Strategic Profit Model- RETAIL MANAGEMENT PDF

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Strategic Profit Model

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STRATEGIC PROFIT MODEL

LO 6-2 Contrast the two paths to financial performance using the strategic profit model.

The strategic profit model (SPM) , illustrated in Exhibit 6–1 , is a method for summarizing the factors that affect a firm’s financial performance, as measured by ROA. Return on assets is an important performance measure for a firm and its stockholders because it measures the profits that a firm makes relative to the assets it possesses. Two retailers that each generate profits of $1 million on $20 million in net sales, at first glance, might look like they have comparable performance. But the performance of the retailers looks quite different if one has $10 million in assets and the other has $25 million. The performance of the first Page 158 would be higher because it needs fewer assets to earn its profit than does the other. Thus, a retailer cannot concern itself only with making a profit. It must make a profit efficiently by balancing both profit and the assets needed to make the profit. about:srcdoc

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EXHIBIT 6–1 Strategic Profit Model

The net profit margin (in %)

refers to how much profit (after taxes, interest income, and extraordinary gains and losses) a firm

makes divided by its net sales. Thus, it reflects the profits generated from each dollar of sales. If a retailer’s net profit margin percentage is 5 percent, it generates income of $0.05 for every dollar of merchandise or services it sells. Asset turnover is the retailer’s net sales divided by its assets. This financial measure assesses the productivity of a firm’s investment in its assets. It indicates how many sales dollars are generated for each dollar of assets. If a retailer’s asset turnover is 3.0 it generates $3 in sales for each dollar invested in the firm’s assets. The retailer’s ROA is determined by multiplying the two components together:

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These two components of the strategic profit model illustrate that ROA is determined by two sets of activities—profit margin management and asset turnover management—and that a high ROA can be achieved by various combinations of net profit margin percentages and asset turnover levels.

La Chatelaine Bakery (left) is a low-profit-margin/high-turnover operation, whereas Lehring Jewelry (right) is a high-profit-margin/lowturnover operation. But both stores have the same return on assets (ROA). (first): © Claudia Dewald/Getty Images; (second): © Image Source

To illustrate the different approaches for achieving a high ROA, consider the financial performance of two very different hypothetical retailers, as shown in Exhibit 6–2 . La Chatelaine Bakery has a net profit margin percentage of only 1 percent and a asset turnover of 10, resulting in an ROA of 10 percent. Its net profit margin percentage is low because it is in a highly competitive market with little opportunity to differentiate its offering. Consumers can buy basically the same baked goods from a wide variety o retailers, as well as from the other bakeries in the area. However, its asset turnover is relatively high because the firm has a very low level of inventory assets—it sells everything the same day it is baked. about:srcdoc

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EXHIBIT 6–2 Different Approaches for Achieving an Acceptable ROA

La Chatelaine Bakery Lehring Jewelry

Net Profit Margin ×

Asset Turnover =

Return on Assets

1%

10 times

10%

10%

1 time

10%

On the other hand, Lehring Jewelry has a net profit margin percentage of 10 percent—10 times higher than that of the bakery. Even though it has a much higher net profit margin percentage, the jewelry store has the same ROA because it has a very low asset turnover of 1. Lehring’s asset turnover is low compared with the bakery’s because Lehring has a high level of inventory Page 159 and stocks a lot of items that take many months to sell. In the following sections, we take a closer look at these two components of ROA. We examine the relationship between these ratios and a firm’s retail strategy and describe how these financial measures can be used to assess performance with traditional accounting information. To illustrate the financial implications of different retail strategies, we compare the financial performance of Walmart and Nordstrom. The retail strategies of these two retailers are described in Retailing View 6.2

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RETAILING VIEW 6.2

Nordstrom and Walmart: Successful Retailers Using Different Retail Strategies Nordstrom Nordstrom, Inc. has transformed from a small shoe seller in Seattle to the leading fashion specialty retailer that it is today. Its central goal—to help “customers possess style, not just buy fashion”—has made the chain famous for its excellent customer service. Nordstrom encourages its employees to connect with customers and empowers them to help customers as best as they can. Furthermore, it goes above and beyond by sending thank-you cards, offering home deliveries and personal appointments, and issuing personal calls to educate shoppers about upcoming sales. The emphasis on customer service has influenced every aspect of the company, even down to its return policy, which states, “We do not have a formal return policy at our Nordstrom full-line stores or online at Nordstrom.com. Our goal is to take care of our customers, which includes making returns and exchanges easy, whether in stores or online, where we offer free shipping and free returns.” This customer-centric model combined with its impressive assortment has helped make Nordstrom America’s favorite retailer for three consecutive years.

Nordstrom (first) and Walmart (second) have very different retail strategies and financial performance measures. (first): © Kevork Djansezian/Getty Images; (second): © Tim Boyle/Getty Images

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Walmart Walmart’s founder Sam Walton opened the first store in Arkansas in 1962. Now Walmart is one of the biggest and best-known retail chains in the world, with over 11,500 stores in almost 30 countries; its e-commerce website is available in 11 countries. In 2016 Walmart’s revenue reached almost $500 billion, based on its four-pronged strategy focused on price, access, experience, and assortment. As the retail giant notes, “We understand not only what our customers want and need, but also where they want it and how they want to experience it.” A cornerstone of this strategy is Walmart’s everyday low pricing (EDLP) model, which stresses continuity of retail prices at a level somewhere between the regular nonsale price and the deep-discount sale price of its competitors. Selling products for such low prices, such that it earns relatively low profit margins, Walmart maintains a vast assortment that ensures it is a one-stop shopping destination for consumers. Furthermore, Walmart is fanatical about keeping its costs down, which it does by having mastered the art of operational excellence through its private fleets of trucks and modern distribution and fulfillment centers. Walmart also operates Sam’s Club, which competes with companies like Costco, for customers who prefer to buy in bulk. When Sam Walton originally opened Sam’s Club, its target market was small business owners and the goal was to help them save on buying merchandise. However, wholesale clubs like Sam’s Club also have become increasing popular for consumers with families, even as this retail arm continues to appeal to entrepreneurs and serve about half a million business owners each day. Sources: “Nordstrom, 'About Us,' " http://shop.nordstrom.com/c/about-us?origin=breadcrumb; Nordstrom, Inc., “Annual Report,” 2014; Christian Conte, “Nordstrom Built on Customer Service,” Jacksonville Business Journal, September 7, 2012, http://www.bizjournals.com/jacksonville/printedition/2012/09/07/nordstrom-built-on-customer-service.html?page=all; Andrés Cardenal, “How America's Favorite Retailer Is Crushing the Competition,” The Motley Fool, April 14, 2015, http://www.fool.com/investing/general/2015/04/14/how-americas-favorite-retailer-is-crushing-the-com.aspx; Dallas Business Journal, October 17, 2014; http://corporate.walmart.com.

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Profit Margin Management Path The information used to examine the profit margin management path comes from the retailer’s income statement , also called th statement of operations or profit and loss (P&L) statement . The income statement summarizes a firm’s financial shows income statements adapted performance over a period of time, typically a quarter (three months) or year. Exhibit 6–3 from the annual reports of Walmart and Nordstrom Inc. The components in the profit margin management path portion of the strategic profit model are summarized for both retailers in Exhibit 6–4 .

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EXHIBIT 6–3 Income Statements for Nordstrom and Walmart

Nordstrom Income

Walmart Income

Statement (FY 1/30/2016)

Statement (FY 1/31/2016)

Values in Millions

Values in Millions

$14,437

$ 482,130

9,168

360,984

Net sales Less cost of goods sold (COGS)

 

Gross margin

5,269

Less operating expenses (SG&A)

 

Operating profit margin Less other income (expense), interest,

 

121,146

4,168

97,041

1,101

24,105

501

 

9,411

600

 

14,694

taxes Net profit margin Ratios Gross margin as a percentage of sales Operating expenses as a percentage of sales

   

36.50%

25.13%

28.87%

20.13%

Operating profit margin as a percentage of sales

7.63%

5.00%

Net profit margin as a percentage of sales

4.16%

3.05%

Sources: Walmart 10K, filed March 30, 2016; Nordstrom, Inc. 10K, filed March 14, 2016.

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EXHIBIT 6–4 Profit Margin Management Path of Strategic Profit Model

Components in the Profit Margin Management Path The components in the profit margin management path are net sales, cost of goods sold (COGS), gross margin, operating expenses, interest and taxes, and net profit margin. These factors have some unique characteristics when a retailer uses multiple channels to se its goods, as Retailing View 6.3 explains. Net sales are the total revenues received by a retailer that are related to selling merchandise during a given time period minus returns, discounts, and credits for damaged merchandise.

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RETAILING VIEW 6.3

Calculating the Costs and Profits of Online Channels Modern retailers are turning to an omnichannel strategy to remain competitive. And if all they needed to worry about were sales levels, the channels used would not matter. But the margins are different among the channels. For omnichannel retailers, the different profit implications between online and in-store sales can be substantial: According to a recent survey, only 16 percent of omnichannel retailers earn a profit on their operations, and 67 percent of them anticipate further rising costs. The reason has to do with the very nature of the sales channels. In brick-and-mortar stores, the costs to sell to 20 customers are approximately the same as those to sell to 50 customers. That is, the store is already open, staffed, and stocked, no matter how many people enter through its doors. Thus, each additional sale increases the profit that the retailer earns, after paying all its costs. In contrast, each product sold online induces new, unique costs to pick, pack, and ship the item. If 50 people buy pairs of jeans, the costs to the retailer shipping them are much higher than if 20 people buy those jeans.

The retailer’s cost to sell a pair of jeans online is higher than in a store because of shipping, handling, and returns. © payphoto/iStock/Getty Images

Omnichannel operations increase the costs of not just shipping but also handling, returns, and decision making. For example, for each order received, the retailer needs to determine which channel to use to source it. Should it send an employee in the local store into the aisles to pick the item, pack it up, and ship it? Should it procure it from a centralized distribution center? Should it require the manufacturer to ship it directly to the customer? In addition, retailers do not know where they will receive each return, and because Internet shoppers cannot touch or feel products before they buy, returns are far more frequent for online purchases. Therefore, retailers must deal with the costs of returns, including additional shipping, labor to restock, and potential losses if the returned items cannot be resold. Thus at Kohl’s, the profits earned from online sales are approximately half those earned for the same products sold about:srcdoc

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in stores. Both Target and Best Buy announced that their predicted profits would continue to diminish as their online channels grew. Yet as Kohl’s chief executive Kevin Mansell explained, “I don’t care if customers buy online or in store. We’re focused on sales.” This focus may be necessary because customers demand the convenience of online ordering. Even if companies earn less, they likely need a web presence. Not everyone agrees, though: The European discount retailer Primark has pulled itself off the Internet, noting that despite a lot of demand, it could never earn a profit on its online sales. In response, retailers must find ways to enhance their omnichannel performance, including their logistics, transportation, and inventory capabilities. If retailers must create omnichannel environments to stay competitive, they also must engage in intelligence gathering and data analysis that can reveal the most efficient strategies and the most appropriate trade-offs to make in their operations. Sources: Suzanne Kapner, “Internet Drags Down Some Retailers’ Holiday Profit,” The Wall Street Journal, December 1, 2014; Tom Ryan, “Omnichannel Puts Retailers in the Red,” RetailWire, April 20, 2015.

The cost of goods sold (COGS) transportation costs. Gross margin

is the amount a retailer pays to vendors for the merchandise the retailer sells plus , also called gross profit

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, is the net sales minus the cost of the goods sold. It is

an important measure in retailing because it indicates how much profit the retailer is making on merchandise sold, without considering the expenses associated with operating the store and corporate overhead expenses. Some retailers have additional revenue sources related to merchandise sales, such as payments from vendors. For example, grocery retailers often charge vendors for space in their stores, known as a slotting fee or slotting allowance . Retailers may also require that vendors pay a chargeback fee if merchandise bought from the vendor does not meet all the terms of the purchase agreement, such as if the delivery is late. Such payments from vendors are typically incorporated into the income statement as a reduction in the COGS. Gross margin = Net sales − Cost of goods sold Operating expenses , also called selling, general, and administrative (SG&A) expenses , are the overhead costs associated with normal business operations, such as salaries for sales associates and managers, advertising, utilities, office supplies, Page 162 depreciation, amortization, transportation from the retailer’s warehouses to its stores, and rent. Operating profit margin is the gross margin minus the operating expenses. In retailing management decisions we usually focus on the operating profit margin because it reflects the performance of retailers’ fundamental operations, not the financial decisions retailers make with regard to nonoperating income/expense, interest, and taxes.

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Operating profit margin = Gross margin − Operating expenses Finally, net profit margin

, or net income

, is the operating profit margin minus other income or expenses not associated with

the retailers' fundamental operation, such as the cost of opening or closing stores, acquisitions, and credit card programs. Interest an taxes are also subtracted from the operating profit to get the net profit margin. The net profit margin is used to calculate ROA.

Net profit margin = Operating profit margin − Other income or expenses − Interest − Taxes

Analyzing Performance in the Profit Margin Management Path The level of sales, gross margin, operating profit margin, and net profit margin in Exhibit 6–4

provide some useful information

about the financial performance of the two retailers. However, it is difficult to compare the performance of the retailers when they differ in size. If Nordstrom were interested in comparing its performance with Walmart, it would expect that Walmart would have a much greater gross margin and operating profit margin because the latter retailer has nearly 35 times greater sales than Nordstrom. Thus, some of the differences in the income statement numbers are due to differences in size, not the retailers’ performance. It is therefore useful to use ratios with net sales in the denominator when evaluating a retailer’s performance and comparing it with other retailers’. Three useful ratios in the profit margin management path are gross margin percentage, operating expenses as a percentage of sales, and operating profit margin percentage of sales. Gross margin (in %) is gross margin divided by net sales. Retailers use this ratio to compare (1) the performance of various types of merchandise and (2) their own performance with that of other retailers with higher or lower levels of sales.

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Even though Walmart has almost 35 times the sales of Nordstrom, Nordstrom has a higher gross margin percentage. This difference in gross margin percentage can be traced back to the retail strategies of the companies. Department stores, especially high-end department stores like Nordstrom, generally have higher gross margin percentages than full-line discount stores because they target less price-sensitive customers who are interested in luxury branded fashion merchandise and personal service and are willing to pay for it. That is, customers are willing to pay a premium price for a high-fashion dress by a famous designer at Nordstrom, but they expect very competitive and low prices for a six-pack of plain white T-shirts or a pound of Great Value coffee at Walmart. Like the gross margin, operating expenses (in %) can facilitate comparisons among firms. It is important for department stores to achieve relatively high gross margins because their operating expenses tend to be higher...