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Retail Management: A Strategic Approach

Thirteenth Edition

Chapter 12

Operations Management: Financial Dimensions

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Learning Objectives

12.1 To define operations management

12.2 To discuss profit planning

12.3 To describe asset management, including the strategic profit model, other key business ratios, and financial trends in retailing

12.4 To look at retail budgeting

12.5 To examine resource allocation

Operations Management

Operations management involves the efficient and effective implementation of the policies and tasks necessary to satisfy the firm’s customers, employees, and management (and stockholders, if a public company).

This has a major impacon both sales and profits.

This chapter covers the financial aspects of operations management, with emphasis on profit planning, asset management, budgeting, and resource allocation.

Profit Planning

Profit-and-loss (income) statement

Summary of a retailer’s revenues and expenses over a given period of time

Review of overall and specific revenues and costs for similar periods and profitability

A profit-and-loss (income) statement is a summary of a retailer’s revenues and expenses over a given period of time, usually a month, quarter, or year.

It enables the retailer to review its overall and specific revenues and costs for similar periods, as well as analyze profitability.

In comparing profit-and-loss performance over time, it is crucial that the same time periods be used due to seasonality.

Major Components of a Profit-and-Loss Statement—Donna’s Gift Shop 2016

Net Sales

Cost of Goods Sold

Gross Profit (Margin)

Operating Expenses

Taxes

Net Profit After Taxes

Net Sales	$330,000
CGS	$180,000
Gross Profit	$150,000
Operating Expenses	$ 95,250
Other Costs	$ 20,000
Total Costs	$115,250
Net Profit before Taxes	$ 34,750
Taxes	$ 15,500
Net Profit after Taxes	$ 19,250

A profit-and-loss statement consists of these major components:

Net sales—the revenues received by a retailer during a given period after deducting customer returns, markdowns, and employee discounts.

Cost of goods sold—the amount a retailer pays to acquire the merchandise sold during a given time period.

Gross profit (margin)—the difference between net sales and the cost of goods sold.

Operating expenses—the cost of running a retail business.

Taxes—the portion of revenues turned over to the federal, state, and/or local government.

Net profit after taxes—the profit earned after all costs and taxes have been deducted.

Table 12-1 (this slide) shows an annual profit-and-loss statement for Donna’s Gift Shop, an independent retailer.

The firm uses a fiscal year (September 1 to August 31) rather than a calendar year in preparing its accounting reports. These observations can be drawn from the table: ▶▶ Annual net sales were $330,000—after deducting returns, markdowns on the items sold, and employee discounts from total sales. ▶▶ The cost of goods sold was $180,000, computed by taking the total purchases for merchandise sold, adding freight, and subtracting quantity, cash, and promotion discounts.

Gross profit was $150,000, calculated by subtracting the cost of goods sold from net sales. This went for operating and other expenses, taxes, and profit. ▶▶ Operating expenses totaled $95,250, including salaries, advertising, supplies, shipping, insurance, maintenance, and other expenses. ▶▶ Unassigned costs were $20,000. ▶▶ Net profit before taxes was $34,750, computed by deducting total costs from gross profit. The tax bill was $15,500, leaving a net profit after taxes of $19,250. Overall, fiscal 2016 was pretty good for Donna; her personal salary was $43,000 and the store’s after-tax profit was $19,250.

Percent Profit & Loss Statement: Donna’s Gift Shop 2016

Net sales

Cost of Goods Sold

Gross Profit

Operating Expenses

Net profit Before tax

Net Sales	100.0
CGS	54.5
Gross Profit	45.5
Operating Expenses	28.9
Other Costs	6.1
Total Costs	34.9
Net Profit before Taxes	10.5
Taxes	4.7
Net Profit after Taxes	5.8

Asset Management

The Balance Sheet

Assets

Liabilities

Net Worth

Net Profit Margin

Asset Turnover

Return on Assets

Financial Leverage

Each retailer has assets to manage and liabilities to control.

A balance sheet itemizes a retailer’s assets, liabilities, and net worth at a specific time. Table 12-2 has a balance sheet for Donna’s Gift Shop.

Assets are any items a retailer owns with a monetary value.

Current assets are cash on hand and items readily converted to cash, such as inventory on hand and accounts receivable.

Fixed assets are property, buildings (a retail store, warehouse, etc.), fixtures, and equipment; they are used for a long period of time.

Fixed assets are recorded at cost less accumulated depreciation.

Hidden assets are reflected on a retailer’s balance sheet at low values relative to their actual worth.

Liabilities are financial obligations a retailer incurs in operating a business.

Current liabilities are payroll expenses payable, taxes payable, accounts payable, and short-term loans; these obligations must be paid in the coming year.

Fixed liabilities comprise mortgages and long-term loans; these are generally repaid over several years.

A retailer’s net worth is computed as its assets minus its liabilities. It is also called owner’s equity and represents the value of a business after deducting all financial obligations.

Net profit margin is a performance measure based on a retailer’s net profit and net sales: Net profit margin = Net profit after taxes/Net sales.

Asset turnover is a performance measure based on a retailer’s net sales and total assets: Asset turnover = Net sales/Total assets.

Table 12.2 A Retail Balance Sheet for Donna’s Gift Shop (as of August 31,2016)

Assets	Blank	Liabilities	Blank
Current	Blank	Current	Blank
Cash on hand	$ 19,950	Payroll expenses payable	$ 6,000
Inventory	36,150	Taxes payable	13,500
Accounts receivable	1,650	Accounts payable	32,100
Total	$ 57,750	Short-term loan	1,050
Blank	Blank	Total	$ 52,650
Fixed(present value)	Blank	Blank	Blank
Property	$ 187,500	Fixed	Blank
Building	63,000	Mortgage	$ 97,500
Store fixtures	14,550	Long-term loan	6,750
Equipment	2,550	Total	$ 104,250
Total	$ 267,600	Total liabilities	$ 156,900
Total assets	$ 325,350	Blank	Blank
Blank	Blank	Net Worth	$ 168,450
Blank	Blank	Liabilities+ net worth	$ 325,350

Asset turnover is a performance measure based on a retailer’s net sales and total assets: Asset turnover = Net sales/Total assets.

Return on assets can be computed by looking at the relationship between net profit margin and asset turnover:

Return on = Net profit after taxes X Net sales

assets Net sales Total assets

= Net profit after taxes

Total assets

Financial leverage is a performance measure based on the relationship between a retailer’s total assets and net worth: Financial leverage = Total assets/Net worth.

Figure 12.1 The Strategic Profit Model

The relationship among net profit margin, asset turnover, and financial leverage is expressed by the strategic profit model, which reflects a performance measure known as return on net worth. See Figure 12-1.

According to the strategic profit model, a retailer can raise its return on net worth by lifting the net profit margin, asset turnover, or financial leverage.

Return on = Net profit after taxes X Net sales X Total assets

net worth Net sales Total assets Net worth

Table 12-3 applies the strategic profit model to various retailers.

In evaluating the data, it is best to make comparisons among firms within given retail categories. The individual components of the strategic profit model must be analyzed, not just the return on net worth.

This is how the strategic profit model can be applied to Donna’s Gift Shop: Return on net worth = Net profit after taxes Net sales * Net sales Total assets * Total assets Net worth = +19,250 +330,000 * +330,000 +325,350 * +325,350 +168,450 = 0.0583 * 1.0143 * 1.9314 = 0.1142 = 11.4,

Increasing Profit Margins

Increase sales of private label brands

Centralize buying to increase bargaining power

Reduce SKUs in each category to increase bargaining power

Reduce operating expenses via self-service operations, and through “buy on line, pick up in-store” to reduce delivery costs

Increase Web sales

Reduce labor expenses through increased use of part-time help, better scheduling

Increasing Asset Turnover

24/7 operations

Outsource delivery and credit operations

Lease instead of own assets (virtual corporation owns few assets)

Reduce inventory levels through quick response, through reducing product proliferation, and through drop shipping

Utilize second-use locations to reduce store renovation expenses

Utilize inexpensive fixtures—pipe rack, cut case displays

Other Key Business Ratios

Quick ratio—cash plus accounts receivable divided by total current liabilities (due within one year).

Current ratio—total current assets (including inventory) divided by total current liabilities.

Collection period—accounts receivable divided by net sales and then multiplied by 365. (Aging accounts receivable).

Accounts payable to net sales—accounts payable divided by annual net sales.

Overall gross profit—net sales minus the cost of goods sold and then divided by net sales.

▶▶ Quick ratio: Cash plus accounts receivable divided by total current liabilities, those due within one year. A ratio above 1-to-1 means the firm is liquid and can cover short-term debt.

▶▶ Current ratio: Total current assets (cash, accounts receivable, inventories, and marketable securities) divided by total current liabilities. A ratio of 2-to-1 or more is good.

▶▶ Collection period: Accounts receivable divided by net sales and then multiplied by 365. If most sales are on credit, a collection period one-third or more over normal terms (such as 40.0 for a store with 30-day credit terms) means slow-turning receivables.

▶▶ Accounts payable to net sales: Accounts payable divided by annual net sales. This compares how a retailer pays suppliers relative to volume transacted. A figure above the industry average indicates that a firm relies on suppliers to finance operations.

▶▶ Overall gross profit: Net sales minus the cost of goods sold and then divided by net sales. This companywide average includes markdowns, discounts, and shortages.

Financial Trends in Retailing

Slow growth in U.S. economy

Cautious discretionary spending

Increased retailer spending on information technology

Funding sources

Mergers, consolidations, spinoffs

Bankruptcies and liquidations

Questionable accounting and financial reporting practices

The state of the U.S. economy.

During a strong economy, high consumer demand may mask retailer weaknesses.

When the economy is weak or sluggish growth, the following can result:

Stagnant sales.

4. Cash flow problems.

The need for heavy markdowns.

Consumers’ reluctance to purchase big-ticket items.

Depressed stock prices.

Walmart Acquires Jet.com for $3B

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2:50 minutes

Is Walmart's Deal to Jet.com for $3B a 'Desperate Move'?

Bloomberg

Published on Aug 8, 2016

Aug. 8 -- Wal-Mart Stores Inc. agreed to buy e-commerce startup Jet.com Inc. for about $3 billion in cash, giving the world’s largest retailer the resources for a stronger shopping website to compete with Amazon.com Inc., the online market leader. Bloomberg's Jeffrey McCracken reports on "Bloomberg ‹GO›."

Funding Sources

Mortgage refinance (due to low interest rates)

REIT (retail-estate investment trust) to fund construction

Company dedicated to owning and operating income-producing real estate

Initial public offering (IPO)

Many companies have refinanced their mortgages and leases due to low interest rates. This can dramatically decrease monthly interest payments. Retailers in strong positions have retained some leverage. Shopping center developers often use a retail real-estate investment trust (REIT) to fund construction. Investors buy shares in an REIT. The long-term forecast for REITs is good, as explained in the textbook. An initial public offering (IPO) allows a firm to raise money by selling stock. It typically funds expansion.

Angie’s List, Dunkin’ Brands, Groupon, and Zipcar are retailers that became public companies in 2011.

Bankruptcy and Liquidations

Bankruptcies allow retailers to safeguard themselves against mounting debts, as well as to continue in business.

With this protection, retailers can renegotiate bills, get out of leases, and work with creditors to plan for the future. Declaring bankruptcy has major ramifications. Sports Authority bankruptcy video

Liquidations firms ultimately go out of business

Bankruptcies and liquidations

Bankruptcies allow retailers to safeguard themselves against mounting debts, as well as to continue in business.

With this protection, retailers can renegotiate bills, get out of leases, and work with creditors to plan for the future. Declaring bankruptcy has major ramifications. A recent bankruptcy example is presented for food company Harry and David.

Liquidations are where firms ultimately go out of business.

The Demise of Sports Authority

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1:27 mins.

Sports Authority Is Bankrupt; How Did The Sports Retail Giant Fall? - Newsy

Published on Mar 2, 2016

Sports Authority announced it will close or sell 140 stores. It's rumored Dick's Sporting Goods could buy some of those locations. Transcript: Once a heavy-hitter in the sporting goods retail business, Sports Authority has fallen on tough times. The retailer filed for Chapter 11 bankruptcy on Wednesday and announced it will be forced to close or sell roughly 140 of its 450 stores nationwide. CEO Michael Foss said in a statement, "Due to the changing retail environment, we have a long-term plan to streamline and strengthen our business ... including upgrading our in store experience and enhancing our website.“ Some of those 140 stores could be sold to Dick's Sporting Goods, which has only grown while Sports Authority struggled. Bloomberg blames the Sports Authority's slump, in part, on missing the opportunity to "exploit the fitness boom.“ The outlet said, "As big-box giants and online merchants encroached on clothing stores and consumer electronics chains, sports were one of the few healthy areas." Sports Authority's been hounded by debt in recent years following its $1.3 billion acquisition by private equity firm Leonard Green & Partners. The bankruptcy filing isn't a total shock since the Englewood, Colorado-based company missed a $20 million interest payment in January.

Budgeting

Budgeting outlines a retailer’s planned expenditures for a given time based on expected performance.

Costs are linked to satisfying target market, employee, and management goals.

Figure 12.3 The Retail Budgeting Process

Preliminary Budgeting Decisions

Budgeting authority is specified.

Top-down budgeting places financial decisions with senior executives.

Bottom-up budgeting requires lower level executives to develop departmental budget requests.

The budgeting time frame is defined.

Most retailers have budgets with yearly, quarterly, and monthly components.

Retailers with large capital expenditures may have 5-year budgets; those with perishable goods may have weekly budgets.

Budgeting frequency is determined. Review of budgets can be ongoing, once a year, or several months in a year.

Benefits of Budgeting

Expenditures are related to expected performance.

Costs can be adjusted as goals are revised.

Resources are allocated to the right areas.

Spending is coordinated.

Planning is structured and integrated.

Cost standards are set.

Expenditures are monitored during a budget cycle.

Planned budgets versus actual budgets can be compared.

Costs/performance can be compared with industry averages.

Preliminary Budgeting Decisions

Specify budgeting authority

Define time frame

Determine budgeting frequency

Establish cost categories

Set level of detail

Prescribe budget flexibility

Cost Classifications

Capital expenditures—long term investments (can be leased, often depreciated

Fixed costs– constant over range of sales

Direct costs—can be traced to departments, stores, products

Natural account expenses—classified by name such as salaries

Operating expenses—short run expenses

Variable costs-based on sales levels

Indirect expenses-general overhead that can be allocated to cost centers

Functional account expenses-classified by purpose or activity, such as cashiers, customer service personnel;

Cost categories are established.

Capital expenditures are long-term investments in land, buildings, fixtures, and equipment. Operating expenditures are the short-term expenses of running a business.

Fixed costs (e.g., store security) remain constant for the budget period. Variable costs (e.g., sales commissions) are based on performance.

Direct costs are incurred by specific departments, product categories, and so on. Indirect costs are shared by multiple departments, product categories, and so on.

Natural account expenses (e.g., salaries) are reported by the names of the costs. Functional account expenses (e.g., cashier salaries) are classified on the basis of the purpose or activity for which expenditures are made.

Bad Costs

Bad costs are costs incurred for customer services that:

Customers do not value (will pay not additional prices for)

Are not required by customers

Causes and Examples of Bad Costs (1 of 2)

Cause	Example
Over-centralizing stores operations	Common hours of operation and services regardless of location needs
Reducing all expenses on a proportionate basis	Some services are more highly valued like low waiting lines or custom-made sandwiches
Trading-up to capture more affluent customers	Alienating existing customers and not attracting more affluent ones

Causes and Examples of Bad Costs (2 of 2)

Cause	Example
Not responding to changes in consumer behavior due to technology	Ignoring Web– order on-line and pick up in-store; using catalogs versus Web
Not responding to competition	Not understanding low-cost competition, unbundled pricing opportunities

Ongoing Budgeting Process

Set goals

Specify performance standards

Plan expenditures in terms of performance goals

Make actual expenditures

Monitor results

Adjust budget

Ongoing Budgeting Process

After making preliminary decisions, the retailer engages in the ongoing budgeting process (shown in Figure 12-3). Goals are set based on customer, employee, and management needs. Performance standards are specified. Expenditures are planned in terms of performance goals. In zero-based budgeting, a firm starts each new budget from scratch and outlines the expenditures needed to reach that period’s goals.

With incremental budgeting, a firm uses current and past budgets as guides and adjustments are made. Actual expenditures are made. Results are monitored.

Actual expenditures are compared with planned spending for each expense category, and reasons for any deviations are reviewed.

The firm learns if performance standards have been met and tries to explain deviations.

The budget is adjusted.

Cash Flow

Cash flow relates the amount and timing of revenues received to the amount and timing of expenditures for a specific time.

In cash flow management, the usual intention is to make sure revenues are received before expenditures are made.

If cash flow is weak, short-term loans may be needed or profits may be tied up in inventory and other expenses.

For seasonal retailers, erratic cash flow may be unavoidable.

Table 12.6 The Effects of Cash Flow

Resource Allocation

Capital Expenditures

Long-term investments in fixed assets

Operating Expenditures

Short-term selling and administrative costs in running a business

The Magnitude of Various Costs

Capital expenditures are long-term investments in fixed assets. Operating expenditures are short-term selling and administrative costs in running a business. These were the average capital expenditures for erecting a single store for a range of retailers in 2011 (and do not include land and merchandise costs):

Big-box store (including department store)—$3.7 million

Supermarket—$5 million

Home center—$2.7 million

Big-box store—$5.65 million

Convenience store—$685,000

Besides new building construction costs, remodeling is also expensive. To reduce their investments, some retailers insist that real-estate developers help pay for building, renovating, and fixture costs. Operating expenses range from 20 percent or so in supermarkets to more than 40 percent in some specialty stores. For a retailer to succeed, these costs must be in line with competitors’. Resource allocation must consider opportunity costs. They are the possible benefits a retailer forgoes if it invests in one opportunity rather than another.

Enhancing Productivity

A firm can improve employee performance, sales per foot of space, and other factors by better matching employee workloads to store traffic patters, upgrading training programs, increasing advertising, evaluating item profitability and turnover, etc.

It can reduce costs by automating, having suppliers perform certain tasks, etc.

Productivity: Many retailers place great priority on their productivity, the efficiency with which a retail strategy is carried out.

Productivity can be described in terms of costs as a percentage of sales, the time it takes a cashier to complete a transaction, profit margins, sales per square foot, inventory turnover, and so forth. Because different retail strategy mixes have distinct resource needs as to store location, fixtures, personnel, and other elements, productivity must be based on norms for each type of strategy mix.

There are two ways to enhance productivity. A firm can improve employee performance, sales per foot of space, and other factors by upgrading training programs, increasing advertising, and so forth. It can reduce costs by automating, having suppliers do certain tasks, and so forth. Productivity must not be measured from a cost-cutting perspective alone; this may undermine customer loyalty.

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