1. Financial Strategy Chapter 6
START AT WHITEBOARD! Even though most of this course is more marketing-driven, retail is a business of numbers too. Retailers need to decide whether to follow the PROFIT PATH or the ASSET PATH to maximize shareholder return (ROI). Explain briefly what each one means. PROFIT PATH seeks to widen gap between profit on mdse sold and expenses, ASSET PATH seeks to maximize sales on assets like inventory, buildings, etc. ILLUSTRATE ON WHITEBOARD: profit path and asset path both lead to improved ROA
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Questions
How is a retail strategy reflected in retailers’ financial objectives? (Three strategic elements: target, format, competitive advantage)
How do retailers need to evaluate their performance? What measures do they use?
What is the strategic profit model, and how is it used? What is the profit path vs. the asset path?
What methods do retailers use to plan their business? (“Top Down” vs. “Bottom Up”)
Retail is a business of numbers whether you are in merchandising, marketing, finance or elsewhere. Focus on measurable results for shareholders (ROI)
TIE first question on slide to 3 legs of a retail strategy

3. Strategic Profit Model: Financial Tradeoff Made by Retailers to Increase ROA
Outlines Tradeoff Between
--Gross Margin and
Cost Management
--Asset Management
(Inventory, cash, etc.)
Net Profit Margin
DISCUSS These two concepts! Retailers in different segments of the business will take different paths to increase shareholder ROI. Two dramatic examples: Asset Turnover model (food retailers) vs. Net Profit Margin model (Jewelry retailers)
Asset Turnover

4. Components of the Strategic Profit Model Top: Profit Path Bottom: Asset Path
This is ex. 6-1 on page 143 …. Important! TOP HALF IS “PROFIT PATH,” BOTTOM HALF IS “ASSET PATH”
INVENTORY TURNOVER is the key controllable asset from a merchandising perspective, and GROSS MARGIN is the key controllable on profit margin
MACY taking “profit path,” COSTCO taking “asset path,” it doesn’t mean one is more “right” than the other.

5. The Strategic Profit Model: An Overview
Profit Margin x Asset turnover = Return on assets
Net profit x Net sales (crossed out) = Net profit
Net sales (crossed out) Total assets Total assets
Net Profit Margin: reflects the profits generated from
each dollar of sales (LOOK AT THE INCOME STATEMENT)
Asset Turnover: reflects the sales productivity of a firm’s
investment in its assets (LOOK AT THE BALANCE SHEET)
Fundamentally a very simple concept but you need to know where to look on companies’ balance sheets and income statements

6. The Strategic Profit Model: Profit Management Path
Net Profit Margin
Sales
Net Profit
Gross Margin
Total Expenses
Net Sales
Cost of Goods Sold
15% 15 40
100 60 25 -
Will explain GM more thoroughly on slide 12. Everything expressed as % of sales volume.

7. The Strategic Profit Model: Asset Management Path
Asset Turnover
Total Assets
Sales
Current Assets
Fixed Assets
Inventory
Accounts Receivable
2.5
100 10 5 4 40 30
+ + +
Other Current Assets 1
Concept of asset path (and asset mgt) is how many sales can you generate from your company’s current assets (like inventory or cash) and fixed assets (like bldgs. and warehouses)

8. The Strategic Profit Model: Putting It Together to calculate ROA
Net Profit Margin
Sales
Net Profit
Gross Mar
Total Exp.
Cost Goods Sold
15% 15 40
100 60 25 -
Asset Turnover
Total Assets
Current Assets
Fixed Assets
Inventory
A/R
2.5 10 5 4 30 +
Other Current Assets 1
Return on
Assets
37.5%
Times
Net Profit Net Profit Net Sales
Total Assets = Net Sales x Total Assets
Net Sales ( )
Profit Management
Even though you can take a shortcut to ROA by dividing net profit by total assets, important to evaluate the two branches of this “tree” separately when you are comparing competitors in the same segment.
Asset Management

9. Strategies Used By a Bakery and Jewelry
Store – who is using profit vs. asset path?
Again, use this model to compare two competing jewelry stores…which one achieves a higher profit margin? What is the “standard”? Which one is doing a better job turning its assets?
WHich of the two companies you are studying is doing a better overall job on ROI and how are they doing it?

10. Profit Management Path for Macy’s and Costco – Who’s doing better?
Next several slides explore components of net profit at Macys and Costco – but important to keep in mind that this is not the whole picture until you know which store has better asset turnover. This is the “PROFIT PATH”

11. Profit Margin Management
Net Sales (Gross Sales + Promotional Allowances – Returns)
MINUS
Cost of Goods Sold (COGs)
EQUALS
Gross Margin (GM)
Expenses
Variable (e.g.. sales commissions)
Fixed (rent, depreciation, staff salaries)
Net Profit = Net Sales – COGS - Expenses
Gross margin is essentially the profit you make on the goods you sell, before considering expenses like payroll, rent, etc.

12. Components of Gross Margin
Gross Sales
Less Returns
Plus Promotional Allowances
Gross Margin
Gross Margin
Net Sales
COGS
Whiteboard: Simplified calculation of GM% -- TAKE TIME ON THIS CONCEPT
Markup (explain) – deduct MD/shrink % x inverse of markup from initial MU
Gross Margin (Gross Profit) : profit made on merchandise sales without considering the operating expenses and corporate expenses.

13. Maintaining/Increasing Gross Margin
Pay a Lower Price to Vendor
Reduce clearance markdowns
Charge Customers a Higher Price (not easy...)
Reduce Price Competition
Exclusive Merchandise (Apparel)
Brand Variants (Electronics)
Reduce Retailer Supply Chain Costs
Floor Ready Merchandise, Vendor Source Tagging
Packaging -- Shipping, Display
Lower Freight Costs
DISCUSS: In today’s economic crunch, how do stores improve their margins w/o raising prices?

14. PROFIT PATH: Gross Margin for Macy’s and Costco
Gross Margin = Gross Margin %
Net Sales
Macy’s: $ 10,773 = %
$15,630
Costco: $ 7,406 = %
$60,151
DISCUSS questions on slide
Why does Macy’s have higher margins than Costco?
Do the higher margins mean Macy’s is more profitable?

15. Profit Margin Management: Gross Margin
Gross margin percentage is gross margin dollars divided by net sales.
Retailers use GM% to compare
the performance of various types of merchandise
their own performance with that of similar retailers with higher or lower sales (INCOME STATEMENT)
An important benchmark for comparing performance of different mdse. Depts, different vendors within a dept. etc.
Gross margin $
Net sales
= Gross margin %

16. Profit Margin Management: Expenses
SG & A or operating expenses can be expressed as a percentage of net sales to facilitate comparisons across items, stores, and merchandise categories within and between firms. (COSTS OF RUNNING THE BUSINESS)
Operating expenses
Net sales
= Operating expenses %
SG&A= Selling (payroll for sales associates)…General (paying the utility bills etc.)…Administrative (HQ expenses)

17. Operating Expenses Operating Expenses = Operating Expenses % Net Sales
= Selling, general and administrative expenses (SG&A) depreciation + amortization of assets
Includes costs other than the cost of merchandise
Operating Expenses = Operating Expenses %
Net Sales
Macy’s: $8,937 = %
$26,970
Costco: $5,781 = 9.6%
$60,151
Continuing on the “profit path”…Thoughts as to why Macy operating expenses are higher? Payroll…real estate…advertising…what else?

18. Types of Retail Operating Expenses
Selling expenses = Sales staff salaries + Commissions Benefits
General expenses = Rent + Utilities + Miscellaneous expenses
Administrative expenses = Salaries of all employees other than salespeople + Operations of buying offices + Other administrative expenses
When you see “SG&A” on an income statement, this is what it refers to

19. Operating Profit…Macy’s is higher
Before interest expenses/income, taxes, and extraordinary expenses
A commonly used overall profit measure due to the lack of control over taxes, interest, and extraordinary expenses
Allows for a comparison of financial performance across companies or divisions within companies
Gross Margin – Operating Expenses = Operating Income %
Net Sales
Macy’s: $10,773 – 8,937 = % (39.9% %)
$26,970
Costco: $7,406 - $5,781 = % (12.3% - 9.6%)
$60,151
Bigger gap between margins and operating costs in Macy’s case lead to higher net income…but this is only part of the ROA story

20. Macy’s also higher Net Profit % (after taxes) compared to Costco
Net Profit = Gross Margin – Operating Expenses – Net Interest - Taxes
Net profit after taxes = Net Profit % after taxes
Net sales
Macy’s: $ = %
$26,970
Costco: $1, = %
$60,151
Operating profit – interest and taxes = net profit (Companies with lots of DEBT on their balance sheets accrue high interest payments, bad place to be right now)

21. But: Asset Management is the other side of the Strategic Profit Model
Assets:
Economic Resources (e.g., inventory, buildings, computers, store fixtures) owned or controlled by a firm
Difference between Current Asset and Fixed Asset
Current Assets =
Inventory + Cash + Account Receivable
Fixed Assets = Fixture, Stores (owned)
Asset Turnover = Sales/Total Assets
Inventory Turnover = COGS/Avg. Inventory (cost)
What is asset management, anyway?
Asset management is the rest of the ROA story – note differences between fixed and current assets

22. Macy’s and Costco’s Balance Sheets: Why is Costco ROA so much greater?
Costco generating more sales on fewer assets, especially inventory

23. Asset Management Path for Macy’s and Costco
This is exhibit 6-6 on page 150

24. Inventory Turnover: A key element
A Measure of the Productivity of Inventory:
It is used to evaluate how effectively retailers utilize their investment in inventory
Shows how many times, on average, inventory cycles through the store during a specific period of time (usually a year)
You will see inventory turnover stated on a “cost” basis on balance sheets (EXPLAIN)
Inventory Turnover = Sales/ avg inventory (retail)

25. Importance of inventory turnover rate
Inventory turnover rate differs by
Industry (BAKERY vs. JEWELER)
Product categories (JEANS vs. SHORTS)
Many retailers that are not achieving adequate profits have a poor turnover rate, due to weak inventory management (too much of the wrong goods, not enough of what’s selling)
Supply chain management improving the odds of “the right goods in the right store”
Good inventory management key to a successful outcome esp. in an economic slowdown. Can affect gross margin (cost of excess inventory), cash flow, cost of mdse. Handling etc.

26. Inventory Turnover drives Costco’s high Asset Turnover results (and fewer SKUs)
Sales__________ = Inventory Turnover
Average inventory
Macy’s: $26, =
$5,317
Costco: $ =
$4,569
Twice the sales on less inventory than Macy’s!
This is the key to Costco’s effective asset mgt.

27. Importance of Inventory turnover
How do retailers increase Inventory Turnover?
Increase Sales
Decrease Inventory
Decrease delivery lead-time
Drive waste out
Right goods in the right stores
It’s important to have an efficient turnover rate: not so slow that things seem stale and shopworn, yet not so fast that the floor looks half-empty. (“FAST FASHION”)
Some stores managed their inventory too conservatively during the slowdown

28. Asset Turnover…inventory is just one part
Net Sales = Asset Turnover
Total Assets
Macy’s: $26,970 = 0.91
$29,550
Costco: $60,151 = 3.44
$17,494
Assets include inventory, buildings, cash, etc.
Other assets besides inventory discussed on page 178…fixed assets like bldgs, other capital investments
NOTE that Costco asset turnover is 3x faster than M…what does this mean for overall ROI?

29. Put it together: Costco beats Macy’s ROA
Net Profit Margin x Asset Turnover = Return on Assets
Macy’s: % x = %
Costco: % x = %
Return on Assets is a very important performance measure because it shows how much money the retailer is making on its investment and different ways to meet goals
Bottom line: Costco overall generating better ROA for its investors based on superior turnover

30. Evaluation of Financial Path: Macy’s and Costco
Higher net profit margin
Higher asset turnover
Retailers (and investors) need to consider
both net profit margin and asset turnover when evaluating their financial performance
the implications of strategic decisions on both components of the strategic fit model
EX: Increasing prices => gross margin, net profit margin
sales, asset turnover
The right answer depends on your store’s strategy: TARGET, FORMAT, SUSTAINABLE ADVANTAGES
There are multiple paths to successful ROA. Worth comparing Macy’s to other dept. stores more than to a completely different type of retailer

31. The Strategic Profit Model
Net Sales
Cost of goods sold
Variable expenses
Fixed expenses
Gross margin
Total expenses
Net profit
Net profit margin
Asset turnover
RETURN
ON ASSETS - +
Inventory
Accounts receivable
Other current assets
Total current assets
Fixed assets
Net sales
Total assets x
Profit Management
SIMPLIFY ON WHITEBOARD: Net Profit/Net Sales X Net Sales/Total Assets = Net Profit/Total assets = ROA (EX 6-4, also see tutorial on student website)
Asset Management

32. Setting and Measuring Performance Objectives: Who decides about ROA?
Retailers will be better able to gauge performance if they have specific objectives in mind to compare performance.
Should include:
numerical index of performance desired
time frame for performance
necessary resources to achieve objectives
Retailers often use industry benchmarks, and also judge themselves against a plan…not necessarily “last year”
How this works in the real world…compare top-down to bottom-up on the next 2 slides
GOOD PLANNING INVOLVES COMBINATION OF BOTH but it needs to start with top mgt. overall vision of the business, which businesses need to be grown faster and why…acting like

33. Setting Goals in Large Retail Organizations
Top-Down Planning
Corporate Developmental Strategy
Need connection between overall company goals and individuals’ ability to deliver
Category, Departments and sales associates implement strategy

34. Top-down vs. bottom-up goal settling
Corporate
Again, consistency between bottom-up planning of the details and corporate strategy
Not every business can or should be planned the same way…discuss seasonal planning
Bottom-Up Planning
Buyers and Store managers estimate what they can achieve
Operation managers must be involved in objective setting process

35. Performance Measures Used by Retailers
(What can you control directly?)
Different parts of an organization are accountable for different things that they can control, and should plan accordingly (walk thru next 3 slides quickly to illustrate)

36. Evaluating Financial Performance
Growth in Earnings and Shareholder Value = Higher Stock Price
ROA Benchmarks
Improvement Over Time
Compare performance indicator for three years
Performance Relative to Comparable Firms
Compare performance indicators with major competitors for PROFIT and ASSET paths
This is the real point – using Strategic Profit Model metrics to compare two competitive retailers’ performance

37. Key Sources of Financial Reporting
Balance Sheet (Snap Shot at One Time)
Key to understanding Asset Mgt. Path
Income Statement (Summary Over Time)
Key to Profit Margin Management Path
Both sources of information are key to understanding the Strategic Profit Model (SPM) and Return on Assets (ROA)
(GOOD MIDTERM QUESTION!)
Remember for midterm: Balance sheet key to understanding asset mgt – income statement key to understanding profit mgt – both pieces are part of ROA