Why retailers shift from retail to cost accounting

Behind the math on why making the switch is not just an accounting exercise but a business transformation??

Authors: Suni Shamapande, Gianna Hayes, Tess Taylor, Caitlyn Quilty, Ronald Simon, Courtney Keating

The Benefits of Cost Accounting?

Retailers that have made the decision to switch to cost accounting are embracing their decision. There are three drivers influencing organizations to make this switch.?

• Firstly, it can enhance cost accuracy and visibility, aiding in increased accuracy and performance across operations?
• Secondly, the method promotes operating model changes, improving inventory productivity and margin management. Converting also better aligns financial and merchant reporting, creating one version of the truth. Lastly, it can improve shrink accuracy, reducing losses from theft or damage?
• These insights were gleaned from analyzing publicly traded companies, engaging in discussions with them, and reflecting on PwC’s firm-wide experience?

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This article is the debut of PwC’s retail-to-cost series spotlighting the benefits of cost accounting, particularly weighted-average cost (WAC), for retailers. This first installment illuminates how cost accuracy and visibility can improve performance. Stay tuned for insights on shrink accuracy and operating model impacts, as we unravel the profound impact of cost accounting on the retail sector.??

Imagine this:??

A buyer for a high end department store is eagerly awaiting the end of the month so that they can dig in and assess their category’s sales and margin performance. Handcuffed by reporting limitations, they missed out on an opportunity to proactively accelerate sales with a targeted shallow promotion. As a result, they have no choice but to react with a deep markdown that will have a significant negative impact on the bottom line.?

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Now picture this:???

A buyer has access to sales and margin performance at the item level mid-week. In their daily dashboard they are alerted to skus falling below performance expectations that were set when the product was purchased. With the click of the mouse they are able to proactively select styles that should be promoted as soon as possible to optimize recovery and preserve margin. On the dashboard they see the financial impact to your proposed actions before sending them for approval to their manager. Ultimately, with visibility to real time results, the buyer is able to react swiftly and keep up with the market and increase profitability.?

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How to get there and what to expect:??

The method used to calculate the value of inventory can be a root cause for some of these challenges. After an assessment, organizations will create a business case to make the transformative switch from one valuation methodology to another. This change can help drive top and bottom line results across an entire organization and these financial gains are actually driven by behavior changes. Renewed focus on selling velocity, freshness and inventory movement both in, out and across the network can result in potential financial gains such as:?

• Gains of 50-100 basis points in revenue?
• Improvement of 50-150 basis points in margin?
• Reductions of 5-15% of inventory carrying costs?
• ~1 day reduction in dock to stock time?
• ~20 hour reduction in time to floor??

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Cost Accounting explained:?

There are two common inventory valuation methods used by retailers, retail inventory management (RIM) and cost accounting. An ERP system leveraging the cost accounting method, records each transaction to very precisely quantify the exact cost inventory value of every item at every location. With every transaction, the inventory value is re-calculated. When comparing cost accounting to the RIM method, cost accounting is more accurate. It is not uncommon for organizations to upgrade their ERP system while making an accounting method switch.?

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The most common inventory valuation method used is the weighted average cost method (WAC) but others include First in First Out (FIFO) and Last in First Out (LIFO). Organizations will decide which method to use based on commodity type. Over 50% of US retailers have switched to using cost accounting and as a result on average, these retailers have realized financial gains.??

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Per the TD Cowen Equity research team in June 2023, “[the research team has] a strong view that all retail should be using the cost method of accounting in order to better align inventory returns with returns on invested capital. This adjustment should have been implemented once point of sale systems that identified SKUs were in-store, but better late than never. The cost method - compared to the retail method - unlocks gross margin return on inventory (GMROI) and gives merchants the tools to measure and buy against markdowns occurring in real-time versus overbuying and cushioning against markdown allowances. The bottom line is that we believe the cost method helps unlock selling the same or more with less inventory and chasing and using reserves.”?

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With cost accounting, retailers are able to predict their gross profit performance based on sales performance 98% of time due to the KPIs high correlation, compared to 87% with RIM method (Shamapande, S. (2023). Correlation between gross profit and retail sales [unpublished paper]. Consulting Solutions, PricewaterhouseCoopers)?

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Behavior Changes with Cost Accounting:?

In order to realize gains, those managing the day in and day out business should operate differently when making business decisions. Business team members such as buyers, planners, inventory managers and leaders (just to name a few) gain visibility to real time inventory movement, such as sales, returns, markdowns, purchases and transfers.?

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This end to end network visibility, at a customized level of detail, allows teams to renew focus on selling velocity, freshness and inventory movement both in, out and across the network. A mindset shift of becoming equally focused on the importance of both unit and dollars leads often to not only improved pricing decisions but quicker and more frequent decision making in general. Changed behaviors, renewed access to data and improved item level forecast accuracy can empower retail teams to drive improved results.?

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Amongst these teams, merchandise planning and buying organizations often experience one of the higher degrees of change in the way they manage their business day to day. With increased visibility to a more precise valuation of cost inventory as well as what dollar and units are on order, merchandise planners are able to proactively recommend changes for future inventory complexion across categories, brands and locations. As a result on average, sales, margin and inventory forecast accuracy improves and margin gains increase. Comparatively with the RIM method, a use of a cumulative markup to estimate the cost value of inventory on a monthly basis. The use of these estimates can reduce forecasting accuracy, leading to margin volatility.??

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Transitioning to Cost Accounting:?

The transition to cost accounting is a journey that not only includes system changes but behavior changes as well. Preparation is key, as well as a strong appreciation that it is a big change across the entirety of an organization. With that said, the benefits realized are quantifiable and tangible.??

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PwC has helped many retailers make this change. By possessing the appropriate depth of knowledge, proven experience, and the ability to leverage capabilities in order to reduce complication and invested time, PwC can help your organizations realize the benefits of switching to cost accounting.?

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