Retail Dilemma: Quality Over Price?

Retailers may have to decide whether to lower the quality of their products or take a hit to margins as sourcing costs increase.
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NEW YORK (

TheStreet

) --

Retail sourcing costs

may be grabbing the headlines, but the impact of labor shortages on the quality of merchandise may trump rising prices as a growing concern.

Wall Street is, naturally, focused on the numbers -- how much will higher prices eat into retailers' bottom lines? But the average shopper doesn't know or care

how much it costs for retailers to get the merchandise onto the shelves

. They are concerned about the product. More than ever before, consumers are assessing a product's design, uniqueness and quality, while simultaneously evaluating what will give them the most bang for their buck.

Those retailers that were late in diversifying their sourcing out of China may find that quality, on-time delivery and production are at risk. This outweighs the threat of any cost increases, according to UBS analysts.

5 Retail Stocks That Can Withstand Rising Costs >>

China, which accounts for the crux of retail manufacturing, is seeing fewer people entering the labor force as its economy grows. There is also a shrinking surplus in workers due to years of the "one child only" rule. Phoenix Institutional Equities analyst Robert Samuels is hearing that the new class of factory workers along China's coast is not willing to put in overtime hours as their parents once did.

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On top of this, China is experiencing wage hikes. Currently, the average Chinese worker earns $3,900 a year, up from $1,900 in 2009 and $1,000 in 2000, according to Credit Suisse.

Retailers that failed to anticipate the labor issues in China are now scrambling to shift production out of the country, into markets like the Middle East and Latin America. But a majority of the more desirable locations are at, or over, capacity.

These countries tend to be significantly less developed than China and maintaining quality standards and guaranteeing delivery could be very difficult, UBS warns. In fact, many retailers could face issues receiving 100% of their fourth-quarter orders.

Anecdotally, UBS analysts have heard of order cancellations in Bangladesh because of quality concerns, significant price increases, over-capacity and delivery issues, none of which bodes well for other tertiary Asian countries.

Regardless, retailers that are set on maintaining margins may end up having to source from these less reliable regions where delivery could be an issue. "We have heard that specialty retailers went from accepting cost increases fairly easily a month ago to now playing hard-ball and focusing on maintaining margins, even at the risk of quality and delivery standards," UBS wrote.

Ultimately, retailers' remedies for mitigating costs will likely translate into lower quality. While some companies like

Children's Place

(PLCE) - Get Report

and

Buckle

(BKE) - Get Report

have said they will increase prices on select items, pushing costs off to the shoppers isn't a viable option for most, especially given stubbornly low consumer-confidence levels.

Abercrombie & Fitch

(ANF) - Get Report

, for one, has admitted that it plans to remove the bells and whistles from some of its merchandise to cut costs. Management at most companies won't openly confess they are lowering quality and sacrificing style for cost.

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"In some instances, consumers may not notice until they've washed the garment several times. In others, consumers won't be fooled and may refrain from purchasing, which will lead to mark-downs well beyond the product cost savings," UBS wrote. "Longer-term, it could also destroy the brand or at least be disruptive to brand loyalty in the interim."

Those retailers catering to a lower-income demographic, like

Wal-Mart

(WMT) - Get Report

and

Dollar Tree

(DLTR) - Get Report

, have the best chance of customers' accepting lower quality. As low-price leaders, these discounters have the leverage to narrow the pricing gap with full-price retailers.

4 Retail Stock Losers: Victims of Rising Costs >>

Teen retailers like

Aeropostale

(ARO)

and

American Eagle Outfitters

(AEO) - Get Report

can also afford to reduce quality without offending shoppers, UBS said.

But higher-end retailers like

Saks

(SKS)

and

Nordstrom

(JWN) - Get Report

, as well as women's retailers like

AnnTaylor Stores

(ANN)

,

Chico's

(CHS) - Get Report

and

Coldwater Creek

(CWTR)

, will likely face criticism if they alter their price/value equation, according to the UBS report.

"We believe those retailers who want to keep a loyal customer and manage business for the longer term as well as manage vendor relations will be willing to take the hit to costs now," the analysts wrote.

-- Written by Jeanine Poggi in New York.

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Jeanine Poggi

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