Profitability and Performance Management in Retail Industry

(9-10 Minutes)

Executive Summary: This article shares ideas on how to improve profitability calculations to support informed decision making. It starts with highlighting main challenges retailers face during profitability calculations, continues with sharing basic information on the solution and ends with explaining how we simplify the complexities.

We’re going through a technological leap period in information processing. Everyday we’re producing more data and trying to get the most out of that data by leveraging big data technologies. In this article, I want to focus on how retail industry transforms decision-making processes around profitability and performance management.

Profitability calculations in retail get more and more complex every day. The competition and tight margins put pressure on business and this forces procurement, merchandising and marketing teams to transform their processes. This in turn results in a transformation in financial calculations.

In Retail, what we do is running stores. We buy from suppliers and sell to end users. Our profitability is the difference between retail price and supplier price. Sometimes procurement team get creative and engage into private label or contract manufacturing agreements. The cost of goods change often and we want to be informed asap so that we may update our retail prices based on them. We have logistics and store operations. Logistics and storage costs should be taken into consideration while calculating profitability. Sometimes prices change retrospectively. Contracts are renegotiated to be effective valid from previous months/terms.

Retail is the business of volume that produces limited profit margin. Any problem with cash flow may consume that small profit. We need to keep good track of all our cash transactions. Because any issue with cash flow leads to financial costs that will again consume our profit margin. We need to consider customs and tax costs as we include them in our retail price and any change will consume the margin. Transfer pricing between different subsidiaries should be carefully calculated to avoid paying excess tax or receiving fines from the governments.

There will always be overheads like energy, rents, salaries, IT etc. We need to incorporate them into our profitability calculations. Retailers take investment decisions every day. Opening new stores, renovating or relocating them, launching new lines of products. Environmental concerns and regulations require us to keep track of our carbon footprint. There will always be some goods, which are not going to be sold because of spoils, spills, expiry, flaws and becoming out of season creating additional costs. The management of returns and online channel logistics costs are also important.

Retail and Consumer Products industries run on rebates or commissions based on targets. Which is a major indirect income. While marketing creates new promotions to increase sales, they further complicate financial and profitability calculations.

msg global develops Profitability and Performance Management (PaPM) solution together with SAP to address such business complexities and support informed decision making. There are three basic things to keep in mind about PaPM.

1. It can retrieve and process data from any source. These include non-SAP sources, SAP applications, web services or text files.
2. It includes a very robust calculation engine with predefined functions that can help us to address all kinds of financial calculations and address additional business cases.
3. It keeps trace of all actions for future reconciliation checks and includes a simulation engine that allows us to create projections to reflect parametric changes.

We supply industry specific and generic contents with the solution for free. These include...

• Profitability and Cost Management. Along with the generic module we also offer industry specific modules.
• IT Cost Allocation.
• Cash Flow Projection.
• Carbon Footprint Management.
• Transfer Pricing for FSI.

In this article, I will focus on major use cases for retail industry. The most popular ones are profitability calculation, cash flow projection, investment analysis, transfer pricing & tax optimization and sustainability analysis.

Sustainability: We supply a carbon emissions calculation and analysis module on PaPM to help you to manage your company’s carbon footprint. This module simplifies calculation processes and allows you to project future values.

Transfer Pricing and Tax Optimization: Multinational companies have to manage their transfer prices to avoid customs issues and paying excess tax. We supply transfer pricing calculation functionality and our partners develop transfer pricing and tax optimization modules for industries on PaPM. These models allow you to manage transfer prices in the system and optimize tax payments to reduce tax provisions, eliminate cash leakage and maximize profitability.

Cash Flow Projections: Retail business can be perceived as running thousands of stores even if you don’t have that many. Every product group is a business itself, becoming a wheel of many in your retail machine. Retail is probably the industry that takes the highest number of investment decisions because you open, merge or shut down many stores. Every decision has some initial investment that will bring future profit. Calculation of net present value of future financial transactions is a standard functionality in PaPM. This way we simplify the calculations for investment decisions and allow you to simulate with multiple options. This reduces the time spent for number crunching and increase the time for decision-making. Cash Flow is influenced by many external factors. Retailers usually have  

• Lots of payment contracts for supply operations, rents, energy and utilities, loans, salary and bonus payments.
• Along with cash payments, a bunch of receivable contracts for treasury operations, rebates, credit card payments and corporate customers.

These are the direct factors only. In addition to these, there are indirect influencers like exchange rates or commodity prices.

All these factors make it hard to manage Cash Flow, we simplify this process with PaPM and add projection or simulation capability to that. First, we create your cash flow calculations and reflect it on your calendar, then you can change the parameters like currency or salary increase or add new inputs like a new loan with 5 year payment plan and PaPM creates the projected cash flow based on your inputs.

Profitability: There are two main approaches to profitability calculations Accounting and Decision-Making.

Accounting approach originates from the need to calculate tax. It is bound by accounting rules like working in monthly terms and term closures. It is usually summary based not to complicate the calculations, because the main goal of this approach is calculation of the total profitability (to calculate tax) instead of segment profitability. Financial cost or income is calculated after EBITDA as it is totally separate from operations. This approach uses only finalized data in GL.

On the other hand, decision-making approach calculates profitability to measure the performance of segments or business decisions. With this approach we can answer questions like

• Which product is more profitable?
• Which store is not making money?
• When I consider the IT, marketing and logistics costs and returns, is online store still more profitable than physical stores?
• What is the effect of this promotion on my profitability?

Decision-making approach is forward looking, it is not bound by finalized data and can incorporate data from sales orders or estimations. The calculations can be down to the very detail even on every transaction.

Using CO-PA for profitability is a good example of accounting approach. It has structural limitations by being and integral part of GL. Because of that, it is hard to maintain decision-making allocations in CO-PA. Because of the design of CO-PA every time an allocation is run, there is some residual left and that needs to be managed. This residual grows every month and our CO-PA (actually my GL) gets harder and harder to manage every day.

To support decision-making approach we can calculate profitability even down to transaction level. From there we can reach any segment’s profitability. We can allocate indirect costs and indirect incomes down to the level we prefer. We can calculate actual costing along with standard costing. If needed we can calculate the standard cost variance and write it back to GL. We can also calculate the order to cash durations to find out the funding required for each transaction.

Running simulations or projections is key in decision-making. We have an extremely robust engine that allows us to process millions of records within seconds. Hence, a change in parameters is recalculated and the results are displayed on the screen to run projections.

How PaPM addresses complexities around supplier operations…

Private Label: Private label and contract manufacturing requires special effort to calculate the costs and simulate potential profitability. Manufacturing cycles are long and we may have an agreement with the manufacturer on a profit sharing or cost + margin base. PaPM allows retailers to make such calculations as it already offers this functionality for consumer products and manufacturing industries.

Price Changes: In our dynamic world prices change often, for example, price of raw materials, exchange rates and logistics costs change. Some products like fruits and vegetables have seasons and their prices change even daily based on availability. To beat the competition and protect profitability, pricing decisions should be made based on actual costs of the products. With PaPM you can easily calculate the effect of price changes daily or instantly and take timely actions to protect your profitability or competitive advantage. In addition, instead of calculating or knowing price of batches, we can calculate actual costs of the product.

Retrospective Price Updates: Retrospective price updates happen when procurement teams go creative. Sometimes procurement teams renegotiate with the supplier in May for a new price. If this price is effective from the beginning of the year as finance cannot update the previous months’ data they have to put this change in May crippling the ability to understand why previous months were less profitable than May. In PaPM we can manage such actions the way finance prefers.

How PaPM addresses complexities around central operations

Financing Costs: We can process your transactions to calculate the financing cost or profit of each transaction, hence reaching financing cost or profit of each transaction/product. As a result of this calculation we calculate both unit profitability and total profitability of each product. Yes, we can assign financial cost to the transaction and yes, this means we can move financial cost or profit above EBITDA for decision-making purposes. There are two order to cash cycles in retail

1. Order sent to supplier and then when it is due paid to the supplier
2. Product sold to the end user and payment received in cash or from bank in case of credit card transaction.

If for a product (or transaction), 1 is longer then 2 then I’m using my suppliers capital to do business, if 2 is higher than 1 then I’m using my capital causing financial cost. We can reflect these profit or costs to the transaction or product level. I will know how much capital I allocate each product and how much money I get in return.

Logistics Costs: We can also take into consideration logistics costs or storage costs. For example if I have 10 jackets in a box that occupies 1m3, I can calculate the cost of storing per m3 by allocating the cost of the inventory operations to the products.

HQ Costs: We can allocate indirect costs like HQ costs down to any level, including down to the level of transactions. These can be rents, HR costs, insurance costs, IT costs etc. In this process any allocation key can be used and outputs of different allocation keys can be simulated.

How PaPM addresses complexities around store operations

Expired or Flawed Products, Spoils, Spills, Scraps and Returns: That’s the nature of the business, there can always be some products that for some reason you can not to sell to the customers. Flawed stitches, expired dairy products, spilled detergents or damaged packaging… how they’re processed differ by case but the effect of this loss on segment profitability should be reflected, because I am using my capital to handle this matter. For example, if I cannot sell a shirt because it is flowed or is defective, I have to handle it and return it to the supplier. The costs of these operations or losses need to be allocated to relevant segments.

Channel Profitability: The use of online channel has increased widely in recent years. It seems very profitable when compared against physical stores. Is it really profitable? What are the costs associated with an online transaction? IT infrastructure costs, web design and marketing costs, logistics costs, handling of returns and financing costs of sales cycles from order to returns. How many times is a product ordered and returned before it is sold to final customer? We can allocate these costs to the related transactions to see actual profitability of the segments.

Rebates and Commissions: Sales is a commission based business. You may offer commissions to your employees based on their performance and expect rebates from your suppliers based on the amount you sell in a fixed term. By nature these rebates and commissions can be calculated after accounting term closure. For example you may have an agreement with a supplier such that if you sell 500 items you’ll get 10K Euros rebate. If you sell 50 items every month the supplier pays you 10K in November. How do you book it? Because it is not money made in November, it was originated by activities done during the year, not just in November. You may put some accruals accordingly in accounting but what happens if you don’t reach your target and don’t get the rebate? This results in Cause of Change analysis in reporting.

Seasonality: Some companies like fashion retailers execute based on seasons. They try to take decisions well ahead of accounting calculations. The simulation capability of PaPM helps our customers to calculate projected profitability based on prices, financial parameters and their estimations. We face a similar use case in CP industry. Some companies manufacture on orders and these orders may take several months to be completed. As accounting runs on monthly terms and is based on invoices, the profitability of sales orders in production (or pending) cannot be calculated. We can retrieve data from sales orders and project your future profitability based on product costs and prices.

Marketing Costs: Marketing is the area that your colleagues get extra creative and expect you to adapt financial calculations to their changes. It is probably the hardest topic as it effects each segment differently.

• Issuing loyalty points or vouchers. The customer spends 100 Euros for product 1 and in return you give them a voucher for 100 Euros. Financially this voucher is a liability but it cannot be deducted from the profit of the transaction as that voucher may not be used. After two months the customer comes and buys product 2 for 200 Euros and pays only 100 using the voucher. How would you distribute the voucher cost to the products and months? Are we creating a game that benefits the merchandising team of product 1 and punishing product 2?
• Buy three products and cheapest one is free. Did I take this into consideration while setting the prices? If not, how much loss will this campaign can cost me?
• During any campaign, we can calculate if we’re really making money out of this, or are we losing? We can project this every day, no need to wait for the month closure.

These are some of the areas you can benefit from PaPM. There are others and every company has its own dynamics. If you’re interested please drop me a message and we can discuss your cases further.

Aykut Tellibayraktar - 7 April 2019