Strategic Profit Model - Retail Management 2

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 and 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. 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 than those of other retail formats like discount stores. Nordstrom spends proportionally more on customer service and selling expenses, more to maintain the appearance of its stores, and more on rental expenses per square foot because most of its stores are located in premium malls. Discount stores instead operate with relatively fewer administrative staff than do department stores. Walmart's buying expenses are comparatively lower because it needs fewer buyers to complete the simpler buying process associated with the relatively few SKUs for commodity-type merchandise, like packaged foods and fresh meat and produce. Nordstrom instead faces more complex, and more expensive, buying processes for the fashion apparel it stocks, including the expenses of sending its buyers to fashion markets around the world. Walmart has little need to make such expenditures. But then why is Walmart's operating expenses as a percentage of sales (20.1 percent) significantly lower than the value for Nordstrom (28.9 percent)? Part of the reason comes from Walmart’s strategic choice to have lower-cost store locations compared to Nordstrom. Similar to the gross margin and operating expenses, operating profit margin (in %) , expressed as a percentage of net sales, facilitates comparisons across firms. It is calculated as operating profit margin divided by net sales. Nordstrom's operating profit margin percentage is 50 percent larger than Walmart's. The reason is that Nordstrom's gross margin percentage is much higher than Walmart's even though its operating expenses percentage is also higher. Thus, the profit margin management path of the strategic profit model suggests that Nordstrom is outperforming Walmart. But the asset turnover management path tells a different story. Finally, net profit margin percentage also facilitates comparisons across firms. It is calculated as net profit divided by net sales. Asset Turnover Management Path The information used to analyze a retailer’s asset turnover management path comes primarily from the retailer’s balance sheet. Whereas the income statement summarizes financial performance over a period of time (usually a year or quarter), the balance sheet summarizes a retailer’s financial position at a given point in time, typically the end of its fiscal year. Nordstrom and Walmart balance sheets are shown in Exhibit 6–5 , and the asset turnover management path components in the strategic profit model are shown in Exhibit 6–6 . EXHIBIT 6–5 Balance Sheets for Nordstrom and Walmart Nordstrom Income Walmart Income Statement (FY 1/30/2016) Statement (FY 1/31/2016) Values in Millions Values in Millions Cash and cash equivalents 595 8,705 Merchandise inventory 1,945 44,469 Other current assets 474 7,065 Total current assets 3,014 60,239 Property & equipment (net) 3,735 110,171 Intangible assets 435 23,040 Other noncurrent assets 514 66,370 4,684 139,342 Total noncurrent assets Total assets Inventory turnover (cost of goods sold ÷ inventory at cost) Asset turnover (sales ÷ total assets) ROA (net profit margin ÷ total assets) or net profit margin percentage × asset turnover Sources: Walmart 10K, filed March 30, 2016; Nordstrom, Inc. 10K, filed March 14, 2016. 7,698 4.71 1.88 7.79% 199,581 8.12 2.42 7.36% EXHIBIT 6–6 Asset Turnover Management Path in Strategic Profit Model Components in the Asset Turnover Management Path Assets are economic resources (e.g., inventory, buildings, computers, store fixtures) owned or controlled by a firm. There are two types of assets, current and noncurrent. We examine examples of these assets and how they play into the financial pictures of Nordstrom and Walmart. Current Assets Assets that can normally be converted to cash within one year are considered current assets . For retailers, current assets are primarily cash, merchandise inventory, and other assets such as accounts receivable. Cash and cash equivalents include currency, checks, short-term bank accounts, and investments that mature within three months or less. 5 Traditional retailers require some minimal amount of cash and cash equivalents to conduct their day-to-day business. Merchandise inventory is a retailer's lifeblood; the primary reason the retailer exists is to sell its merchandise inventory. Getting the right merchandise in the right quantities at the right time and place is critical. Stocking more merchandise enhances sales because it increases the chances that customers will find something they want. But it also increases the investments that retailers must make in this asset. Retailing View 6.4 describes how crowdfunding can subvert traditional inventory models, allowing retailers to maintain a bare minimum of inventory on hand. RETAILING VIEW 6.4 Basing Inventory Levels on Crowdfunding Campaigns Crowdfunding raises money to support a particular project by convincing a large group of people to donate money, often in relatively small amounts. It has enabled filmmakers to produce their movies, musicians to get their albums recorded, and candidates to run political campaigns. In some recently emerging examples, it also has given retail entrepreneurs a means to get their innovative products to customers, without forcing them to incur the risk and cost of massive inventories. Fashion retailers always confront the inherent gap between when they purchase their inventory and when the demand for that inventory becomes evident. As a result, inventory management is especially challenging for them, often leaving retail shelves bare of popular fashions but weighted down with unpopular options. With crowdfunding, retail entrepreneurs can avoid starting production until they have actual orders in hand. They also know exactly how much fabric to purchase or how many buttons they will need, which helps reduce their supply chain costs. If you want a good deal on jeans and you don’t mind waiting a couple of months to get them, try Gustin. It uses a crowdfunding model to keep its costs low. Source: Gustin On Kickstarter, the vintage-inspired lingerie brand Blackbird Underpinnings raised more than $40,000 before it even found a factory that could handle full production runs of its products. The 10-Year Hoodie planned to raise $50,000, but it proved so popular to Kickstarter users that it took in more than $1 million beyond its goal. The men’s denim brand Gustin also relied on Kickstarter for its first crowdfunding campaign, after deciding that a traditional retail fashion model was too costly, both for the company and for customers. Its premium denim products were selling in local retail boutiques for $205. Through Kickstarter at first, and now through its own proprietary crowdfunding site. Gustin instead waits until it has sufficient orders for each style to initiate a production run. With this approach, it can sell raw selvedge denim jeans for as low as $81. In addition to the price benefits, Gustin highlights how its innovative strategy reduces waste overall, which is more sustainable. It also offers guarantees of high quality because it remains in close contact with its customers every time they order directly from the retail site. Examples of successes are still relatively rare, though. Without a compelling appeal to crowdfunders, basic fashion brands tend to get overlooked. Fashion customers generally don’t like to wait the 60 to 90 days to get their apparel. Unlike a movie or political campaign, selling fashion through crowdfunding also creates challenges in terms of returns, which can be more problematic since the normal business model is “buy and pay now, but wait to receive.” Sources: Rachel Brown, “Kickstarter Fashion: Retail Disrupter, or Oxymoron?,” San Francisco Chronicle, January 27, 2016; Ellen Huet, “Crowdfunding Might Be Right Fit for Fashion Startups,” SFGate, January 3, 2014; Christina Desmarais, “How 3 Kickstarter Projects Beat the Odds,” Inc., May 8, 2013; https://www.weargustin.com. Inventory turnover, which measures how effectively retailers utilize their investment in inventory, is another important ratio for assessing retail performance. Inventory turnover shows how many times, on average, inventory cycles through the store during a specific period of time (usually a year). It is calculated as the COGS during a time period, typically a year, divided by the average level of inventory (expressed at cost) during the time period. Some retailers use an equivalent inventory turnover calculation using retail values, i.e., net sales (at retail) divided by average inventory (also at retail). A surrogate measure for average inventory is the inventory value at the end of the fiscal year reported on the balance sheet. Note that the inventory level reported on the balance sheet is the level on the last day of the fiscal year, not the average level. To measure the average inventory level more accurately, retailers measure the inventory level on each day of the year and divide by 365 Walmart's inventory turnover is almost two times faster than Nordstrom's. Walmart's higher inventory turnover is to be expected, considering the nature of its retail strategy and the merchandise it sells. That is, most items in Walmart are low-cost staples such as food, batteries, housewares, and basic apparel items. Unlike apparel fashions that are the mainstay for Nordstrom, these staples can be replenished quickly. Walmart stores typically have relatively few SKUs in a particular product category, such as men's dress shirts. Nordstrom, in contrast, may stock 500 SKUs of men’s dress shirts (different colors, sizes, styles, and brands). Larger assortments, like those in department stores, require relatively higher inventory investments, which slows inventory turnover. Noncurrent Assets Assets that are not likely to be converted to cash within one year represent noncurrent assets . For retailers, noncurrent assets primarily include fixed assets and intangible assets. In retailing, the principal fixed assets are buildings, distribution centers, fixtures (e.g., display racks), and equipment (e.g., computers, delivery trucks). Intangible assets include nonphysical assets such as patents and goodwill. Notice that the balance sheet does not include most of the critical assets used by retailers to develop a sustainable competitive advantage (discussed in Chapter 5 ) such as brand image, customer loyalty, customer service, information and supply chain systems, human resources (committed, knowledgeable employees), and a database of customer buying behaviors and preferences. These factors are critical assets, but because they cannot be valued by accountants, they are not included on the balance sheet (unless they are the result of an acquisition). So while these assets are important for generating long-term financial performance, they are not included in the calculation of return on assets. Analyzing the Performance of the Asset Turnover Management Path Asset turnover is used to assess the performance of the asset management component in the strategic profit model. It is net sales divided by total assets. Walmart's asset turnover is 25 percent greater than that of Nordstrom. The difference in their asset turnovers is due to Walmart's higher inventory turnover and the lower cost of the fixed assets in its stores. As we noted earlier, retailers like Walmart that sell basic merchandise at low prices typically have higher inventory turnover than fashion apparel sold by retailers like Nordstrom. Also, Nordstrom stores include much more expensive fixed assets, such as fixtures, lighting, mannequins, and flooring, than does a typical Walmart store. Combining the Profit Margin and Asset Turnover Management Paths In terms of the profit margin management path, Nordstrom has a higher operating profit margin percentage and thus performs better than Walmart on profits. But Walmart has a higher asset turnover. Although this type of performance is expected, given their overall strategy and retail formats, both retailers strive to increase their performance on these key ratios. For example, department stores like Nordstrom are working to develop supply chains and buying systems that mimic those of successful fast-fashion retailers like Zara and H&M that allow less merchandise to be delivered more often—more closely matching supply and demand. This lower average inventory and total assets, while also potentially increasing sales, results in higher inventory and asset turnovers. Discount stores like Walmart instead are attempting to increase their gross margins by carrying more fresh and organic produce, meat, and prepared foods. Although most experts have been underwhelmed by its efforts to offer more fashionable apparel, Walmart regards this merchandising strategy as a way to increase its profit margins.6 The two retailers’ overall performance, measured by ROA, can be determined by considering the effects of both paths—that is, by multiplying the net profit margin by asset turnover. Nordstrom had a significantly higher operating profit margin percentage than Walmart, and its net profit margin was also much higher. Yet Nordstrom's performance on asset turnover was inferior to Walmart’s. As a result, the two retailers' overall performance, as measured by ROA, are remarkably similar! Implications for Improving Financial Performance The profit margin management and asset turnover management paths in the strategic profit model suggest different approaches for improving financial performance. Focusing on the profit margin management path, the operating profit margin could be increased by increasing sales or reducing COGS or operating expenses. For example, Walmart could increase its sales by increasing promotions to attract more customers. The increase in sales will have a positive effect on Walmart’s operating profit margin percentage and its ROA as long as the increase in promotional expenses generates more gross margin dollars than they cost. In addition, the increase in sales will increase Walmart’s asset turnover because sales will increase but assets will remain the same. The net effect will be a positive impact on ROA. Looking at the asset turnover management path, Nordstrom could increase its asset turnover by decreasing the dollar amount of inventory in its stores. However, decreasing the level of inventory could actually decrease sales because customers might not find the products they want to buy, causing them to shop elsewhere. If they tell their friends, post negative online reviews, or use social media like Twitter to voice their discontent, the lack of salable inventory could have a cascading deleterious impact on sales and profits. The strategic profit model illustrates two important issues. First, retailers and investors should consider both operating and net profit margin and asset turnover when evaluating their financial performance. Firms can achieve high performance (high ROA) by effectively managing both profit margin and asset turnover. Second, retailers need to consider the implications of their strategic decisions on both components of the strategic profit model. For example, increasing prices might increase the gross margin and operating profit margin in the profit margin management path. However, increasing prices could also result in fewer sales, with negative impacts on both total gross margin and net operating profit margin dollars. At the same time, assuming the level of assets stays the same, asset turnover will decrease. Thus, a simple change in one strategic variable, such as pricing, has multiple repercussions on the strategic profit model, all of which need to be considered when determining the impact on ROA.