there are inventory holding costs associated with backrooms. Equipping backrooms represents another cost, which can be especially significant in businesses such as food service that handle perishable items.

Researchers have identified inadequate backroom organization and planning (how backrooms are configured and how stock is arranged to meet the needs of the front space) as a major source of store stockouts.2 In the food-service business, the impact on customer service can be even more pronounced, because backroom spaces also function as production areas.

In short, the way backrooms are configured and managed influences their ability to supply the product that is sold in the store, and hence the store's sales performance. Retailers therefore need to pay more attention to the amount of front and backroom spaces that will yield the maximum profit potential and how backrooms are managed to support the store's demand profile. Currently, store design practices give priority to front-of-store spaces, which is understandable since this is the customer-facing portion of outlets. However, more detailed analyses of how backrooms impact store performance and profitability is needed, and these factors should be given more weight when stores are designed or refurbished.

Retailers would benefit from analyzing their backroom operations and tackling the root causes of poor performance. These analyses should study the way backrooms operate in relation to the demand for product, and then pinpoint key factors that influence the efficiency of back-of-store operations.

Three critical factors: size, profit margin, and importance

Many factors affect the allocation of backroom storage space. Three that are especially important to consider include the size of the packs that are stored, the revenue yield of each individual item, and the importance of the item to the store's operation. First we will introduce these factors, and then will discus how, when considered together, they influence store profitability.

Pack size. The size of the packs received by stores from suppliers might seem like a relatively mundane detail. However, pack size can have a big impact on the backroom's ability to function effectively; the size of the units stored determines how much inventory can be shelved and how accessible the items are.

Pack-size policies tend to be set at a corporate level, yet backroom space constraints and customers' buying patterns vary from store to store. Retailers need to work with store personnel and suppliers to determine which pack sizes are the most efficient for the configuration of particular backrooms and in light of the product demand in individual stores. This information can be used to better align store replenishment systems with demand.

As they conduct this analysis, companies need to look at two pack sizes: order and "storable" (also known as "intrapack"). Order size refers to the size of the units delivered by suppliers, and this affects the quantity of individual sellable units that the store has on hand. Storable, or intrapack, size pertains to the way the contents of larger units are often packed. A coffee shop might receive cases of 36 croissants that contain nine inner packs, each holding four pastries. Typically the outer pack will be discarded and the inner packs are held in inventory. These inner pack sizes and configurations impact the space occupied by the inventory in the backroom, and hence the availability of sellable items in a multiple stock-keeping unit (SKU) setting where SKUs are competing for space in a constrained environment.

Profit margin per item. Our research also highlights the importance of optimizing for profit—rather than simply minimizing cost—when modeling for backroom space allocation, owing to the close and direct links between store backroom and front-room areas. For example, devoting too much backroom space to items that have a very low revenue yield can undermine the overall profitability of a store. For this reason, when a retailer determines how much space is allocated in the backroom for a particular item, it should consider the item's revenue yield—along with the costs associated with it. For example, if the value of the end item sold to customers is low, retailers need to ask themselves whether the amount of revenue generated by the item (or its ingredients) is too low to warrant the amount of space it is allocated in the back room. The revenue generated by an item might not meet the targets set by management, for instance.

For a food-service retail store, there is an additional factor that should be considered in regard to profit margin per SKU: the distinction between (i) sellable items that go directly to the consumer's hands and (ii) the SKUs that are used in some combination to produce the former in the store. Hence, the profitability of an SKU is a function of the number of sellable items that incorporate it, the quantity of that SKU that is used in each item, and the complementarity between the SKU and other SKUs (that is, all the SKUs required for the sellable item must be available to produce it).

Importance of the item. The relative importance of items also needs to be considered when configuring a backroom space for a new or refurbished store or revamping an existing space. Some items—cups in a coffee shop, for example—are essential; the store can't deliver the product without them. Another reason for deeming an item essential is that it is a signature item that is being promoted by corporate. Other ingredients are less important because they are not an essential part of products, and therefore should be allocated less backroom space in a constrained environment.

Influence on profits
The way a retailer weighs these various factors and builds these weightings into the operation of a backroom can have a huge bearing on the profitability of the store. For example, a store might be making space-allocation decisions based only on the profit margin per item and the importance of the item but without considering the item's pack size. By failing to balance all three factors, the store could be creating an inefficient backroom operation that could inhibit its profitability.

The research on retail backroom performance described in this article was carried out in collaboration with a major U.S. food retailer. In addition to completing extensive desk research, the project team analyzed backroom operations in 126 stores around four large U.S. cities—Atlanta, Boston, Chicago, and New York City—and visited 20 outlets. The research sample was chosen to reflect different product mixes.

One of the many findings was that having smaller storable packs within an order pack can lead to better space utilization and increased profitability for the same amount of space utilized in the store. Store-level data from our industry partner revealed that reducing the storable pack size by 15 percent for 30 percent of the top-performing SKUs (that is, those that contribute the most to store revenue) increases profit per unit of refrigerated, freezer, and ambient equipment by 4 to 10 percent. Imagine the potential returns if every SKU in every store was analyzed in this way.

Rethinking backrooms in the omnichannel age
Allocating and managing backroom space is more complicated than it might first appear, and neglecting the factors that impact performance can exact a high price in terms of store profitability and service levels. There is also a price to pay in the upstream supply chain. For example, supplier delivery schedules based on flawed store ordering practices can increase costs and exacerbate customer service issues.

As part of our research with the food-service provider, we have developed a tool that helps retailers to understand the impact of factors such as pack size on inventory levels and a store's ability to meet customer demand. The tool enables retailers to create a database of the factors that are critical to the performance of backrooms and to analyze those factors in relation to store profitability. It can be used to evaluate existing backrooms and to integrate the optimum allocation of backroom space into the design of new outlets.

The models we have developed are now being extended to include a more sophisticated valuation of front-room spaces. The idea is to help retailers capture the trade-offs between allocating backroom and front-room square footage and to achieve the optimum balance between the two.

Looking ahead, the need to rethink approaches to backroom strategies is more urgent than ever, as new retailing models such as the use of stores to fulfill online orders increase in importance. Typically, backroom spaces in retail stores have been perceived as places for "overflow inventory." In the emerging competitive environment, however, this approach is no longer tenable, and it is important to recognize the untapped opportunities of the space.

More research is needed on how backroom formats and management practices impact the upstream supply chain. Also, the retail industry needs to explore new, innovative back-of-store configurations, such as the concept of multiple stores sharing a hub backroom space.

Meanwhile, retailers can improve the performance—and hence profitability—of their outlets by recognizing that backroom spaces represent a critical link in the retail supply chain rather than an appendage to front-of-store spaces.

1 M. G. Sternbeck and H. Kuhn, "An integrative approach to determine store delivery patterns in grocery retailing,"Transportation Research Part E: Logistics and Transportation Review, 70 (2014): 205-224.
2 T. Gruen and D. Corsten, "Rising to the challenge of out-of-stocks," ECR Journal, 2 no. 2 (2002): 45-58.

Chris Caplice is the Executive Director of the Massachusetts Institute of Technology (MIT) Center for Transportation & Logistics and the founder and director of the MIT FreightLab. Lita Das is Research Assistant and Ph.D. candidate, MIT Center for Transportation & Logistics.