As we move into the Fall and into Joint Business Planning Season, whether you’re working for a retailer or a vendor, think about how the decisions or recommendations that you make influence the retailer’s financial statement.
Not sure? That’s what this article is about. This perspective can help you make better decisions and recommendations by better understanding what the retailer is trying to accomplish from a big picture perspective — their financial statement. In every business there is never ending number crunching going on, and the retail business is no different. The financial analysts have to look at the numbers from every angle to ensure on-going profitability, using their income statements, or sometimes referred to as
P&L statements. One of the retailer’s financial statements is the Income Statement. Income statements may come with various terms (e.g. “statement of income,” “statement of earnings,” “statement of operations”). In addition, the terms “profits,” “earnings” and “income” all mean the same thing and are used interchangeably. The income statement shows how much money the company generated (revenue or sales), how much it spent (or expenses) and the difference between the two (or profit) over a certain time period.
Retail Income Statement
The first line of the statement — sales — is generally the most straightforward part of the income statement. Often, there is just a single number that represents all the money a company brought in during a specific time period (big companies sometimes break down revenue by business segment or geography).
The next line is the cost of goods sold, which is the expense most directly involved in creating revenue. It represents the costs of producing or purchasing the goods or services sold by the company.
The third line is gross profit, where retailers turn as an indication of the sales dollars remaining after subtracting the costs of goods. To calculate gross margin, the gross profit from the income statement is divided by the business’ net sales, also found on the income statement. The higher the number, the better.
When you consider these three lines of a retailer income statement, think about how your category management team can influence net margin within your categories. You can either increase sales or decrease cost of goods sold (you may have limited influence in decreasing operating expenses). Obviously, category management is not the only department responsible for the results on the income statement, but for the purposes of this article, we will focus on their responsibilities and how they influence sales and cost of goods sold.
How Category Managers Influence Sales
The overall responsibility of the category manager is to optimize sales for a particular group of products (categories). The primary responsibilities of a category manager and their team include 1) category management process and analysis responsibilities (including assortment, space, pricing and promotion); and 2) negotiations, over and above tradespend and logistics.
When a category manager is looking at the business from a sales perspective, they usually look at two key performance indicators, or KPIs. First, they want to understand how sales are performing compared to prior period, which is usually a year ago. They can look at absolute dollar change or per cent change versus year ago. Next, they want to know how sales are performing versus their targets or budgets for the fiscal year.
Category managers can influence sales through changes they implement through the “Four P’s”, or the tactics. And there are different measures that category managers look at across the tactics to understand the key drivers of their business.
Something else that influences sales is “other income” captured by the retailer. This can include over and above spending by vendors. Some vendors will offer deals and allowances based on ad space, promotional activity, or buying deals. For retailers who have “dead net” pricing, the over and above spending may be allocated directly to price and would be included in the cost of goods sold calculations, versus in other income. “Other income” can also include cash discounts that are paid by vendors if the terms are met when paying invoices within a specific amount of time.
Shrink is the difference in dollars, between the amount of inventory in the system, and the actual physical inventory count. It is subtracted from the sales in the retailer’s income statement. Shrinkage is primarily the result of spoilage, which can be influenced by poor forecasting or planning or excessive inventory, which is the responsibility of the category management team. It can also be driven by theft or by accounting issues.
How Category Managers Influence Cost of Goods Sold
Cost of goods sold is the second line on the statement, and, in general terms, is the cost of the merchandise that was sold to customers. This figure not only tells the dollar amount of the cost of the items that have been sold, but it is also subtracted from the net sales to arrive at gross profit. Many retailers develop strategies to reduce total cost of goods sold, which will ultimately build their gross margins. This calculation gives the total amount of inventory or, more specifically, the cost of this inventory, sold by the company during the period.
Category managers can influence the cost of goods sold by 1) influencing gross profit; and 2) focusing on inventory management, through effective product supply. Gross profit can be influenced by pricing strategies (because retail price obviously plays a significant role in how much volume and profit are generated in a category) and promotional strategies (associated with temporary price reductions on promotions). The common variables across each of gross margin, markup and markdown, and temporary price reductions is unit cost and retail price. Category managers can affect gross margin dollars by reducing the unit cost, or by increasing the retail price.
Here are some activities that can accomplish this:
• Reduce item cost
• Dead net pricing
• Clearout items
• Price increases by Vendors
• Deal pricing (floor stock protection)
• Price increases / decreases by Retailer
Based on this, vendor negotiations play a significant role for both category managers and have a direct impact on a retailer’s gross profit. Much time is spent planning, both for the retailer and vendor, to create business plans that will help them to achieve their overall company objectives. Then, through retailer and vendor negotiations, an agreement is made on volume targets, O&A deals, product cost and terms and payment terms that will collectively affect the “other income” and “cost of goods sold” lines in the retailer’s income statement. The objective of the negotiations is to come up with a joint business plan that helps both companies to achieve their overall goals.
Something else that is not included on the income statement, but is recorded as part of the financial reporting for the retailer, is the retailer’s balance sheet. It includes a “current asset section” called merchandise inventory. This asset consists of goods the company owns on the balance sheet date and holds for the purpose of selling to its customers. The merchandise inventory line is the costs incurred to buy the goods, ship them to the store, and otherwise make them ready for the sale. This is mentioned because category management teams are responsible for managing inventory within their categories. If a retailer’s assets are tied up in high amounts of inventory, it restricts other more productive investments. It’s important to understand how the decisions or recommendations that you make within or to a retailer influence their income statement. Understanding all of the “retail math” measures and associating them with the decisions that you make will help.