Retail Financial Objectives and Strategic Profit Model

Learning Objectives

• The strategic objectives of a retail firm are reviewed
• Two paths to financial performance are contrasted using the strategic profit model
• The strategic profit model is used to analyze growth opportunities
• The measures retailers use to assess their performance are reviewed

Questions of Focus

• How a retail strategy is reflected in retailers' financial objectives
• How retailers need to evaluate their performance
• What the strategic profit model is and how it's used
• What measures retailers use to assess their performance

Retailer Objectives

• Financial objectives are primarily focused on return on investment (ROI) rather than profits alone.
• Societal objectives involve contributing to the betterment of the world.
• Personal objectives encompass self-gratification, status, and respect.

Strategic Profit Model

• It outlines the tradeoff between margin management and asset (inventory) management
• It reflects the profits generated from each dollar of sales
• Asset turnover assesses the productivity of a firm's investment in its assets

Components of the Strategic Profit Model

• Net profit margin is calculated by dividing net profit after taxes by net sales
• Asset turnover is calculated by dividing net sales by total assets
• Return on assets is found by multiplying net profit margin by asset turnover

Strategic Profit Model: Profit Management

• Sales = 100, Cost of Goods Sold = 60, Gross Margin = 40, Total Expenses = 25, Net Profit = 15, Net Profit Margin = 15%

Strategic Profit Model: Asset Management

• Sales = 100, Current Assets = 10, Fixed Assets = 30, Total Assets= 40, Inventory = 5, Accounts Receivable = 4, Other Current Assets = 1, Asset Turnover = 2.5

Strategic Profit Model: Return on Assets

• Sales = 100, Cost of Goods Sold = 60, Gross Margin= 40, Total Expenses = 25, Net Profit = 15, Net Profit Margin = 15%, Total Assets = 40, Asset Turnover = 2.5, Return on Assets = 37.5%

Financial Implications of Strategies

• La Chatelaine Bakery: Net Profit Margin is 1%, Asset Turnover is 10 times, Return on Assets is 10%
• Lehring Jewelry: Net Profit Margin is 10%, Asset Turnover is 1 time, Return on Assets is 10%

Income Statements

• The income statement for Nordstrom (FY 1/30/2016) shows net sales of $14,437 million and a net profit margin of $600 million
• The income statement for Walmart (FY 1/31/2016) shows net sales of $482,130 million and a net profit margin of $14,694 million
• Income statements for Macy's and Costco are also shown
• Profit Management Path of Strategic Profit Model and Income Statement Analysis of Gifts To Go Growth Opportunities are shown

Margin Management Definition

• Net Sales = Gross Sales + Promotional Allowances - Return
• Cost of Good Sold (COGs)
• Gross Margin (GM) = Net Sales - COGs
• Expense can be either Variable (e.g.. sales commissions) or Fixed (rent, depreciation, staff salaries)
• Net Profit = Net Sales – COGS - Expenses

Components of Gross Margin

• Gross Margin (Gross Profit) is the profit made on merchandise sales without considering the operating expenses and corporate overhead expenses

Maintaining/Increasing Margins

• Paying a lower price to vendor
• Charging customers a higher price
• Reducing price competition via exclusive merchandise or brand variants
• Lowering retailer costs through Direct Product Profitability (DPP) and Activity Based Costing, including floor ready merchandise, vendor source tagging, and optimized packaging/shipping/display

Gross Margin

• It is calculated as Gross Margin / Net Sales
• Macy's: $10,773 / $15,630 = 39.9%
• Costco: $7,406 / $60,151 = 12.3%

Operating Expenses

• It is equal to Selling, general and administrative expenses (SG&A) + depreciation + amortization of assets
• It includes costs other than the cost of merchandise
• It is calculated as Operating Expenses / Net Sales
• Macy's: $8,937 / $26,970 = 33.1%
• Costco: $5,781 / $60,151 = 9.6%

Types of Retail Operating Expenses

• Selling expenses includes Sales staff salaries + Commissions + Benefits
• General expenses includes Rent + Utilities + Miscellaneous expenses
• Administrative expenses include Salaries of all employees other than salespeople + Operations of buying offices + Other administrative expenses

Net Operating Income

• It is calculated as Gross Margin – Operating Expenses / Net Sales
• Macy's: $10,773 – 8,937 / $26,970 = 6.81%
• Costco: $7,406 - $5,781 / $60,151 = 2.70%

Net Profit (after taxes)

• Calculated as Net Profit = Gross Margin – Operating Expenses – Net Interest - Taxes
• Net profit after taxes is equal to Net Profit % after taxes / Net sales
• Macy's: $995/$26,970 = 3.70%
• Costco: $1,103/$60,151 = 1.83%

Asset Management

• Assets are Economic Resources (e.g., inventory, buildings, computers, store fixtures) owned or controlled by a firm, and may either be Current Assets or Fixed Assets
• Current Assets = Inventory + Cash + Account Receivable
• Fixed Assets = Fixture, Stores (owned)
• Asset Turnover = Sales/Total Assets
• Inventory Turnover = COGS/Avg. Inventory (cost)

Asset Information from Macy's and Costco's Balance Sheet

• Inventory turnover, asset turnover, and ROA are shown
• Macy's: Accounts receivable $ 517, Merchandise inventory is $5,317, Asset turnover is 0.91
• Costco: Accounts receivable $565, Merchandise inventory is $4,569, Asset turnover is 3.44

Inventory Turnover

• It measures the productivity of inventory and evaluates how effectively retailers utilize their investment in inventory
• Demonstrates how many times, on average, inventory cycles through the store during a specific period of time (usually a year)
• Inventory Turnover = COGS/avg inventory (cost) or Sales/ avg inventory (retail)

Importance of stock turnover rate

• It differs by industry and product categories
• Most retailers that are having problems achieving adequate profits have a poor Inventory Turnover Rate; example Kmart vs. Wal-Mart
• Inventory Turnover Rate for Three Retailers in 2000 is shown for Wal-Mart Stores, Target Corporation, and K-Mart
• Inventory Turnover of Apparel Retailers: Zara has apparel retailers that are three times times faster Saks Fifth Avenue or Abercrombie & Fitch and 1.5 times faster than H&M

Inventory Turnover Calculations

• Macy's: $16,197/$5,317 = 3.04
• Costco: $52,746/$4,569 = 11.54
• How Retailers increase inventory turnover
• Increase Sales
• Decrease Inventory

Turnover Efficiency

• It's important to have an efficient turnover rate; not so slow that things seem stale and shopworn, but not so fast that the floor looks half-empty

Asset Turnover

• Net Sales / Total Assets
• Macy's: $26,970/$29,550 = 0.91
• Costco: $60,151/$17,494 = 3.44

Return on Assets

• Net Profit Margin x Asset Turnover
• Macy's: 3.70% x 0.95 = 3.37%
• Costco: 1.80% x 3.44 = 6.19%
• It is a very important performance measure because it shows how much money the retailer is making on its investment

Evaluation of Financial Path

• Macy's and Costco have divergent financial paths: Macy's has a higher net profit margin, while Costco has higher asset turnover
• Retailers (and investors) need to consider both net profit margin and asset turnover when evaluating financial performance
• Strategic decisions impact components of the strategic fit model: increasing prices leads to higher gross margin and net profit margin, and lower sales and asset turnover

Strategic Profit Model Ratios for Selected Retailers

• Net Profit Margin (%), Asset Turnover, Return on Assets (%) for various retailers are given

Setting and Measuring Performance Objectives

• Retailers will be better able to gauge performance if specific objectives are kept in mind to compare performance
• Numerical index of performance desired, a time frame for performance, and necessary resources to achieve objectives should be included

Setting Objectives

• Top-down planning begins with corporate developmental strategy, then moves to category, departments and sales associates implement strategy
• Bottom-up planning starts with buyers and store managers estimating what they can achieve and moves up to operation managers with corporate level

Productivity Measures

• Input Measures assess the amount of resources or money used by the retailer to achieve outputs such as sales
• Output measures assess the results of a retailer's investment decisions
• A productivity measure determines how effectively retailers use their resources to yield what profit they get on their investments

Financial Performance

• Outputs (performance) includes sales, profits, cash flow, growth in sales/profits, and same store sales growth
• Inputs Used by Retailers includes inventory ($), real estate (sq. ft), employees (#), overhead (corporate staff and expenses), advertising, energy costs, and MIS expenses

Productivity: Outputs/Input

• ROA = Profits/Assets and comparable store sales growth are Corporate Level calculations
• Gross Margin % = Gross Margin/Sales, Inv Turnover = COGS/ Avg. Inventory (cost), GMROI = Gross Margin/Average Inventory, and Advertising as % of sales are Buyer factors
• Sales/Square Feet, Sales/Employee, Inventory Shrinkage/sales, Average Transaction (sales/# of transactions), Items Per Ticket (total items sold/total transactions), and Conversion Rate (total transactions/total traffic) are Store variables

Examples of Performance Measures Used by Retailers

• Performance Measures are used by Retailers and vary with the Organization Level
• They include Outputs, Inputs, and Productivity calculations

Evaluating Financial Performance

• Financial performance can be evaluated by Growth in Stockholder Value via Stock Price, Accounting Measures like ROA (Risk adjusted), using benchmarks, Improvement Over Time, or Performance Relative to Comparable Firms
• Compares performance indicator for three years and compares performance indicators with major competitors for one year

Sources of Information

• Balance Sheet (Snap Shot at One Time) which is for Asset Management
• Income Statement (Summary Over Time) which is for Margin Management
• Annual Reports/ SEC Filings

Financial Performance

• Macy's and Costco's Financial Performance Over Three Years is given from 2004 to 2006 with values for Gross Margin %, Operating expenses %, Net profit %, Asset turnover, ROA, Inventory turnover, Sales per employee, Sales per square foot, Growth in same-store sales

Financial Performance of Macy's

• Financial Performance of Macy's and Other National Department Store Chains including JCPenney, Sears, Dillard's, Nordstrom, Kohl's has also been tabulated

Evaluating Investment Opportunities

• ROI - Discounted Cash Flow takes the time value of money and cost of capital into account
• ROI - Breakeven Analysis determines how much needs to be sold to breakeven (recover investment)

Income Statement

• Using an example income statment where Net Sales = $1,000,000, COGs were $800,000 (80%), Gross Margin was $200,000 (20%), Operating Expenses had Variable expense of $100,000 (10%) and Fixed Expenses of $80,000 (8%) leaving a Profit of $20,000 (2%)

Variable and Fixed Operating Expenses

• Includes Wages and Salaries with Rent and Maintenance

Break Even Analysis

• Profit = Sales - COGS-Var Cost - Fixed Cost
• 0 = Sales - COGs% x Sales - VC% x Sales - FC
• Break-even Sales x (1-COGS% -VC%) = FC
• Break-even Sales = FC/(1-COGS% -VC%)
• Break-even Sales = FC/(GM%-VC%)
• An example with $80,000/(.2-.1) = $800,000 has been evaluated by making a few business decision and their effect.
• Fixed cost of $30,000 + $80,000 = $1,100,000
• Retailer Drops price by 5% new break-even = $1,600,000
• Retail desires a profit of $100,000, break-even $1,800,000