By Bill Scott
Part 2
Category Management is an important tool that should be included in every retailer’s tool kit, but it’s not the ONLY tool.
Over 11 years ago, when I purchased my current home, I had been living in an apartment for a decade, and most of my tools had been permanently loaned out to relatives who never brought them back. Maybe you have a similar problem.
One of my first task was to visit a hardware store and purchase basic tools—screwdrivers, spanners, a saw, a hammer and nails (mostly to hang pictures), an electric drill, etc. However, after eleven years in my new home my tool kit has expanded to include a table saw, a cement mixer, a tractor, two zero-turn mowers, a utility trailer, a volt/ohm meter, a drill press, a radial saw, a transit, and thousands of dollars in other tools required to keep the place up. I even purchased a drive-way grader that keeps my gravel driveway in usable condition.
If my intention had been to become a master carpenter, I would need more professional carpentry tools such as a router, a planer, and other things specific to the jobs I encountered. If I had relied on the initial tool kit I acquired when I moved here, I would not have been able to manage my property in a way that sustained my property’s value.
The same is true in running a business. You need paper, pencils, pens, a filing cabinet… and these days you need a computer. Imagine running your business without a computer. Running a business without one would be difficult, if not impossible. Yet, 30 years-ago we did alright without them. What’s changed? Everything!
Retail-based accounting has many challenges, but none more difficult that determining a true cost of goods sold. Retail-based accounting (aka Retail Accounting) is far from being accurate, as inventory is thrown into buckets and mixed up to make-up ‘categories’. Every type of retailer has its own collection of categories.
In the convenience store industry the most common categories are Groceries, Beer, Tobacco, Deli and Fountain, Non-Alcoholic Drinks, Phone Cards and HBA. More sophisticated enterprises may break basic departments into sub-departments. For example: groceries may be sub-categorized as Edible and Non-edible groceries. There may be other departments like General Merchandise, Automotive, Novelties and Gifts, T-Shirts, Signs, Head Coverings, and on, and on, and on.
To make matters worse, in my 40 years of working with over 360 companies owning multitudes of convenience stores, every company had its own set of departments, and the standards that are suggested by the industry are rarely (if ever) followed. The comparisons between one company’s grocery department and another company’s would be an impossibility. So, when we are told that the Grocery category should produce a gross profit percentage of say 30%, it’s a wild-guess at best, causing profit calculations to produce ambiguous results. Items in categories range from 10% to 50% profit or more. For example, the average gross margin on Cigarettes may be 15%, whereas Other Tobacco (not cigarettes) has a gross margin of around 32%. The spread between Candy and Salty Snacks is 12%.
With retail prices on grocery items based upon size, the margins can be all over the place, with popular items priced the same as items that rarely sell. And to make matters worse, almost everything in the store is rounded to the 9th cent. This madness needs to stop, and it needs to be ended quickly.
Why have departments anyway?
Once a month or so, most stores employ outside auditors to add up the retail value of each department and these figures are used for accounting. Therefore, items must be segregated into departments and counted based upon where they are found in the store. If an item does not scan, then the cashier chooses which department key to assign the sales to, and mistakes are made all the time. For example: if gloves are located in the Automotive department (where the auditors encounter them), a cashier may choose Clothing, General Merchandise or even Grocery when posting the sale. Scanning can assists in posting the sales to the proper departments, however auditors don’t have access to this information, and when purchases are assigned to departments, the department chosen is based primarily on the supplier’s idea of what department an item belongs to.
With a plethora of choices like this occurring in every store, how can we ever expect to get anything close to actual figures to deal with? We cannot, and convenience store owners have been faced with these errors for so long they have become ‘acceptable’.
Would you feel comfortable guessing at how much money you had in the bank, or how much you owed, or reporting your income and expenses to the IRS? I think not. Then, why do we accept wild guesses on the value of our inventory and our profits earned from sales?
Using Category Management as a tool to calculate profits has never made sense to me, especially when it can be done properly for far less money.
In a recent article published by the Category Management Knowledge Group, the method of determining Gross profit over a period is as follows:
The “Total COGS” is subtracted from the gross sales to produce the Gross Profit. One thing that is unclear about this formula is whether the beginning and ending inventories are presented at cost or, are they at retail? The answer can be assumed by taking note that the values must be at cost, else the addition of beginning inventory and purchases AT COST would not work. For example, if we started with $1,500,000 at RETAIL and purchased $500,000 at COST, the resulting calculations would be incorrect.
So, if the beginning figure ($1,500,000) is at cost, how was the cost for beginning inventory calculated? It must be from an assumption, and an arbitrary cost percentage was used to come up with the $1,500,000 figure, and that ‘cost percentage’ came from a belief that a store always has an average cost component of XX%. This is false, and it is the poison that makes this kind of accounting suspicious.
The actual profit percentage used in this exercise is irrelevant, but I am going to pick a gross margin percentage of 30% (excluding gasoline sales) to create a gross sales figure of $1,428,571.43 (calculations explained below). In this case, subtracting the Total COGS of $1 Million from that figure would result in an estimated Gross Profit of $428,571.43.
Few convenience store owners know what their actual cost of goods sold are, and therefore their profit, and this is a problem. The figures can’t accurately be calculated with formulas that are generated by assumptions. This type of accounting is over 100 years old, and only makes some sense when huge markups were present, and costs were nowhere near what they are today.
Not understanding how cost relates to retail is dangerous!
Some 34 years ago, I became involved in an argument with a new customer that marked his inventory up to produce a 30% profit by multiplying the cost by 130%, which of course is a common mistake that continues to be made by a large number of retailers everywhere. A 30% markup, actually results in a much lower number. An $1 item marked up to $1.30 only produces a 23% profit, and a seven percent loss over a year of sales can result in catastrophe. Most retailers rely on their suppliers to set the retail prices based on the MSRP, but these percentages can be wrong. Worse, if inventory is only repriced annually, which is the case in far too many convenience stores, what started as a 23% profit in January, could result in a 23% LOSS by December.
In my books, I go to great pains to explain that Cost, Retail, and %Cost can be demonstrated with a pyramid with Cost on the top and Retail and %Cost beneath it.
This Cost pyramid can be very useful to show the relationships between Cost, Retail and %Cost. The Cost at the top of the pyramid can be determined by the two figures on the bottom of the pyramid, and one on the bottom can be determined by the Cost and the number next to itself. All you need is two of the parameters to obtain the third.
Cost = Retail * %Cost, Retail = Cost / %Cost, %Cost = Cost / Retail
Using the Cost pyramid above, a cost of $1,500,000 with an ‘assumed” profit of 30%, would result in cost of 70% and a retail of ($1,500,000 / 70%) = $2,142,857.14 . Whereas, a markup of 30% would result in a retail of only ($1,500,000 * 130% = $1,950,000 and a profit potential of only ($1,950,000-$1,500,000) = $450,000. ($450,000/$1,950,000) = 23.07%. If I wanted a profit of 30% my markup should be 142.857% and not 130%. Why? Because 1/(1 – 0.30) = 1.42857. To calculate the profit we can use the Profit pyramid below.
The Profit pyramid consists of the elements Profit, Profit% and Retail and helped me to compile the figures above.
Profit = Profit% * Retail, Profit% = Profit / Retail, Retail = Profit / Profit%
Accounting when the costs is ambiguous is complicated and fraught with errors, and I have lost track of new customers that assumed their inventory was earning a great deal more than what they actually made. Category Management style accounting is a good reason as the why NACS has reported a 2.1% net profit margin across the industry.
The only accurate method of calculating profit is to have accurate cost figure to start with, and if we use someone’s notion about what those cost ‘should’ be, we have just set off a chain of events that cripples our accounting processes from the very beginning.
(Continued in Part 3)
