With VAT set to rise retailers will struggle to absorb the increase, especially as other costs are rising. Some are already putting prices up to make January’s change less noticeable, Nicola Harrison discovers

If there is one thing retailers have become expert at in the last two years it is changing their price tags.

Store groups have dealt with two VAT changes since 2008 and are now preparing for a third, when VAT rises from 17.5% to 20% on January 4.

When VAT increased from 15% to 17.5% at the start of this year some retailers passed the increase on to customers while others chose to absorb it.

But things are different now. VAT is one of many cost increases retailers must contend with and the question this time is not if retailers will pass the VAT rise on, but how and when?

Some have started to increase prices already to “allow customers to adjust”, as one observer puts it, rather than slap on the increase in its entirety - which amounts to around a 2% price rise - in January.

Pass it on

One retail chief executive that operates in the home market says while his business was able to take most of this year’s VAT rise on the nose, it will not be able to in 2011.

“We tried to absorb the bulk of 2010’s VAT rise, but we can’t on this one,” he says. He has already started to push prices up to reflect the tax increase, although only on some items.

He contextualises the issue among other pressures facing retailers. “Retailers will struggle to absorb [the VAT rise],” he says. “We’re getting pressure from our suppliers asking for a price increase.” Shipping costs have risen and goods are taking longer to arrive because freight firms’ ships are travelling more slowly to save on fuel costs.

B&Q owner Kingfisher group chief executive Ian Cheshire said B&Q is “expecting to pass the VAT rise on”, and has begun putting prices up this month to change all the prices in time for January. “It’s simple logistics,” he said. “B&Q has 40,000 products.”

These retailers are not alone. Although few will stick their heads above the parapet, it is widely believed that many retailers are pushing up prices before January 4. As well as getting accustomed to higher prices, retailers also hope to gain a little extra margin in the Christmas period before the January Sales begin.

Verdict head of research Maureen Hinton says: “Retailers will be subtly putting prices up before Christmas to let consumers adjust to it. I don’t think it’s realistic to expect retailers to absorb the increase.

“They’ve been absorbing costs for three or four years now and more aggressively than in the past. It will be much more difficult for them to do that now.”

PricewaterhouseCoopers UK retail and consumer leader Mark Hudson says it makes “economic sense” to pass on the increase to customers, and notes that “prices are already going up to reflect rising costs”.

He adds: “[The rise] is right in the middle of the January Sales, new ranges will be coming in for the spring/summer period and will be priced according to higher costs and VAT, labour, and transport. Clever retailers will be introducing subtle price increases now so it doesn’t feel like there’s been a big step up next year.”

One report in September found that most major retailers are planning to increase prices due to the VAT increase. A survey of 30 retail bosses - including Marks & Spencer chairman Sir Stuart Rose, and Next chief executive Lord Wolfson - revealed that 60% expect to pass the majority of the VAT rise on to customers and that a further 17% will pass on at least part of it.

So if retailers are already putting prices up, how are they doing it? The home sector chief executive says a variety of factors come into play.

He explains: “In some cases we will put the prices up, and in some cases we won’t because of the rationalisation of our supplier base, and the large volumes we’re selling. We’re expecting suppliers to help us.”

Although some prices had been increased already, he says the majority will go up in the new year. “We’ll try not to put prices up until we’ve got our January Sale out of the way, but we’ll be looking at our margin as the weeks go by,” he says.

Hudson believes most retailers will aim to raise the prices of their better and best lines. “The opening price points will change too, but you have less flexibility,” he says. “You can either reduce the quality and keep the price the same, or take a deep breath and increase the price points. You might move one thing from £3 to £4 and hold others at £3. People are operating on lean businesses - there is very little wiggle room.”

Gus Ormond, director at strategy and marketing consultant Simon-Kucher & Partners, says retailers “need to have a sense of which products are more price-sensitive and where they have room for manoeuvre”. He suggests putting up prices accordingly and highlighting where prices have remained the same.

Hudson says retailers will also re-engineer product to achieve the same margin at the same price point. This means in some cases reducing the quality of the product, or the size - a strategy that will be used by single price point retailers such as Poundland.

However, the VAT rise also offers the opportunity to up the prices while increasing the quality of the product.

Booz & Co principal Jason Gordon says: “Fashion is one sector that has already begun putting prices up. But you need to be quite careful for frequently bought products. Rather than making it about pricing, change the nature of the product, use better fabric, or buttons. The key is not allowing customers to compare apples with apples.”

Some furniture retailers are using the timing of the tax change to their advantage with ‘Beat the VAT increase’ advertising to pull in shoppers early. Beds giant Dreams is among those using the tactic. Topps Tiles has said it will not put prices up immediately in the new year either.

One senior furniture retail executive says it is likely his business will hold prices until after the crucial January Sale period. “Everyone will be making noises about holding VAT - you’ve got to be in the game,” he maintains. “It would be silly not to for the sake of 2%.”

Steven Round, chief executive of hardware retailer Robert Dyas, said his business would be “trying to get through the January Sale period without putting the prices up”. Last month, DFS chairman Richard Baker said DFS is “not just going to stick all the prices up”.

Gordon predicts that for big ticket retailers, the first quarter of next year will “border on brutal” because, having likely pulled sales forward to the final quarter of this year there will be limited spend to battle for in early 2011.

Reputation

There is the issue of reputation to consider too. Retailers do not want to hit headlines, singled out for putting up prices if their rivals have held them for longer. “Some retailers won’t want to put prices up across the board, due to negative press,” says Ormond.

The January Sales could cause confusion among customers, who will not know if the prices have gone up or not. “They’ll be all sorts of messages in the Sale period - it will be very difficult to tell what’s going on,” says Hudson.

The home sector chief executive says he will not be communicating any messages about holding prices to concentrate on the January Sale message, which he says is “more important”.

So how will customers react to yet another rise in prices, on top of energy, food and transport costs?

The initial response seems to be confusion. According to a report produced by Simon-Kucher & Partners, while 89% of consumers were aware of the VAT rise, only 53% knew when it would happen.

And more than 85% overestimated the real price increase, while a quarter of respondents wrongly guessing that a £5 product will increase to £6. The real increase would be to £5.11, but just 15% of respondents estimated that correctly. On average, respondents thought the price would rise to £5.52.

Smarter shopping

Hudson describes the UK consumer as a “very smart animal” that “adapts to changing circumstances”. He cites the example of 2008 when Lehman Brothers collapsed and consumer confidence plummeted.

“There was smarter shopping, using promotions and special offers, trialling more own-label and going to lower priced stores,” he says. He expects that pattern of behaviour to continue and points out that consumers “won’t increase the proportion of money they spend on retail”, versus outgoings such as phone bills, energy and rent.

The senior furniture executive says: “I don’t think the impact on the consumer will be huge. It’s just another brick they’ll have to carry.”

Hudson says retail volumes, which remained robust throughout the recession as prices continued to drop, will now start to fall as prices creep up. “Retailers will have to put prices up, and fewer units will be sold, so we’ll see a drop off in volume,” he explains.

Some retailers may use the VAT rise to their advantage, says Ormond. “It’s a one-off opportunity to reposition pricing,” he says. “But retailers shouldn’t move too aggressively.”

The chief executive of the home goods retailer believes that “aggressive competition will keep prices low”. Gordon adds: “Some will choose to undercut the opposition.” That may be the case, but in the value sector there is little room for manoeuvre. “Value retailers will be hit harder as they have less margin to play with,” says Hudson.

Primark, arguably the king of the value field, has indicated that it will do all it can to retain its position of price leadership. Last month, John Bason, finance director of Primark-parent Associated British Foods, said: “Primark is going to remain the best value on the high street, absolutely - that’s what Primark is about.”

However, New Look chief executive Carl McPhail said last month that rising costs including increases in cotton prices and freight charges, and the increase in VAT, will lead to price hikes in the new year likely to be at the top end of the 5% to 8% largely forecast for fashion retail.

And home shopping group Shop Direct chief executive Mark Newton-Jones said last week his firm would pass the VAT rise on to customers in the new year.

Hinton believes that because most retailers will have to pass the rise on eventually, those that have relied on price will have to find other ways of standing out from the competition - better product, service and store environment, for example.

Retailers could see the VAT rise as an opportunity to realign pricing, up their game and use it as a tool to draw in shoppers before January 4. As Gordon says: “This is not an Armageddon moment. Retailers are very resilient. They are pretty good at evolving.”

And they are also very good at changing price tags.

Shoppers attempt to beat the VAT rise

Retailers including DFS, John Lewis and Argos are expecting a spike in sales in the run-up to Christmas as shoppers try to beat the VAT increase.

According to research conducted by the Centre for Retail Research for Mydeco.com, 39% of consumers are planning to make a major purchase before January 4.

It found that 37% of people plan to make purchases in electronics, 27% in furniture, 17% in appliances and 14% are planning to buy a new kitchen.

DFS has brought forward its Sale to capitalise on the demand. A DFS spokesperson said the VAT hike “may well be on people’s minds”, adding: “In the circumstances we felt it appropriate to do it now.”

A spokesperson for Home Retail Group, owner of Argos, said: “We are preparing in both Argos and Homebase stores for the VAT rise, and do expect a short spike in demand for higher ticket items in advance of the change.”

A John Lewis spokesperson said it expects sales on big-ticket items to increase, particularly on TVs, computers, household appliances, and furniture, before VAT increases to 20% next year.