Financial Management and Accounts

MBA(DISTANCE MODE)

DBA 1739

RETAIL ACCOUNTING AND FINANCE

III SEMESTERCOURSE MATERIAL

Centre for Distance EducationAnna University Chennai

Chennai – 600 025

Author

DrDrDrDrDr.B.B.B.B.B. Y. Y. Y. Y. Yamamamamamuna Krishnauna Krishnauna Krishnauna Krishnauna KrishnaDirector

Insititute of Management StudiesEaswari Engineering College

Chennai - 89

DrDrDrDrDr.T.T.T.T.T.V.V.V.V.V.Geetha.Geetha.Geetha.Geetha.GeethaProfessor

Department of Computer Science and EngineeringAnna University Chennai

Chennai - 600 025

DrDrDrDrDr.H.P.H.P.H.P.H.P.H.Peereereereereeru Mohamedu Mohamedu Mohamedu Mohamedu MohamedProfessor

Department of Management StudiesAnna University Chennai

Chennai - 600 025

DrDrDrDrDr.C.C.C.C.C. Chella. Chella. Chella. Chella. ChellappanppanppanppanppanProfessor


Chennai - 600 025

DrDrDrDrDr.A.K.A.K.A.K.A.K.A.KannanannanannanannanannanProfessor


Chennai - 600 025

Copyrights Reserved(For Private Circulation only)

Editorial Board

Reviewer

MrMrMrMrMr. Mahammad R. Mahammad R. Mahammad R. Mahammad R. Mahammad Rafafafafafi Syi Syi Syi Syi Syed, AICWAed, AICWAed, AICWAed, AICWAed, AICWADeputy Manager Finance,

ETA General (P) Ltd, Seethakathi Chamber,5th Floor, 688, Anna Salai,

Chennai - 600 006

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ACKNOWLEDGEMENT

The author has drawn inputs from several sources for the preparation of this course material, to meet therequirements of the syllabus. The author gracefully acknowledges the following sources:

• “Retail Manage ment”, ICFAI Centre for Management Research, May 2003• David Gilbert, “Retail Marketing Management”, Financial Times, Prentice Hall and an imprint of Pearson

Education, 2000• Barry Berman & Joel R.Evans, “Retail Management – A strategic Approach”, Prentice Hall of India,

2007• Chetan Bajaj, Rajnish Tuli, Nidhi Srivastava, “Retail Management”, Oxford University Press, 2007• Brealey and Myers, “Investment Management”• R.S.N.Pillai and V.Bhagavati, “Management Accounting”, S.Chand & Company Ltd, Ram nagar, New

Delhi – 110 055.• I.M.Pandey, “Financial Management”, Vikas publishing house pvt .Ltd, 2006• M.Y.Khan & P.K.Jain, “Financial Management”, Tata Mcgraw Hill Publishing company Ltd, 2007• Dr.S.N.Maheshwari, “Financial Management – Principles and Practice”, Sultan Chand & Sons, 2000.• I.M.Pandey, “Elements of Management accounting”, Vikas publishing house pvt .Ltd, 1993• Eugene. F.Brigham, Michael.C.Ehrhardt, “Financial Management – theory and practice”, Thomson

southwestern, 2006.• Salil Panchal and Morpheus Inc. 2003, ‘What is VAT7 And why VAT’ www.rediff.com, April 12

Inspite of at most care taken to prepare the list of references any omission in the list is only accidentaland not purposeful.

Dr.B.Yamuna Krishna Author

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DBA 1739 RETAIL ACCOUNTING AND FINANCE

UNIT I IMPORTANCE OF ACCOUNTS & FINANCE

Role of finance managers in retail environment – Sources of Finance – Short term Vs Long term finance –Working capital management – Capital investment decisions.

UNIT II RETAIL INVENTORY MANAGEMENT

Inventory budget - Forecasting techniques – Inventory order management – Material issue management – Pricingof inventory – ABC and VED analysis

UNIT III MERCHANDISE PERFORMANCE

Analyzing merchandise performance – Weeks supply method – Stock to sales method – Preparation of comparativesales statements.

UNIT IV PROFIT MEASUREMENTS

Financial performance measure – Sales per square metre – Sales per employee – Elements of cost and profitability– Components of retail cost – Margins and markups – Customer service cost and benefits.

UNIT V FINANCIAL STATEMENTS

Financial accounting concepts and principles – Accounting records in a retail shops - An overview of Branch andJoint venture accounting –– Financial Statements – Value Added Tax – Types of audit and auditing procedure –An introduction to accounting software packages.

REFERENCES

Retail Marketing – Peter McGoldrick – The McGraw – Hill Companies – Second EditionRetail Accounting and Financial Control – Robert M.Zimmerman – John Wiley & SonsAccounting for Marketing – Richard M.S. Wilson – International Thomson Business pressRetail Marketing Management – David Gilbert – Financial Times & Prentice Hall.

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CONTENTUNIT I

IMPORTANCE OF ACCOUNTS & FINANCE

1.1 INTRODUCTION 11.2 LEARNING OBJECTIVES 11.3 DEFINITION OF ACCOUNTING AND

FINANCIAL MANAGEMENT 21.4 ROLE OF FINANCE MANAGERS IN RETAIL ENVIRONMENT 31.5 SOURCES OF FINANCE 3

1.5.1 Obtaining funds – the correct approach 41.5.2 Classification of sources of finance 5

1.6 SHORT TERM VS LONG TERM FINANCE 51.6.1 Different aspects of short term finance 6

1.7 LONG TERM FINANCE 91.7.1 Types of long term debt products 9

1.8 LINK BETWEEN LONG TERM AND SHORT TERM FINANCING 101.8.1 Corporations vs Companies 101.8.2 Popular sources of finance 10

1.9 WORKING CAPITAL MANAGEMENT 111.9.1 Concepts of Working capital 121.9.2 Need for Working capital 121.9.3 Components of Working capital 131.9.4 Nature of Working capital 141.9.5 Types of Working capital 141.9.6 Importance of adequate Working capital 151.9.7 Danger of inadequate Working capital 151.9.8 Danger of excessive Working capital 161.9.9 Factors effecting working capital needs of a firm 161.9.10 Sources of Working capital 181.9.11 Estimating the Working capital requirements 18

1.10 CAPITAL INVESTMENT DECISIONS 211.10.1 Features of Capital budgeting decisions 211.10.2 Assumptions of Capital budgeting decisions 221.10.3 Types of investment decisions / proposals 221.10.4 Types of Capital budgeting techniques 22

1.11 ILLUSTRATIONS 261.12 CAPITAL RATIONING 291.13 SUMMARY 311.14 Short Questions 381.15 Long Questions 39

UNIT IIRETAIL INVENTORY MANAGEMENT

1. INTRODUCTION 431.1 DEFINITION 431.2 COMPONENTS OF MERCHANDISE MANAGEMENT 432. LEARNING OBJECTIVES 443. INVENTORY BUDGET 443.1 LIFE CYCLE STAGES OF PROJECTS 454. FORECASTING TECHNIQUES 464.1 FORECASTING TECHNIQUES 464.2 TYPES OF MERCHANDISE 464.3 PROJECTED SALES 474.4 INVENTORY PLAN 484.5 ESTIMATED REDUCTIONS 484.6 ESTIMATED PURCHASE LEVELS 484.7 BUDGET PROCESS 504.8 CHALLENGES FACED BY RETAILERS

WHILE PREPARING DEMAND FORECASTS 514.9 LARGE SCALE AUTOMATED FORECASTING 524.10 FORECASTABILITY OF RETAIL DEMAND 524.11 SALES / DEMAND FORECASTING 534.12 METHODS OF SALES FORECASTING WHEN

A FIRM IS A NEWLY STARTED FIRM 534.13 SOME DO’S AND DON’TS OF SALES FORECASTING 544.14 EQUATIONS TO CALCULATE RETAIL SALES AND STOCK 544.15 ESTIMATION OF STORE SALES WHEN

A FIRM IS AN EXISTING ONE 564.16 HOW TO MAKE A TRAFFIC COUNT 574.17 IMPLEMENTING MERCHANDISING PLANS 584.18 RETAIL LOGISTICS MANAGEMENT 664.19 RETAIL SUPPLY CHAIN MANAGEMENT 665. ORDER PROCESSING AND FULFILLMENT

IN RETAIL BUSINESS 67

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5.1 RETAIL TRANSPORTATION AND WAREHOUSING DECISIONS 685.2 RETAIL INVENTORY MANAGEMENT 695.3 RETAIL INVENTORY LEVELS 715.4 REVERSE LOGISTICS 745.5 RETAIL INVENTORY ORDER MANAGEMENT 745.6 COMMUNICATIONS TRACKING IN RETAILING 755.7 RETAIL WAREHOUSING LOCATIONS MANAGEMENT 755.8 PHYSICAL INVENTORY COUNT MANAGEMENT IN RETAIL 755.9 RETAIL INVENTORY TRANSFER MANAGEMENT 755.10 RETAIL DECISION MANAGEMENT 766. MATERIAL ISSUE MANAGEMENT 766.1 RETAIL INVENTORY METHOD 766.2 THE COST METHOD 776.3 A PHYSICAL INVENTORY SYSTEM USING THE COST METHOD 776.4 A BOOK INVENTORY SYSTEM USING THE COST METHOD 776.5 THE RETAIL METHOD 786.6 ADVANTAGES OF RETAIL METHOD 796.7 LIMITATIONS OF RETAIL METHOD 796.8 WEIGHTED AVERAGE COST METHOD 806.9 FIRST IN FIRST OUT METHOD (FIFO) 806.10 LAST IN FIRST OUT (LIFO) 816.11 DISTINCTION BETWEEN FIFO AND LIFO 826.12 DISADVANTAGES OF COST BASED INVENTORY SYSTEM 827. PRICING OF INVENTORY 827.1 OBJECTIVES OF PRICING POLICY 837.2 CLASSIFICATION OF CUSTOMERS 847.3 PRICING PHILOSOPHIES 857.4 PRICING STRATEGY 857.5 EXTERNAL FACTORS THAT INFLUENCE THE

RETAIL PRICING STRATEGY 867.5.1 Influence of demand on retail pricing 867.5.2 Influence of competition on retail pricing 867.5.3 Influence of cost on retail pricing 877.5.4 Influence of product characteristics on retail pricing 877.5.5 Influence of legal considerations on retail pricing 87

7.6 RELATIONSHIP BETWEEN DEMAND AND TOTAL REVENUE 877.7 THE VARIOUS FACTORS THAT INFLUENCE

THE PRICE SENSITIVITY OF A PRODUCT / SERVICE 907.8 SETTING RETAIL PRICES 91

7.8.1 Concepts and calculations for setting retail prices 91

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7.8.2 Cost of goods sold 927.8.3 Net sales 937.8.4 Gross margin 937.8.5 Percentage gross margin 937.8.6 Markups and Margins 937.8.7 Markdowns 947.8.8 Methods for setting retail prices 957.8.9 Retail pricing strategies and practices 96

8. ABC ANALYSIS 1008.1 PROCEDURE SUGGESTED FOR

DEVELOPING AN ABC ANALYSIS 1039. VED ANALYSIS 10410. SUMMARY 10511. SHORT QUESTIONS 12812. LONG QUESTIONS 12813. EXERCISES 129

UNIT IIIMERCHANDISE PERFORMANCE

1 INTRODUCTION 1312 LEARNING OBJECTIVES 1313 ANALYZING MERCHANDISE PERFORMANCE 1313.1 METHODS OF PLANNING AND

CALCULATING INVENTORY LEVELS 1343.1.1 Basic stock method of planning inventory 1343.1.2 Percentage variation method 1353.1.3 Week’s supply method 1363.1.4 Stock to sales method 137

3.2 OTHER FACTORS WHICH INFLUENCETHE ESTIMATION OF INVENTORY REQUIREMENTS 137

4. MERCHANDISER SKILLS 1374.1 DEVELOPING THE FIRST STAGE OF

THE MERCHANDISING PLAN 1394.2 VARIATIONS IN DEMAND 1394.3 RETAIL RANGE PLANNING 1404.4 DEVELOPING RANGE PLANNING AND

MERCHANDISE ALLOCATION PLAN 1414.5 ASSORTMENT PROFILES FOR DIFFERING

MERCHANDISE STRATEGIES 143

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4.6 STORE GRADING 1434.7 DEVELOPMENT OF CONTROL MECHANISM OF

THE MERCHANDISE PLAN 1444.8 MERCHANDISE ASSORTMENT AND SUPPORT 1444.9 NEGOTIATING THE TERMS OF PURCHASE 1455. PREPARATION OF SALES BUDGETS 1466. SUMMARY 1477. SHORT QUESTIONS 1558. LONG QUESTIONS 155

UNIT IVPROFIT MEASUREMENTS

1. INTRODUCTION 1572 LEARNING OBJECTIVES 1573 RETAIL PERFORMANCE MEASURES (FINANCIAL) 1583.1 PROFIT PLANNING 1583.2 ASSET MANAGEMENT 1583.3 THE STRATEGIC PROFIT MODEL 1603.4 OTHER KEY BUSINESS RATIOS 161

3.4.1 Measures of profit and growth 1613.4.2 Measures of cash flow and growth 1603.4.3 Measures of costs 163

3.5 SALES AND PROFITABILITY 1643.5.1 Sales per square meter or profit per square

meter or sales per square foot 1643.5.2 Sales per linear meter or profit per linear

meter or sales per linear foot of shelf space 1653.5.3 Sales per cubic meter or profit per cubic meter 1653.5.4 Sales by department or product category 165

3.6 MEASURING PRODUCTIVITY OF STAFF 1653.6.1 Sales per transaction 1663.6.2 Sales per employee 1663.6.3 Labor productivity 1663.6.4 Gross margin per FTE (Sales) Employee 1663.6.5 Suppliers per buyer 167

3.7 CALCULATING RETAIL SELLING SPACE 1674 OVERALL FINANCIAL AND ADMINISTRATIVE STANDARDS 1674.1 MARKETING AND MERCHANDISING STANDARDS 1674.2 MEASURES OF MARKETING PERFORMANCE 168

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4.3 MEASURES OF MERCHANDISING PERFORMANCE 1695 INVENTORY STANDARDS 1705.1 MEASURES OF INVENTORY 1706 FACILITIES STANDARDS 1716.1 MEASURES OF SPACE PERFORMANCE 1717 ESTABLISHING A PERFORMANCE

MEASUREMENT PROGRAM 1728 SALES MANAGEMENT 1748.1 TRACKING KEY INDICATORS 1749 PERFORMANCE EVALUATION 17710 REFERENCE GUIDE FOR RETAIL

PERFORMANCE INDICATORS 17810.1 SALES STATISTICS 17810.2 INVENTORY STATISTICS 17910.3 PAYROLL STATISTICS 18110.4 FINANCIAL STATISTICS 18210.5 CUSTOMER SERVICE TERMINOLOGY 18311 MEASURING THE RETAIL SHOP’S PRODUCTIVITY 18311.1 PROFIT PER SQUARE FOOT 18311.2 SALES PER LINEAR FOOT 18312 CASH FLOW FORECASTING 18312.1 CASH FLOW PROJECTION 18412.2 CASE STUDY: PERFORMANCE EVALUATION 18413 COMPONENTS OF RETAIL COST 18713.1 SPECIMEN OF A COST SHEET 18714 COST FACTORS AND PRICING 19014.1 EXAMPLE OF FIGURING THE COSTS AND PROFITS FOR .

A CONSULTANT SERVICE 19014.2 COST OF GOODS SOLD/COST OF SALES 19014.3 EXPENSES 19115. MARGINS AND MARKUPS 19116. CUSTOMER SERVICE COST AND BENEFITS 19316.1 COST OF AN AVERAGE SALES CALL 19316.2 COST OF KEEPING A CUSTOMER 19317. SUMMARY 19318. SHORT QUESTIONS 20119. LONG QUESTIONS 201

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UNIT VFINANCIAL STATEMENTS

1. INTRODUCTION 2032. LEARNING OBJECTIVES 2043. FINANCIAL ACCOUNTING CONCEPTS AND PRINCIPLES 2043.1 ACCOUNTING CONCEPTS 2043.2 ACCOUNTING CONVENTIONS 2054. ACCOUNTING RECORDS IN RETAIL SHOPS 2065. AN OVERVIEW OF BRANCH AND JOINT

VENTURE ACCOUNTING 2065.1 BRANCH ACCOUNT 206

5.1.1 Branch not keeping full system of accounting 2075.1.2 Abnormal losses – treatment 2085.1.3 Branch keeping full system of accounting 208

5.2 JOINT VENTURE ACCOUNTING 2085.3 ACCOUNTING TREATMENT 210

5.3.1 Separate books method 2105.3.2 Complete accounting in the books of the co-venturer5.3.3 Memorandum joint venture method. 210

6. FINANCIAL STATEMENTS 2116.1 INCOME STATEMENT AND RELATED CONCEPTS 2116.2 FORMAT OF INCOME STATEMENT OF

A RETAILER / MERCHANDISER 2126.3 COMPONENTS OF A BALANCE SHEET 2126.4 BALANCE SHEET AND RELATED CONCEPTS 2146.5 FORMAT OF BALANCE SHEET OF A RETAIL BUSINESS 2156.6 THE BASIC FUNCTIONS OF A BALANCE SHEET 2186.7 COMMON ADJUSTMENTS AFFECTING THE

PREPARATION OF A BALANCE SHEET 2187. VALUE ADDED TAX 2217.1 GOODS COVERED UNDER VAT 2227.2 NECESSITY OF VAT 2237.3 IMPORTANCE OF VAT 2237.4 ADVANTAGES OF VAT 2247.5 CRITICISM OF VAT 2247.6 VAT VS.SALES TAX 2268. TYPES OF AUDIT AND AUDITING PROCEDURE 2268.1 ESSENTIALS OF A GOOD RETAIL AUDIT 227

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8.2 RETAIL AUDIT PROCESS 2278.3 TYPES OF AUDIT 2289. AN INTRODUCTION TO ACCOUNTING

SOFTWARE PACKAGES 23110. SUMMARY 23511. SHORT QUESTIONS 24012. LONG QUESTIONS 241

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1 ANNA UNIVERSITY CHENNAI

UNIT I

IMPORTANCE OF ACCOUNTS & FINANCE

1.1 INTRODUCTION

There are many approaches to understanding and defining retailing; most considerretailing as the business activity of selling goods or services to the final consumer. It maybe defined thus as – “any business that directs its marketing efforts towards satisfying thefinal consumer based upon the organization of selling goods and services as a means ofdistribution”. Retailing involves a set of business activities that add value to the productsand services sold to the final consumers for their personal, family or household use.

The pre-90’s saw retailing in India in an unstructured and fragmented market with theword ‘retailers’ meaning peddlers, vegetable vendors, grocery stores and the like, whomostly operated in a single locality. Indian organized retailing during those days was led byonly a few manufacturer owned retail outlets such as Bombay dyeing, Raymonds etc.Post- 90’s changed the pace of ‘retailing’ in India with the advent of several measurestaken by the Indian Government including liberalization of Indian economy. These measuresencouraged the entry of MNCs into the Indian market, which in turn impacted the changingprofiles of Indian consumers. The pace of technological development in India contributedto – higher pay cheques, increased emphasis on western lifestyle, increased standard ofliving, gradual increase in GDP and purchasing power of Indians, increased urbanization,growing momentum of consumerism, and increased brand consciousness of Indianconsumers etc. All these factors resulted in the mushrooming of lifestyle shops, brandshops, ethnic malls etc to cater to the likes of the changed Indian consumer psyche. Todaymany retail chains set up by domestic as well as foreign retailers can be seen, which areoperating in urban as well as rural markets. Now, “retail” is the buzz word of business.

1.2 LEARNING OBJECTIVES

After going through this chapter, the reader is expected to –

1. Understand what accounting is, does and how its different branches serve the purposeof providing information to the needy

2. Understand the meaning of Finance and what it entails in an organization

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3. Know the role of finance managers in retail environment and the various challengesthey face

4. Understand the various sources of finance (short term, mid term and long term) withtheir respective merits and demerits

5. Understand the distinctions between long term and short term sources of finance6. Understand the basics of working capital management7. Develop an idea about capital investment decisions, the metrics of deciding the

desirability of various projects with or without any limitations

1.3 DEFINITION OF ACCOUNTING

The American Institute of certified public accountants (AICPA) definedaccounting as “Accounting is the art of recording classifying and summarizing in a significantmanner and in terms of money transactions and events which are in part at least of afinancial character and interpreting the results thereof”.

Accounting has been termed as the language of business. The basic function ofaccounting thus is to communicate the operating results of the business to the stake holdersand share holders of a business. Basic accounting deals with preparing and providing aconsolidated feedback report on the policies followed by a business during the respectiveperiod of 365 days to the shareholders and stakeholders for internal decision making andto the external interested parties for external decision making.

The term Financial management has been defined by management experts in manyways reflecting the duties and responsibilities of a finance manager over the years. Someof the popular definitions are as follows –• R.C.Osborn – ‘Finance Function is the process of acquiring and utilising funds of a

business’• Bonneville and Dewey – ‘Financing consists of the raising, providing, managing of

all the money, capital or funds of any kind to be used in connection with the business’• Phillippatus – ‘ Financial Management is concerned with the managerial decisions

that result in the acquisition and financing of long-term and short term credits for thefirm’

In Finance, investment decisions are related to allocation of funds in long term orfixed assets. These decisions are also known as capital expenditure decisions / capitalbudgeting decisions. These decisions relate to the profitability of a business. Financialmanagement is related to procurement of funds at cheaper cost and allocating them toprojects at higher rate of return. The borrowing or procuring function is related to thecalculation of the cost of each type of source of funds as well as the overall cost of all typesof funds borrowed or to be borrowed by a business. The guiding principle in both thesedecisions is that – the overall cost of capital must be the lowest and the return on thevarious investments must be the highest at any given period of time. These two decisionswill decide the financial health of an organization.


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1.4 ROLE OF FINANCE MANAGERS IN RETAIL ENVIRONMENT

The Indian CFO is evolving as the bean counters of yore are becoming businesspartners. With the growing complexity of the business environment, the CFO’s role hasexpanded dramatically into hitherto un-treaded areas such as –involvement in businessplans, strategy formulations, fund raising activities, risk management processes and planningnew financial products, introduction of IT support into the organization, corporategovernance, dealing with overseas businesses, efficient tax management, financialrestructuring, etc. Thus, the list goes on. He/she is expected to be more proactive thanever before, given the dynamic environment corporate world exists in. In companies withinternational operations, risk profiling of countries, assessing country profitability and ensuringcompliance with multiple regulatory environments have become a part of the CFO’s duties.

Thus, today’s CFO needs to understand the nuances of business, be they related tomarketing, HR, administration or products. He/she should be involved with strategyformulation, and it is important that he/she be well acquainted with almost all the functionsin an organization. He/she certainly needs to understand IT and the nuances of financialderivative products which involve significant complexities.

On line with the growing emphasis on retail boom, some of the add-ons to a CFO’sjob include –

o Supporting the development of a strategy that effectively supports the sale of a dealernetwork through dedicated retail finance solutions and programs

o Working closely with the sales & marketing team in determining the needs andrequirements for retail finance support

o Supporting the implementation of the strategieso Coordinating all relationships with banks and finance companies regarding retail finance

supporto Supporting the potential negotiations with banks and finance companies for

cooperation agreements and lead the negotiations of all the memorandums ofunderstandings.

o Monitoring the effectiveness of cooperation with banks and finance companieso Preparing and analyzing the regular reporting on the key retail finance metricso Monitoring retail finance environment in the Indian agricultural and industrial marketso Observing the retail finance schemes and programs of the competitorso Reporting regularly on the competitive environment in the retail finance area.

1.5 SOURCES OF FINANCE

Sourcing money may be done for a variety of reasons such as - capital assetacquirement - new machinery or the construction of a new building or depot. Thedevelopment of new products can be enormously costly and here again capital may berequired. Normally, such developments are financed internally, whereas capital for the

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acquisition of machinery may come from external sources. In this day and age of tightliquidity, many organizations have to look for short term capital in the way of overdraft orloans in order to provide a cash flow cushion. Interest rates can vary from organization toorganization and also according to purpose.

In the market, there are various sources of finance, with differing risk characteristicsand with differing cost structures. A limiting factor in the provision of finance for successfulbusiness is risk. The debt capacity of a borrower depends on the extent to which he/sheis able to reassure the lender(s) that the risk element can be controlled through carefulplanning and implementation of common sense management procedures. For this, he/shehas to understand – how to reach the sources of finance available to them and also how tocapitalize on the use of these resources in order to reduce the risk factor.

1.5.1 Obtaining Funds – The Correct Approach

Whenever possible, long-term assets must be financed by using long-term sources offinance. Short-term assets, such as stock and debtors, should be financed by using short-term sources of money, e.g. overdrafts. A business can be throttled by having to repayshort-term liabilities quickly from the sale of long-term assets which are not meant fordisposal. Before procuring funds, it is necessary for a business to ask the followingquestions.

• Where and when should it look for money for its business?• Is debt good or bad or both?• What should be known before going for debt?

To manage the finances of a business successfully, the following need to be done

1. Recognize when the funds are needed: Any best financing plan involves carefulplanning. An effective plan usually includes the analysis of the following

• Why is the money required?• How is it going to be used?• How much money is required?• How much the business can afford to pay for the funds?• How and when the money will be repaid?

This analysis will make it easier for the business to avoid last minute fund procurementwhich usually is expensive.

2. Identify the various sources of funds: There are numerous ways in which money couldbe procured, with respective costs and benefits. In order to develop the best financingplan, a manager has to know two things – i) what sources are available for the moneyneeded? ; ii) what are the best sources of all?


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There are three general categories for funding the financial requirements of a business.They are – i) Internal sources, ii) equity and iii) debt. The priority first should go to theinternal sources as they may be the cheapest and easiest source available to a business. Incase internal sources are not adequate for the fund requirement, a business may need tolook at external sources such as debt or equity. Before deciding further, all the sourcesmust be analyzed as to – i) Cost – how will the source of funds affect the cash flow / profitof a business? ii) Risk – will the source expose the business to danger? iii) Flexibility –will the source limit the ability of the business to seek additional funds or use of funds? iv)Control – is there any danger of loss of control or sharing of decision – making because ofthe source being used? v) Availability – when the funds could be acquired?

3. Effectively manage the funds to take full advantage of the least expensive sources. Itdepends on the creativity of the finance manager to match the cost of the funds with thereturns on the investments and also to match the cash inflows with the cash outflows.Thus, effective management of funds entails creative and effective procurement andinvestment of funds.

Establishment of an effective financial plan will take full advantage of all sources withoutdamaging the credit rating or endangering the sources for the company.1.5.2 Classification of Sources of Finance

Several management experts have tried to classify them into several categories basedon the time factor, ownership pattern, source of generation, and convenience. The resultingclassification of finance is as follows

• On the basis of period – long term, medium term and short term• On the basis of ownership – own capital and borrowed capital• On the basis of source of generation – internal sources and external sources• On the basis of convenience – security financing (shares, debentures etc), Internal

financing (Depreciation funds, retained earnings, reserves etc), Loan financing (longterm loans, medium term loans and short term loans)

1.6 SHORT TERM VS LONG TERM FINANCE

The most useful classification of sources of funds deals with segregation of sourcesinto short term and long term sources of finance. In practice, short term refers to a periodless than one year and long term refers to above five years or sometimes is referred asother than short term. When we say short-term financing, we are looking at short-termassets and short-term liabilities.

Short term financing provides information about the various sources of short termfinance for a year or less. These funds are usually for businesses to run their day-to-dayoperations including payment of wages to employees, inventory ordering and supplies. Anexample of short tern financing could be when a firm places an order for raw materials, itpays with finance and anticipates recouping this finance by selling these goods over the

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period of a year. Industries with seasonal peaks and troughs and those engaged ininternational trade will be heavy users of short term borrowing finance.

The repayment term of short term financing is usually shorter than one year.Creditworthiness is an important aspect which the firm must satisfy before any short termfinancing is granted. The following aspects are considered when assessing creditworthiness.

Character: The reputation of honesty and reliability.Capacity: The business sense of the borrower, the level of experience and businesshistory.

Circumstances: The general business circumstances in the industry and the economy.

Insurance Cover: The extent of the cover of insurable risks taken out by the borrower.

Guarantees: The lender may require the borrower to use assets to guarantee the loan.

1.6.1 Different Aspects of Short Term Finance

Trade creditors

This the basic source of finance and many firms do not realize that by acquiring itemson credit they are obtaining short term finance. Credit just like any other source of financehas interest element hidden which most firms are not able to recognize. Therefore it is nota cheap source of finance. On occasions, trade credit is used because the buyer is notaware of the real costs involved- if he were, he might turn to other sources of trade finance.However, other forms of capital are not always available, and for a company that hasborrowed as much as possible, trade credit may be the only choice left. This is an importantsource of capital for many small companies. A company which provides credit to anotheris in fact putting itself in the position of a banker whose advance takes the form not of cashbut of goods for which payment will be deferred. This use of trade credit between companiesis extremely important from both an industrial and a national point of view.

Terms of Trade Credit

Terms of credit vary considerably from industry to industry. Theoretically, four mainfactors determine the length of credit allowed.

1. The economic nature of the product: Products with a high sales turnover areusually sold on short credit terms. If the seller is relying on a low profit margin and ahigh sales turnover, he cannot afford to offer customers long time to pay back theamount due.

2. The financial circumstances of the seller: If the seller’s liquidity position is weak,he will find it very difficult to allow higher level of credit and will prefer an early cashsettlement. If the credit term is used as part of sales promotion, then, he may allowmore credit period and may use other means for improving his liquidity position.


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3. The financial position of the buyer. If the buyer has a weak liquidity position, hemay take a long time to settle the balance due. The seller may not desire to trade withsuch customers, but where competition is stiff, there is no choice other than acceptingsuch risk and improve the sales levels.

4. Cash discounts: When cash discounts are taken into account, the cost of capital canbe surprisingly high. The higher the cash discount being offered, the smaller is theperiod of trade discount likely to be given.

Trade credit is also used to signal the effect on the performance of both the buyer andthe seller. Where the days allowed to customers are increasing, it may indicate that thecompany is slipping in its debt collection and very soon may encounter cash flow problems,bad debts problem etc, which will reduce the profit levels of the company. On the otherhand, reducing the credit days to customers may result in loss of some customers who willseek a supplier willing to offer more credit days.

However, reducing the day’s payment to the supplier may also indicate that thecompany is not trusted by its suppliers. A company with a poor track record will alwaysface difficulties in negotiating for more days, hence the short payment period.

Factoring

Factoring involves raising funds on the security of the company’s debts, so that cashis received earlier than if the company waited for the debtors to pay. Most factoringcompanies offer the following three services:

• Sales ledger accounting, dispatching invoices and making sure that, bills are paid.• Credit management, including guarantees against bad debts.• The provision of finance, advancing clients up to 80% of the value of the debts that

they are collecting.

a) Sales ledger administration: The factoring company wills takeover the administrationof receivable department, maintaining the sales records, credit control and the collection ofreceivables. It is claimed that the factor will be able to obtain payment from customersmore quickly than if the company was to make collection on its own. The cost of thisadministrative service is a fee, based on the total value of debts assigned to the factor. Thefee rate is based on the work which is to be done and the risk level of bad debts.

b) Credit management: For a fee, the factor can provide up to 100% protection againstnon payment of approved sales. The factoring company will always assess the credit profileof an enterprise before entering into such an agreement. As outlined above, the risk level ofthe company’s debts will be the main factor in determining the fee charge.

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c) Provision of finance: This is the main product which most factoring companies offer.Factor companies provide finance which is used to boost the working capital of the business.The factoring route of financing may not be as cheap as that of bank overdrafts. Also,because the bank borrowing is flexible, it is imperative that the company should approachthe bank first. However, factoring can be particularly useful when a company has exhaustedits overdraft and is not yet in position to raise new equity.

Invoice Discounting

This is purely a financial arrangement which is very beneficial to the liquidity positionof the enterprise. Invoice discounting implies transferring of invoice to a finance house inexchange for immediate cash. The company makes an offer to the finance house by sendingit the respective invoices and agreeing to guarantee payment of any debts that are purchased.If the finance house accepts the offer, it makes immediate cash payment of about 75%,which means that at a specified future date, ex.90 days, the loan must be repaid. Thecompany is responsible for collecting the debt and for returning the amount advanced,whenever the debt is collected.

Bank Overdraft

Bank Overdraft is one of the most commonly used sources of short term financebecause of - its cost and flexibility. When borrowed funds are no longer required, they canquickly and easily be repaid. It is also comparatively cheap because the risks to the lenderare less than those on long-term loans, and all the loan interests are allowable tax expenses.The bank issues overdrafts with the right to call them at short notice. Bank advances are,in fact payable on demand. Normally, the bank assures the borrower that he can rely onthe overdraft not being recalled for a certain period of time.

The borrower is required to use the overdraft to supplement the working capitalshortfall. As the bank overdraft is payable on demand it is not wise to use the money inpurchasing non current assets like machinery. Financing of such assets should be madeusing long-term finance such as lease finance and loans. Any plans that involve an overdraftor short term loan should therefore refer closely to the company’s cash flow analysis sothat it is quite clear how long the funds will be needed and when they can be repaid.

Another purpose for which bank overdraft might typically be used is - to iron outseasonal fluctuations in trade. The banks assists in providing temporary or short term fundsto finance production on the assumption that the goods or products will be sold at a laterseason.

Counter Trade

Counter trade is another method of trade financing, but goods rather than money areused to fund such transactions. It is another form of barter. Goods are exchanged for other


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goods. This form of business for private enterprises is diminishing in local / domestic trade.But, for international trade, it is still the most popular way of funding the business activities.

In contrast to short term financing, long-term financing decisions are involved when afirm invests in assets which will reduce its operating costs over the next five years.

Examples of Short Term sources of financing

There are many sources from which a firm can seek short term financing some ofthese include:

• Overdrafts• Trade credit• Short-term loans• Bills of exchange• Promissory notes/commercial paper• Inventory loan• Letters of credit• Short term Eurocurrency advances• Factoring, etc.

1.7 LONG TERM FINANCING

Long term financing provides information on long term financing including financingsources and products. Long term financing includes the following arrangements.

• Fixed Assets• Large Capital Equipment Purchases• Large Scale Construction Projects• Expansion of Facilities, etc

It also include the following basic sources of long term financing products depending onthe business entity

• Debt• Equity• Derivatives.

1.7.1 Types Of Long Term Debt Products

• Debentures• Secured and unsecured notes• Convertible notes• Fixed deposit loans• Mortgages• Eurobonds• Interest rates swaps• Forward rate agreements (FRA’s)

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• Interest only futures• Options and future contracts• Convertible notes• Subordinated debt• Preference shares

1.8 LINK BETWEEN LONG-TERM AND SHORT- TERM FINANCING

All firms need capital. It is true that capital is the life blood for any organization.This capital requirement can be met with either long term, mid term or short termcapital. Since it is cheaper to issue long-term capital in “big chunks” and the total needs arenot totally predictable, the financing tends to be out of sync with the actual needs.

Some firms may always choose long term financing and have enough excess cashon hand so that they never need to borrow short-term, some other firms may arrange theirfinancing such that they are always borrowing short-term, and yet other firms may managetheir financing needs such that there will be occasional surpluses and occasional deficits.

1.8.1 Debt VS Type of business

Availability of debt products depends on the type of business entity, i.e, which couldeither be a sole proprietorship, a partnership or a corporation.

Non-Corporations are limited to using debt finance while Corporations can use bothdebt and equity products in their long term financing strategies.

Long term, Medium and short term sources of finance

In the present scenario, there are several sources of finance in the market. Selectingthe best sources of funds is a science on its own. Based on the individual firm’s requirementfor funds, the finance sources are chosen. Find below various types of finance source.

1.8.2 Popular sources of Finance: The selection of appropriate source for financing therequirement depends on the strategy(s) the firm is applying for its survival and growth. Inisolation of any other strategy, some sources are all time favorites for corporate houses.Some of them are given below.

Long-term Sources of finance

The long-term sources of finances can be raised from the following sources:

• Share capital or Equity Share.• Preference shares.• Retained earnings.• Debentures/Bonds of different types.• Loans from financial institutions.• Loans from State Financial Corporation.


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• Loans from commercial banks.• Venture capital funding.• Asset securitization, etc

Medium-term Sources of finance

The medium-term sources of finance can be raised from the following sources.

• Preference shares.• Debentures/Bonds.• Public deposits/fixed deposits for a duration of three years.• Loans from Commercial banks.• Loans from Financial institutions.• Loans from State financial corporations.• Lease financing / Hire Purchase financing.• External commercial borrowings.• Euro-issues.• Foreign Currency bonds, etc

Short-term Sources of finance

The most frequently sourced forms of short term finance include

• Trade credit• Loans and overdrafts (short term)• Factoring• Overdrafts• Bills of exchange• Promissory notes/commercial paper• Inventory loan• Letters of credit• Short term Eurocurrency advances, etc

1.9 WORKING CAPITAL MANAGEMENT

Working capital refers to that part of the firm’s capital which is required for financingshort-term or current assets, such as, cash, marketable securities, debtors, inventories,bills receivable etc. It is also known as revolving or circulating capital or short termcapital. The need for Working Capital is omnipresent for all types and sizes of businesses,and as such, cannot be overstressed.

Decisions relating to working capital and short term financing involve managing therelationship between a firm’s current assets and its current liabilities. The goal of workingcapital management is to ensure that the firm is able to continue its operations and hassufficient cash flow to satisfy both maturing short-term debt and upcoming operationalexpenses.

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As per its definition, working capital management entails short term decisions (relatingto the next one year) which are “reversible”. These decisions are hence entirely differentfrom those of capital budgeting decisions and are mainly based on cash flows and profitability.

1.9.1 Concepts of Working Capital

There are two concepts of Working Capital – Gross Working capital and Net Workingcapital.

1. Gross Working Capital

Gross Working capital refers to the firm’s investment in current assets / circulatingassets (Cash, Short Term Securities, Debtors, Bills Receivable and Inventory). Currentassets are those assets which can be converted into cash within a period of one year. Thisconcept focuses on – how to optimize investment in current assets and how should they befinanced? In this instance, both excessive and inadequate investment in current assetsshould be avoided.

2. Net Working Capital

Net Working capital refers to the difference between current assets and currentliabilities. Alternately, it is the excess of current assets over current liabilities or it is thatportion of a firm’s current assets which is financed by long term funds.

Net working capital may be positive or negative. This concept is a qualitative concept.It indicates the liquidity position of the firm and suggests the extent to which workingcapital needs may be financed by permanent sources of capital. Current assets should besufficiently in excess of current liabilities to constitute a margin for maturing obligationswithin the ordinary operating cycle of a business. This concept also covers the question ofjudicious mix of long-term and short-term funds for financing current assets.

The two concepts of Working Capital are not exclusive; rather, they have equalsignificance from management’s view point. Both ‘net’ and ‘gross’ concepts of workingcapital have functional significance. The gross working capital concept is financial or goingconcern concept and deals with the problems of managing individual current assets in shortterm. The net working capital may be suitable only or proprietary from of organizations –sole trader, partnership, firm etc. The gross concept of working capital is suitable to thecompany form of organization.

1.9.2 Need For Working Capital

The basic objective of financial management is to maximize shareholders’ wealth.This is possible only when the company earns sufficient profit. The amount of such profitlargely depends upon the magnitude of sales. But, there is always a possibility of creditsales, always a time gap between the sale of goods and receipt of cash may be expected.Working capital is very much required during this period (gap) in order to sustain the sales


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activity. In case adequate working capital is not available for this period, the company willnot be in a position to sustain the sales since it may not be in a position to purchase rawmaterials, pay wages or other expenses required for manufacturing the goods to be sold.

1.9.3 Components of Working Capital

The term working capital refers to the gross working capital and represents the amountof funds invested in current assets. Current assets are those assets which in the ordinarycourse of business can be converted into cash within a short period of normally oneaccounting year. Current assets are not only short-lived, but also change their form andone type of asset can easily be converted into another, say, cash is converted into rawmaterial etc. That is why they are also defined as circulating assets.

Examples of current assets are:

1. Cash and Bank balances2. Short term loans and advances3. Bills receivable4. Sundry debtors5. Inventories6. Prepaid expenses7. Accrued incomes8. Money receivable within 12 months

In a narrow sense, the term working capital refers to the net working capital. Networking capital is the excess of current assets over current liabilities, or,

Net working capital = current assets – current liabilities

Current liabilities are those liabilities which are intended to be paid in the ordinarycourse of business within a short period of normally one accounting year.

Examples of current liabilities are:

1. Bills payable2. Sundry Creditors3. Accounts payable4. Short term borrowings5. Dividends payable6. Statutory liabilities7. Accrued or outstanding expenses8. Bank Overdraft9. Provident Fund Dues10. Any other payment due within 12 months

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1.9.4 Nature of Working Capital

The nature of working capital is described with the help of nature or operation cycleof the firm. The process of cash or operation cycle starts when a firm uses cash to purchaseraw materials and pay for other manufacturing costs to produce goods. These goods arecarried as inventory for some time till they are sold. When goods are sold, either cash isreceived or accounts receivable are created. When accounts receivable are collectedfrom debtors, cash is brought into the firm. Thus, a cash cycle is completed, and a newprocess of a cash cycle starts over again. These processes are described as circulatingnature of current assets. The speed of circulation of working capital or the turnover ofcurrent assets is an indicator of the degree of efficiency of the management. The faster theturnover, higher is the degree of efficiency.

The goal of working capital management is to manage the firm’s current assets andcurrent liabilities in such a way that a satisfactory level of working capital is maintained. Ifa firm cannot maintain a satisfactory level of working capital, it is likely to become insolventand may even be forced into bankruptcy. The current assets should be large enough tocover its current liabilities in order to ensure a reasonable margin of safety.

1.9.5 Types of Working Capital

Working capital can be divided into two categories on the basis of time. They are –Permanent Working Capital and Temporary or Variable Working capital

Permanent Working Capital refers to that minimum amount of investment in currentassets which is required at all times to carry on minimum level of business activities, evenduring the dullest season of the year. It represents the current assets required on a continuingbasis over the entire year, and hence should be financed out of long term funds. TandonCommittee has referred to this type of Working capital as ‘Core Current Assets’. Thisminimum level of current assets is called permanent or fixed assets. This amount variesfrom year to year, depending upon the growth of a company and the stage of the businesscycle in which it operates. It the amount of funds required to produce the goods andservices which are necessary to satisfy demand at a particular point. Some of the featuresof permanent working capital are as follows:

1. It is classified on the basis of time factor2. It constantly changes from one asset form to another and continues to remain in

the business process3. Its size increases with the growth of business operations

The permanent working capital can further be classified as regular working capitaland reserve working capital. Regular working capital is the minimum amount of workingcapital required to ensure circulation of current assets from cash to inventories, frominventories to receivables and from receivables to cash and so on. Reserve working


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capital is the excess amount over the requirement for regular working capital which may beprovided for contingencies that may arise at unstated periods such as strikes, rise in prices,depression etc.

Temporary Working capital represents the additional current assets required at differenttimes during the operating year. This type of capital represents a certain fluctuations incurrent assets during a short period. These fluctuations are increases or decreases and aregenerally cyclical in nature. Additional current assets are required at different times duringthe operating year. Variable working capital is the amount of additional current assetsrequired for a short period. The capital required to meet the seasonal needs of a firm iscalled seasonal working capital. Some of the features of temporary working capital are:

1. It is not always gainfully employed, though it may change from one asset to another, aspermanent working capital does2. It is particularly suited to business of a seasonal or cyclical nature.

1.9.6 Importance of Adequate Working Capital

Adequate working capital is essential for the successful running of a business. Someof the advantages of having adequate working capital are as follows:

1. CASH DISCOUNT: Adequate working capital enables a firm to avail cash discountprovided by its suppliers, which reduces its cost of purchases.

2. GOODWILL: Adequate working capital enables a firm to make promptrepayments/payments which makes its credit worthiness increase in the eyes of itssuppliers/creditors/financiers. This in turn ensures easy availability of loans at softterms and regular trouble free supply from its suppliers.

3. ABILITY TO FACE CRISIS: Adequate working capital enables a firm towithstand the crisis created during periods of depression.

4. EXPANSION OF MARKETS: A firm with adequate working capital can createfavorable market conditions by increasing its profits through cost control.

5. INCREASED PRODUCTIVITY: Investments in fixed assets is largely determinedby the manner in which its current assets are managed.

6. LIQUIDITY AND SOLVENCY: A sound system of working capital enables afirm to maintain favorable liquidity and solvency position with its creditors so thatgetting funds at favorable terms of credit is possible.

1.9.7 Danger of Inadequate Working Capital

Some of the dangers of not maintaining adequate working capital position are as follows:

1. The firm may not be in a position to take advantage of cash discount offered by itssuppliers.

2. The firm may not be able to take advantage of profitable opportunities for lack offunds

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3. The firm might default its interest payments which may lead to decrease in its creditworthiness, which in turn might result in its inability to get funds when required.

4. The firm may not be in a position to pay dividend to its share holders because ofwhich it might lose favor with its shareholders.

5. The lower liquidity of the firm will lead to lower profitability. This ultimately mightresult in the liquidation of the firm.

1.9.8 Danger of Excessive Working Capital

While inadequate working capital position of a firm poses certain dangers, maintenanceof excessive working capital also might result in certain other dangers such as:

1. Excessive working capital may lead to unnecessary purchases and accumulation ofinventories, which in turn leads to higher wastages, storage costs, etc.

2. Excessive working capital might result in an imbalance between liquidity and profitabilityof a firm.

3. Excessive working capital implies existence of idle funds, which will drag down thereturn on investment of a firm.

4. Excessive working capital might lead to excess production which is contrary to demandposition.

1.9.9 Factors Effecting Working Capital Needs of Firms

A large number of factors influence the working capital requirements of firms. Someof them are as follows:

1. Nature of business:

Working capital needs of a firm are basically influenced by the nature of its business.Trading and financial firms have a small investment in fixed assets, but require a large sumof money to be invested in working capital. Some manufacturing businesses also requireworking capital substantially, whereas public utilities will require very limited investment inworking capital.

2. Production policies:

The working capital requirements of a business vary with various production relateddecisions such as – automation Vs labor intensive process, maintenance of steady productionpolicy Vs varying production policy etc. Where automation may require limited workingcapital investment, labor intensive production process necessitates heavy investment inworking capital. Similarly, where a steady production policy necessitates high level ofworking capital investment, a varying production policy may involve fluctuating investmentsin working capital.


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3. Length of the manufacturing process:

The working capital requirement of a firm also depends on the length of themanufacturing process. If it is longer, it requires heavy investment in working capital and ifit is shorter, it needs lower investment in working capital.

4. Credit policy:

If the credit policy (credit terms offered to the customers of the business) of thebusiness is liberal, it may necessitate a heavy investment in working capital whereas if it isstringent, it may necessitate a lower investment in working capital.

5. Rapidity of turnover

If the turnover rate of the firm is high, lower investment in working capital is impliedand vice versa

6. Seasonal fluctuations

Whenever the demand for the company’s product is seasonal, during on season, theworking capital investment is heavy and during off season, it is low.

7. Fluctuations of supply

Higher levels of supply necessitate higher investment in working capital and vice versa

8. Economic conditions:

During boom period, the working capital requirement of the firm grows along withthe need to finance both fixed assets and current assets. And during depression, level ofworking capital requirements of a firm also will fall.

9. Availability of credit

The working capital needs of a firm are also affected by the credit terms offered bythe creditors. If they are lenient, the working capital requirement is limited and vice versa

10. Operating efficiency and performance

The operating efficiency of the firm relates to the optimum utilization of resources atminimum costs. Better utilization of resources improves profitability and thus helps inreleasing the pressure on working capital as a high net profit margin contributes towardsthe working capital.

11. Profits

Profits are cash equivalents and as such, then profits are more, working capital is saidto be more and vice versa.

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1.9.10 Sources Of Working Capital

The finance manager of any firm is always interested in acquiring the working capitalat the right time, at a reasonable cost and at the best possible favorable terms. In everyconcern, there is always a necessity to maintain a minimum level of permanent investmentin current assets (permanent working capital) to manage its day to day operations. Someof the sources of financing the working capital are as follows:

1. LONG TERM: Issue of sharesFloating of debenturesPloughing back of profitsLoansPublic deposits etc

2. SHORT TERM – INTERNAL DepreciationTaxation provisionAccrued Expenses

3. SHORT TERM – EXTERNAL Trade creditCredit papersBank creditCustomers’ creditGovt. assistanceLoans from directorsSecurity of employees

1.9.11 Estimating Working Capital Requirements

In order to estimate the extent of working capital requirement of a firm, several factorsare to be considered. There are several methods / techniques for estimating the workingcapital requirements of a firm. They include – i) Estimation of components of workingcapital method, ii) Percent of sales method and iii) Operating cycle method

1. Estimation of components of working capital method

As the concept of net working capital refers to the difference between current assets andcurrent liabilities, estimation of both may give the potential working capital requirement ofthe firm.

2. Percent of sales method

According to this method, based on the past data, the relationship between sales andworking capital are found out and are expressed as a ratio. The application and calculationof this ratio on estimated future sales will give the extent of working capital needs of thefirm.


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3. Operating cycle method

Operating cycle is the time duration required to convert sales, after the conversion ofresources into inventories and cash. The operating cycle of a manufacturing co involves 3phases – i) acquisition of resources such as raw material, labor, power and fuel etc, ii)manufacture of the product that includes conversion of raw material into work in processand into finished goods, and iii) sales of the product either for cash or credit. Credit salescreate book debts for collection (debtors).

The length of the operating cycle of a manufacturing co is the sum of – i) inventory conversionperiod (ICP) and ii) Book debts conversion period (BDCP). Together, they are sometimescalled as gross operating cycle (GOC).

GOC = ICP + DCP

The Inventory conversion period is the total time needed for producing and selling theproduct and includes – (a) raw material conversion time (RMCP), (b) work in processconversion period (WIPCP) and (c) Finished good conversion period (FGCP)

ICP = RMCP + WIPCP + FGCP

The payables deferral period (PDP) is the length of time the firm is able to defer paymentson various resource purchases. The difference between the gross operating cycle andpayables deferrals period is the net operating cycle (NOC).

NOC = GOC- Payables deferral period

Illustration 1

A pro forma cost sheet of a co provides the following data

Costs (per unit)

Raw material 52.00Direct labor 19.50Overheads 39.00Total cost (per unit) 110.50Profit 19.50Selling price 130.00

The following is the additional information available

Average raw material in stock: one month, average materials in process: half a month;.Credit allowed by suppliers : one month: credit allowed to debtors : two months. Time lagin payment of wages : one and a half weeks. Overheads : one month. One fourth of salesare on cash basis. Cash balance is expected to be Rs.1,20,000.

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You are required to prepare a statement showing the working capital needed tofinance a level of activity of 70,000 units of output. You may assume that production iscarried on evenly throughout the year and wages and overheads accrue similarly.

Solution:

Illustration 2

A pro forma cost sheet of a company provides the following data

Costs (per unit)Raw Material Rs. 60Direct Labor Rs. 20Overheads Rs. 40

Total cost (per unit) Rs.120Profit Rs. 30Selling Price Rs.150

The following is the additional information available.

Average raw material in stock : one month, average materials in process : half amonth. Credit allowed by suppliers – one month. Credit allowed to debtors – two months.Time lag in payment of wages – 2 weeks and for overhead – one month. Half of the salesare on cash basis. Cash balance is expected to be Rs.2,00,000.


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You are required to prepare a statement showing the working capital needed tofinance a level of activity of 50,000 units of output. You may assume that production iscarried out on evenly throughout the year and wages and overheads accrue similarly

SOLUTION: Calculation of Working Capital needs

1.10 CAPITAL INVESTMENT DECISIONS

Decisions concerning irreversible commitment of funds to projects whose benefitsare to be reaped over a time span longer than the current accounting year are known ascapital expenditure / capital budgeting decisions. They usually are decisions related tofixed / long term assets whose investment decisions involve current outlay of money butreturns are spaced over a period of time longer than one year. These benefits may beeither in the form of increased revenues or reduced costs.

1.10.1 Features of Capital Budgeting Decisions

1. Existence of potentially large anticipated benefits2. Involves a relatively high degree of risk3. Existence of a relatively long time period between the initial outlay and the anticipated

returns4. Generally they are irreversible without incurring loss5. They involve large volume of capital6. They are strategic investment decisions and involve blocking of funds for long term

and inevitably affect the firm’s future cost structure7. They affect the profitability of a firm

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8. They have a bearing on the competitive position of the firm mainly because of the factthat they relate to fixed assets, which in a sense are the earning assets of the firm

9. Cash flow and not profit are important in investment decisions

1.10.2 Assumptions of capital budgeting decisions

1. The investment’s opportunity cost of capital is known2. The expenditure and benefits of the investment are known with certainty

1.10.3 Types of Investment Decisions / Proposals

1. Mutually exclusive investment proposals2. Independent investment proposals3. Contingent investment proposals4. Replacements

1.10.4 Types of Capital Budgeting Techniques

Traditional Techniques: These techniques are generally very simple and easilyunderstandable. But the main draw back of these techniques is that they don’t considerthe time value of money. But in many industries where an instant decision is to be taken,these methods offer the quicker way out. There are mainly two techniques under thiscategory of methods. They are – Accounting rate of return and Pay back period.

Accounting rate of return (ARR):

This method relies on the rate of return each project will earn over its life. It takes thehelp of accounting profit while calculating the returns. There are 2 methods of calculatingARR

(i) On the basis of original investment,

ARR = average after tax annual net profitOriginal investment

This method of calculation was rejected on the ground that the original outlay isgradually recovered over the project life because of depreciation charge.

(ii) On the basis of average investment,

ARR = average annual net profit Original investment / 2

When depreciation is to be taken on a straight line basis and no salvage value isassumed, the average investment is always equal to one-half of the original investment, andthe resulting rate of return is always twice the rate determined on the basis of originalinvestment.


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Advantages of ARR :

• It is easy to understand and simple to calculate• With the help of this method, direct comparisons among proposed projected of

varying lives without a built-in-prejudice in favor of short-term ventures can bemade.

Disadvantages of ARR :

• This method ignores time value of money.• It fails to shed light on yearly rate if return of the project. It may be possible for

the project producing higher earnings in the early years to show a lower averagerate of return and be rejected in favor of other projects.

• Serious errors can occur in selection of projects if corporate managers acceptprojects whose accounting rates are equal to or above some arbitrarily selectedcut-off rate, and they reject projects whose accounting rates fall short of thecut-off rate.

• Accounting information is not suitable for investment decision because if fails todistinguish between cash flowing in and out of the company and book keepingtransactions.

• There is no full agreement on the proper measure of the term investment. Thus,different managers have different meanings when they refer to ARR.

Decision Criteria

As long as the ARR is higher than the cost of capital, a project may be accepted, incase of an independent project accept or reject situation. But, in the case of mutuallyexclusive type of projects, the project with the higher ARR is preferred over the others.

Pay back period (PBP):

This is the most poplar method employed by industrial practitioners for rankinginvestment projects. This is defined as the “period required for a proposal’s initial cashoutlay to be recovered by future additional cash savings generated from the proposal”.The cash flow (after tax & depreciation) is used in calculating the pay back period.

PBP = CO/CF

Where CO = cash outflow of the project and CF = cash inflow

When the cash gains generated by the project are unevenly distributed, cumulativecash gains resulting from the project are to be calculated until the year in which the running/cumulative total is equal to the amount of investment outlay.

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Advantages:

• It is easy to understand and calculate• With the help of this method, projects can be ranked in terms of their economic

merits without much of complication.• It indirectly considers factors like obsolescence and liquidity of investments

because project with shortest pay back period is exposed to fewer risks.• This method is useful to the company experiencing shortage of cash because it

helps in choosing a project that will yield a quick return of cash fund regardlessof its long-term profitability.

Disadvantages:

• It does not measure the profitability of the projects.• It fails to consider any receipts after the pay-back period, no mater how great

they might be. As a result, a project with shorter pay back period may beselected against a project with a longer pay back period but longer incomeproducing life and greater return on investment.

• It ignores time value of money.

A survey conducted by the Machinery and Allied Products Institute disclosed thatabout 2/3rd of the American companies employ pay back approach to appraise merit ofprojects. This is because, in countries where technological changes are rapid, companiesare usually exposed to greater obsolescence risks and where uncertainty surrounding theoutcome estimates is great, prime consideration is the speed of capital investment recovery.

Decision Criteria

The decision rule is, to accept the project if the computed pay back period is lessthan the standard. Otherwise, reject it. While ranking the projects, project with shortestpay back period is assigned the highest rank.

Modern / Discounting Cash Flow Techniques: These techniques usually are of moreuse to businesses in their investment decisions. They take into account the time value ofmoney and adjust their cash flows accordingly before taking a decision. That is the reasonwhy they are considered superior to the traditional techniques. There are four techniquesunder this category of methods. They are –

• Net present value (NPV)• Internal rate of return (IRR)• Profitability index (PI)• Discounted Pay back Period (DPBP)

Net Present Value (NPV):

In this method, future cash flows are discounted to the present and then comparedwith the investment outlay. The basic discount rate is usually the cost of capital to the


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enterprise. For ranking the projects according to this method, the NPVs of variousalternative projects are compared. Project with highest positive NPV or a project withhighest NPV is given highest rank.

Advantages:

• It is simple to understand• Where a company has several mutually exclusive projects in hand, this method

helps the management to choose the most profitable one.

Disadvantages:

• It does not take into consideration the magnitude of the investment outlay andnet cash benefits together.

Decision Criteria

In the case of independent projects, if the present value of cash inflows of a project ishigher than the present value of investment outlay of the project, it should be accepted.Otherwise, it should be rejected. In the case of mutually exclusive projects, a project withhighest NPV should be accepted.

Internal Rate of Return (IRR)

This rate tries to find the earnings rate which equates the present value of the streamsof earnings to the investment outlay. IRR is defined as the rate of return which discounts allthe future cash inflows to exactly equal the outlay. It was also defined as – that rate ofinterest which will equate the cash inflows and the outflows of a project.

Advantages:

• It is useful and has many positive points• It recognizes the time value of money• It helps the management in selecting the most profitable project

Disadvantages:

• It is complicated to calculate by trial and error method• It assumes that the funds received at the end of each year can be invested at the

same rate of return.• It does not provide weightage of the volume of funds committed in the project.• Under certain conditions it becomes very difficult to take any decisions like –

under conditions of irregular cash flows, IRR may give 2 or more answers.

Decision Criteria

The project with IRR higher than the cut-ff rate will be accepted. Otherwise, it willbe rejected. The management will be indifferent if the IRR = cut-of rate. In cases ofmutually exclusive projects, project with highest IRR is accepted/ranked first.

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Profitability Index (PI)

It is a ratio of the present value of the net cash benefits to the present value of the netcash outlay. The higher the PI, the greater will be the return. Any project with a PI higherthan ONE is acceptable since benefits exceed outlay. Projects with PI less than ONE arerejected.

Advantages:

• It places the present value of each investment project on a relative basis so thatprojects of different sizes of capital outlays can be compared.

Decision Criteria

In the case of independent projects, if the PI is more than 1, it should be accepted; ifless than 1, it should be rejected. In the case of mutually exclusive projects, a project withhighest PI should be accepted.

Discounted Pay back Period (DPBP)

The discounted pay back period is the number of periods/years taken in recoveringthe investment outlay on the present value basis. Discounted pay back period will alwaysbe higher than simple pay back period for a project because its calculation is based on thediscounted cash flows. It differs from the simple pay period in that it takes into account thetime value of money. But still, it does not account for post pay back profitability of theproject.

1.11 ILLUSTRATIONS

1. A project cost is Rs.1,00,000 and it yields annual cash inflow of Rs.20,000 for 8years. Calculate its pay back period.

Solution:

PBP = Cash outlay / annual cash inflow

PBP = 1,00,000/20,000 = 5 years

2. Determine the pay back period for a project which requires a cash outlay of Rs.10,000and guarantees cash inflows of Rs.2,000, 4,000, 3,000, and 2,000 in the I, II, III andIV years respectively.

Solution:

Calculation of Pay back period

PBP = Approximately 3 years and 6 months.


NOTES


3. From the following information, calculate the NPV (net present value) of the twoprojects and suggest which of the two projects should be accepted, assuming a discountrate of 10%.

Project X Project Y

Initial investment 20,000 30,000 Estimated life 5 Yrs 5 Yrs Scrap value 1,000 2,000

Profits before depreciation and after taxes are as follows

Years Project X Project Y PV factor

1 5,000 20,000 .9092 10,000 10,000 .8263 10,000 5,000 .7514 3,000 3,000 .6835 2,000 2,000 .621

Solution:Calculation of NPV and PI

4. A project costs Rs.5,00,000 and yields annually a profit of Rs.80,000, after depreciation@ 12% pa, but before tax of 50%. Calculate the pay back period of the project.

Solution:

Hint: For calculating Pay Back Period, Cash flows after tax but before depreciation shouldbe taken into account and not accounting profit.

Calculation of cash flows after tax and before depreciation:

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Profit after depreciation before tax = Rs.80,000(-) Tax @ 50% = Rs.40,000Cash flows after tax = Rs.40,000(+) Depreciation @ 12% (on cost) = Rs.60,000Annual Cash flows after tax and before depreciation= Rs.1,00,000

Pay back period when annual cash flows are regular = Cash outflow / annual cash inflow

PBP = 5,00,000/1,00,000 = 5 years.

5. If expected rate of return is 30%, do you recommend any of the following projects?

Particulars Project A Project B

Capital cost 1,00,000 1,50,000Annual savings (I Yr) 30,000 50,000“ II Yr 30,000 70,000“ III Yr 40,000 80,000 “ IV Yr 50,000 50,000

Solution:

Calculation of NPV

Comment: If expected rate of return is 30%, both the projects show negative NPVs, andhence, are not to be selected.

6. Initial outlay = Rs.50,000Life of the asset = 5 YearsEstimated annual cash inflow = 12,500Calculate internal rate of return.

Solution:

When annual cash inflows are regular, IRR is calculated as follows

Step 1 : Calculate the quotient by applying the formula IRR = Cash outflow/net annualcash inflow


NOTES


Step 2: Look into the Present value of annuity of one rupee table, the rate which equatesthe quotient value derived in step 1.

IRR = Cash outflow / Annual cash inflow = 50,000 / 12,500 = 4 = Quotient

Looking at the present value of annuity of one rupee table, the rate which equates thequotient value of ‘4’ (under the 5th year) = between 7% and 8%. Hence, we canapproximately take IRR as 7.5%.

1.12 CAPITAL RATIONING

Capital Rationing is nothing but optimizing the profit in the limited source of funds.Capital Rationing arises in a situation where a constraint or budget ceiling is placed on thetotal size of capital expenditures during a particular period.

Capital Rationing also refers to the selection of the investment proposals in a situationof constraint on availability of capital funds, to maximize the wealth of the company byselecting those projects which will maximize overall NPV of the concern.

The Capital Rationing may also be introduced by following the concept ofResponsibility Accounting.

The selection of project under capital rationing involves two steps

Step 1: To identify the projects which can be accepted by using the techniques of capitalbudgeting

Step2: To select the combination of projects

The following example can be elaborating the concept of Capital Rationing:

X Ltd is considering five capital projects for the years 2001, 2002, 2003 and 2004.The Company is financed by equity entirely and its cost of capital is 12%. The expectedcash flows of the projects are as follows:

Year and Cash flows (Rs 000)

Projects 2001 2002 2003 2004

1 (70) 35 35 35

2 (40) (30) 45 55

3 (50) (60) 70 80

4 — (90) 55 65

5 (60) 20 40 50

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Figures in brackets represent cash out flows.

All projects are divisible and none of the projects can be delayed or undertakenmore than once.

In such given situation we have only Rs 1,10,000 to invest in the year 2001 and nolimitation in subsequent periods.

In the above scenario we can select the projects by giving ranks after evaluation ofeach project.

Computation of Net Present Value and Profitability Index

YearsProjects PVF@12% 2001 2002 2003 2004 NPV PI

1 0.893 (70) 31.15 28 14.20 3.35 1.0482 0.797 (40) (26.70) 36 39.05 8.35 1.1253 0.712 (50) (53.40) 56 56.80 9.40 1.0914 0.636 — (80.10) 44 46.15 10.05 1.1255 0.567 (60) 17.80 32 35.50 25.30 1.422

In case of project 4 there is no capital rationing which can be selected.

In case of other projects namely projects 1, 2, 3 and 5 required investment is Rs2,20,000 in the year 2001 but we have only Rs 1,10,000. we can select the projectsbased high NPV.

Projects Ranking Amount of initial investment

5 1 Rs 60,0002 2 Rs 40,0003 3 Rs 10,000 (limited or restricted)

———————Rs 1,10,000=========


NOTES


1.13 SUMMARY

* Retailing may be defined as - “any business that directs its marketing efforts towardssatisfying the final consumer based upon the organization of selling goods and services asa means of distribution”. Retailing involves a set of business activities that add value to theproducts and services sold to the final consumers for their personal, family or householduse.

* The American Institute of certified public accountants (AICPA) defined accountingas “Accounting is the art of recording classifying and summarizing in a significant mannerand in terms of money transactions and events which are in part at least of a financialcharacter and interpreting the results thereof”.

* The term Financial management has been defined by management experts in manyways reflecting the duties and responsibilities of a finance manager over the years. Someof the popular definitions are as follows –

R.C.Osborn – ‘Finance Function is the process of acquiring and utilising funds of abusiness’

Bonneville and Dewey – ‘Financing consists of the raising, providing, managing of all themoney, capital or funds of any kind to be used in connection with the business’

Phillippatus – ‘Financial Management is concerned with the managerial decisions thatresult in the acquisition and financing of long-term and short term credits for the firm’

* In Finance, investment decisions are related to allocation of funds in long term or fixedassets. These decisions are also known as capital expenditure decisions / capital budgetingdecisions. These decisions relate to the profitability of a business. Financial managementis related to procurement of funds at cheaper cost and allocating them to projects at higherrate of return. The borrowing or procuring function is related to the calculation of the costof each type of source of funds as well as the overall cost of all types of funds borrowed orto be borrowed by a business. The guiding principle in both these decisions is that – theoverall cost of capital must be the lowest and the return on the various investments must bethe highest at any given period of time. These two decisions will decide the financial healthof an organization.

* With the growing complexity of the business environment, the CFO’s role has expandeddramatically into hitherto un-treaded areas such as –involvement in business plans, strategyformulations, fund raising activities, risk management processes and planning new financialproducts, introduction of IT support into the organization, corporate governance, dealingwith overseas businesses, efficient tax management, financial restructuring, etc. In companieswith international operations, risk profiling of countries, assessing country profitability andensuring compliance with multiple regulatory environments have become a part of the

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CFO’s duties.

* Sourcing money may be done for a variety of reasons such as - capital asset acquirement- new machinery or the construction of a new building or depot. In the market, there arevarious sources of finance, with differing risk characteristics and with differing coststructures. A limiting factor in the provision of finance for successful business is risk. Thedebt capacity of a borrower depends on the extent to which he/she is able to reassure thelender(s) that the risk element can be controlled through careful planning and implementationof common sense management procedures.

* Whenever possible, long-term assets must be financed by using long-term sources offinance. Short-term assets should be financed by using short-term sources of money, e.g.overdrafts. A business can be throttled by having to repay short-term liabilities quicklyfrom the sale of long-term assets which are not meant for disposal.

* To manage the finances of a business successfully, the following need to be done – (i)Recognize when the funds are needed (ii) Identify the various sources of funds (iii)Effectively manage the funds to take full advantage of the least expensive sources

Establishment of an effective financial plan will take full advantage of all sources withoutdamaging the credit rating or endangering the sources for the company.

* Several management experts have tried to classify the sources into several categoriesbased on the time factor, ownership pattern, source of generation, and convenience.

* The most useful classification of sources of funds deals with segregation of sources intoshort term and long term sources of finance. In practice, short term refers to a period lessthan one year and long term refers to above five years or sometimes is referred as otherthan short term

* The various aspects of Short Term Finance include – trade creditors, terms oftrade credit (The economic nature of the product, The financial circumstances of theseller, The financial position of the buyer, Cash discounts), factoring (Sales ledgeradministration, Credit management, Provision of finance, Invoice Discounting, BankOverdraft, Counter Trade, etc) etc.

*In contrast to short term financing, long-term financing decisions are involved when a firminvests in assets which will reduce its operating costs over the next five years.

* Long term financing provides information on long term financing including financing sourcesand products. Long term financing includes arrangements like - Fixed Assets, Large CapitalEquipment Purchases, Large Scale Construction Projects, Expansion of Facilities, etc. Italso includes the basic sources of long term financing products depending on the businessentity, such as – Debt, Equity and Derivatives.


NOTES


* The capital requirement of a firm can be met either with long term, mid term or short termcapital. Since it is cheaper to issue long-term capital in “big chunks” and the total needs arenot totally predictable, the financing tends to be out of sync with the actual needs of a firm.Some firms may always choose long term financing and have enough excess cash on handso that they never need to borrow short-term, some other firms may arrange their financingsuch that they are always borrowing short-term, and yet other firms may manage theirfinancing needs such that there will be occasional surpluses and occasional deficits.

* In the present scenario, there are several sources of finance in the market. Selecting thebest sources of funds is a science on its own. Based on the individual firm’s requirementfor funds, the finance sources are chosen. The various types of finance sources include -Long-term Sources of finance, Medium-term Sources of finance and Short-term Sourcesof finance

* Working capital refers to that part of the firm’s capital which is required for financingshort-term or current assets, such as, cash, marketable securities, debtors, inventories,bills receivable etc. It is also known as revolving or circulating capital or short termcapital. The need for Working Capital is omnipresent for all types and sizes of businesses,and as such, cannot be overstressed.

* There are two concepts of Working Capital – Gross Working capital and Net Workingcapital.

* The term working capital refers to the gross working capital and represents the amountof funds invested in current assets. Current assets are those assets which in the ordinarycourse of business can be converted into cash within a short period of normally oneaccounting year. Current assets are not only short-lived, but also change their form andone type of asset can easily be converted into another, say, cash is converted into rawmaterial etc. That is why they are also defined as circulating assets.

* Net working capital = current assets – current liabilities

* The nature of working capital is described with the help of nature or operation cycle ofthe firm. The process of cash or operation cycle starts when a firm uses cash to purchaseraw materials and pay for other manufacturing costs to produce goods. These goods arecarried as inventory for some time till they are sold. When goods are sold, either cash isreceived or accounts receivable are created. When accounts receivable are collectedfrom debtors, cash is brought into the firm. Thus, a cash cycle is completed, and a newprocess of a cash cycle starts over again. These processes are described as circulatingnature of current assets. The speed of circulation of working capital or the turnover ofcurrent assets is an indicator of the degree of efficiency of the management. The faster theturnover, higher is the degree of efficiency.

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* The goal of working capital management is to manage the firm’s current assets andcurrent liabilities in such a way that a satisfactory level of working capital is maintained. Ifa firm cannot maintain a satisfactory level of working capital, it is likely to become insolventand may even be forced into bankruptcy. The current assets should be large enough tocover its current liabilities in order to ensure a reasonable margin of safety.

* Working capital can be divided into two categories on the basis of time. They are –Permanent Working Capital and Temporary or Variable Working capital

* Permanent Working Capital refers to that minimum amount of investment in currentassets which is required at all times to carry on minimum level of business activities, evenduring the dullest season of the year. The permanent working capital can further be classifiedas regular working capital and reserve working capital. Regular working capital is theminimum amount of working capital required to ensure circulation of current assets fromcash to inventories, from inventories to receivables and from receivables to cash and soon. Reserve working capital is the excess amount over the requirement for regular workingcapital which may be provided for contingencies that may arise at unstated periods such asstrikes, rise in prices, depression etc.

* Temporary Working capital represents the additional current assets required at differenttimes during the operating year. This type of capital represents a certain fluctuations incurrent assets during a short period. These fluctuations are increases or decreases and aregenerally cyclical in nature. Additional current assets are required at different times duringthe operating year. Variable working capital is the amount of additional current assetsrequired for a short period. The capital required to meet the seasonal needs of a firm iscalled seasonal working capital

* Adequate working capital is essential for the successful running of a business.

* A large number of factors influence the working capital requirements of firms. Some ofthem are – (i) Nature of business (ii) Production policies (iii) Length of the manufacturingprocess (iv) Credit policy (v) Rapidity of turnover (vi) Seasonal fluctuations (vii)Fluctuations of supply (viii) Higher levels of supply necessitate higher investment in workingcapital and vice versa (ix) Economic conditions (x) Availability of credit (xi) Operatingefficiency and performance (xii) Profits

* The finance manager of any firm is always interested in acquiring the working capital atthe right time, at a reasonable cost and at the best possible favorable terms. In everyconcern, there is always a necessity to maintain a minimum level of permanent investmentin current assets (permanent working capital) to manage its day to day operations

* In order to estimate the extent of working capital requirement of a firm, several factorsare to be considered. There are several methods / techniques for estimating the workingcapital requirements of a firm. They include – i) Estimation of components of workingcapital method, ii) Percent of sales method and iii) Operating cycle method


NOTES


* Decisions concerning irreversible commitment of funds to projects whose benefits are tobe reaped over a time span longer than the current accounting year are known as capitalexpenditure / capital budgeting decisions. They usually are decisions related to fixed / longterm assets whose investment decisions involve current outlay of money but returns arespaced over a period of time longer than one year. These benefits may be either in theform of increased revenues or reduced costs.

* The features Of Capital Budgeting Decisions include – (i) Existence of potentially largeanticipated benefits (ii) Involves a relatively high degree of risk (iii) Existence of a relativelylong time period between the initial outlay and the anticipated returns (iv) Generally theyare irreversible without incurring loss (v) They involve large volume of capital (vi) Theyare strategic investment decisions and involve blocking of funds for long term and inevitablyaffect the firm’s future cost structure (vii) They affect the profitability of a firm (viii) Theyhave a bearing on the competitive position of the firm mainly because of the fact that theyrelate to fixed assets, which in a sense are the earning assets of the firm (ix) Cash flow andnot profit are important in investment decisions

* The assumptions on which capital budgeting decisions are based are – (i) The investment’sopportunity cost of capital is known, and (ii) The expenditure and benefits of the investmentare known with certainty

* There are 4 major types Of Investment Decisions / Proposals, which are – (i) Mutuallyexclusive investment proposals (ii) Independent investment proposals (iii) Contingentinvestment proposals, and (iv) Replacements

* There are two major types of Capital Budgeting Techniques, which are – (i) TraditionalTechniques and (ii) Modern techniques. Traditional techniques are generally very simpleand easily understandable. But the main draw back of these techniques is that they don’tconsider the time value of money. But in many industries where an instant decision is to betaken, these methods offer the quicker way out. There are mainly two techniques underthis category of methods. They are – Accounting rate of return and Pay back period.

* Accounting rate of return method relies on the rate of return each project will earn overits life. It takes the help of accounting profit while calculating the returns. There are 2methods of calculating ARR

(i) On the basis of original investment, ARR = average after tax annual net profitOriginal investment

This method of calculation was rejected on the ground that the original outlay is graduallyrecovered over the project life because of depreciation charge.

(ii) On the basis of average investment, ARR = average annual net profit Original investment / 2

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* Advantages of ARR include – (i) It is easy to understand and simple to calculate and (ii)With the help of this method, direct comparisons among proposed projected of varyinglives without a built-in-prejudice in favor of short-term ventures can be made. The variousdisadvantages of this method include – (i) This method ignores time value of money (ii) Itfails to shed light on yearly rate if return of the project. It may be possible for the projectproducing higher earnings in the early years to show a lower average rate of return and berejected in favor of other projects (iii) Serious errors can occur in selection of projects ifcorporate managers accept projects whose accounting rates are equal to or above somearbitrarily selected cut-off rate, and they reject projects whose accounting rates fall shortof the cut-off rate (iv) Accounting information is not suitable for investment decision becauseif fails to distinguish between cash flowing in and out of the company and book keepingtransactions (v) There is no full agreement on the proper measure of the term investment.Thus, different managers have different meanings when they refer to ARR.

* The Decision Criteria using ARR is - as long as the ARR is higher than the cost of capital,a project may be accepted, in case of an independent project accept or reject situation.But, in the case of mutually exclusive type of projects, the project with the higher ARR ispreferred over the others.

* Pay back period (PBP) is the most poplar method employed by industrial practitionersfor ranking investment projects. This is defined as the “period required for a proposal’sinitial cash outlay to be recovered by future additional cash savings generated from theproposal”. The cash flow (after tax & depreciation) is used in calculating the pay backperiod.

PBP = CO/CF

Where CO = cash outflow of the project and CF = cash inflow

* Advantages of PBP method include – (i) It is easy to understand and calculate (ii) Withthe help of this method, projects can be ranked in terms of their economic merits withoutmuch of complication (iii) It indirectly considers factors like obsolescence and liquidity ofinvestments because project with shortest pay back period is exposed to fewer risks (iv)This method is useful to the company experiencing shortage of cash because it helps inchoosing a project that will yield a quick return of cash fund regardless of its long-termprofitability.

* Disadvantages of PBP method include – (i) It does not measure the profitability of theprojects (ii) It fails to consider any receipts after the pay-back period, no mater how greatthey might be. As a result, a project with shorter pay back period may be selected againsta project with a longer pay back period but longer income producing life and greaterreturn on investment (iii) it ignores time value of money.


NOTES


* A survey conducted by the Machinery and Allied Products Institute disclosed that about2/3rd of the American companies employ pay back approach to appraise merit of projects.This is because, in countries where technological changes are rapid, companies are usuallyexposed to greater obsolescence risks and where uncertainty surrounding the outcomeestimates is great, prime consideration is the speed of capital investment recovery.

* Decision Criteria by using PBP is to accept the project if the computed pay back periodis less than the standard. Otherwise, reject it. While ranking the projects, project withshortest pay back period is assigned the highest rank.

* Modern / Discounting Cash Flow Techniques usually are of more use to businesses intheir investment decisions. They take into account the time value of money and adjust theircash flows accordingly before taking a decision. That is the reason why they are consideredsuperior to the traditional techniques. There are four techniques under this category ofmethods. They are – (i) Net present value (NPV) (ii) Internal rate of return (IRR) (iii)Profitability index (PI) and (iv) Discounted Pay back Period (DPBP)

* Under NPV method, future cash flows are discounted to the present and then comparedwith the investment outlay. The basic discount rate is usually the cost of capital to theenterprise. For ranking the projects according to this method, the NPVs of variousalternative projects are compared. Project with highest positive NPV or a project withhighest NPV is given highest rank.

* Advantages of NPV technique include – (i) It is simple to understand (ii) Where acompany has several mutually exclusive projects in hand, this method helps the managementto choose the most profitable one.

* Major disadvantage of NPV technique is - it does not take into consideration themagnitude of the investment outlay and net cash benefits together.

* Decision Criteria by using NPV method is - in the case of independent projects, if thepresent value of cash inflows of a project is higher than the present value of investmentoutlay of the project, it should be accepted. Otherwise, it should be rejected. In the caseof mutually exclusive projects, a project with highest NPV should be accepted.

* IRR tries to find the earnings rate which equates the present value of the streams ofearnings to the investment outlay. IRR is defined as the rate of return which discounts allthe future cash inflows to exactly equal the outlay. It was also defined as – that rate ofinterest which will equate the cash inflows and the outflows of a project.

* Advantages of IRR include – (i) It is useful and has many positive points (ii) It recognizesthe time value of money (iii) It helps the management in selecting the most profitable project

* Disadvantages of IRR include – (i) It is complicated to calculate by trial and error method(ii) It assumes that the funds received at the end of each year can be invested at the same

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rate of return (iii) It does not provide weightage of the volume of funds committed in theproject (iv) Under certain conditions it becomes very difficult to take any decisions like –under conditions of irregular cash flows, IRR may give 2 or more answers.

* Decision Criteria by using IRR is - the project with IRR higher than the cut-ff rate will beaccepted. Otherwise, it will be rejected. The management will be indifferent if the IRR =cut-of rate. In cases of mutually exclusive projects, project with highest IRR is accepted/ranked first.

* PI is a ratio of the present value of the net cash benefits to the present value of the netcash outlay. The higher the PI, the greater is the return. Any project with a PI higher thanONE is acceptable since benefits exceed outlay. Projects with PI less than ONE arerejected.

* The major advantage of PI is - it places the present value of each investment project ona relative basis so that projects of different sizes of capital outlays can be compared.

* Decision Criteria by using PI is - in the case of independent projects, if the PI is morethan 1, it should be accepted; if less than 1, it should be rejected. In the case of mutuallyexclusive projects, a project with highest PI should be accepted.

* The discounted pay back period is the number of periods/years taken in recovering theinvestment outlay on the present value basis. Discounted pay back period will always behigher than simple pay back period for a project because its calculation is based on thediscounted cash flows. It differs from the simple pay period in that it takes into account thetime value of money. But still, it does not account for post pay back profitability of theproject.

1.14 SHORT QUESTIONS

1. Define Accounting.2. Define Financial management. What are its aims?3. What are the various sources of finance?4. The responsibility of finance manager is now regarded as much more than mere

procurement of funds. What do you think are the other responsibilities of a financeexecutive

5. Briefly explain the classification of sources of finance6. Distinguish between short term and long term sources of finance.7. Explain briefly the link between short term and long term sources of finance8. Write a brief note on the popular sources of finance9. Define Working capital10. What is the importance of working capital for a manufacturing firm?11. Briefly explain the concepts of permanent and temporary working capital


NOTES


12. What is an operating cycle?13. How do you estimate working capital needs of a firm?14. What are the various concepts of working capital?15. Explain the importance of working capital16. What are the various types of working capital?17. What is the importance of maintaining adequate amount of working capital?18. What are the dangers of inadequate working capital?19. What are the dangers of having excess working capital?20. Write a brief note on the various sources or working capital.21. What do you mean by capital budgeting decisions?22. What are the features of capital budgeting decisions?23. On what assumptions capital budgeting decisions are usually made?24. What are the various types of investment decisions?

1.15 LONG QUESTIONS

1. Comment on the emerging role of the finance manager in India.2. Define Finance. What according to you are the major objectives of financial

management?3. Explain the various sources of Long term finance in depth4. How do you classify the various sources of finance?5. Define the term Working capital. What are the components of Working capital?6. Write a note on the factors influencing the working capital requirement of a firm.7. What is capital budgeting? What is its significance to a firm?8. Briefly explain the various techniques of capital budgeting with their respective merits,

demerits and decision criteria9. Explain the concept of working capital. Are gross and net concepts of working

capital exclusive? Explain.10. Explain the concepts of working capital. What are the determinants of working

capital needs of a firm?11. Briefly explain the factors that determine the working capital needs of a firm?12. How is working capital affected by (a) sales (b) technology (c) production policy and

(c) inflation? Explain.13. Define working capital management. Why is it important to study the management of

working capital as a separate area in financial management?

Exercises

1. A pro forma cost sheet of a company provides the following data



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Average raw material in stock: one month, average materials in process: half a month.Credit allowed by suppliers – one month. Credit allowed to debtors – two months. Timelag in payment of wages – 2 weeks and for overhead – one month. Half of the sales are oncash basis. Cash balance is expected to be Rs.2, 00,000.

You are required to prepare a statement showing the working capital needed tofinance a level of activity of 50,000 units of output. You may assume that production iscarried out on evenly throughout the year and wages and overheads accrue similarly.

2. A pro forma cost sheet of a company provides the following data




Average raw material in stock: one month, average materials in process: half a month.Credit allowed by suppliers – one month. Credit allowed to debtors – two months. Timelag in payment of wages – 2 weeks and for overhead – one month. Half of the sales are oncash basis. Cash balance is expected to be Rs.3, 00,000.

You are required to prepare a statement showing the working capital needed tofinance a level of activity of 50,000 units of output. You may assume that production iscarried out on evenly throughout the year and wages and overheads accrue similarly.

3. There are 2 projects - X & Y. Each project requires an investment of Rs.20,000. Youare required to rank these projects according to the pay back period method from thefollowing information. Net profit before depreciation and after tax for both the projects isas follows.

Years Project X Project Y 1 1,000 2,000 2 2,000 4,000 3 4,000 6,000 4 5,000 8,000 5 8,000 -


NOTES


4. A project requires an investment of Rs.5,00,000 and has a scrap value of Rs.20,000after 5 years. It is expected to yield profits after depreciation and taxes during the 5 years,which amounts to Rs.40,000, 60,000, 70,000, 50,000 and 20,000. Calculate theaccounting rate of return on the investment.

5. Using the information given below, compute NPV.

Initial outlay = Rs.80,000

Estimated life = 5 years

Years Profit after tax

1 6,000 2 14,000 3 24,000 4 16,000

5 -

Depreciation has been calculated under straight line method. The cost of capital may betaken at 20% pa and the present value of one rupee at 20% pa is as under

Years : 1, 2, 3, 4, 5

PV factor : .83, .69, .58, .48, .40.

6. Project X costs Rs.2500 now and is expected to generate year-end cash inflows ofRs.900, Rs.800, Rs700, Rs.600 and Rs.500 in years 1 through 5. The opportunity costof capital may be assumed to be 10%. Advise whether the project should be accepted ornot.

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UNIT II

RETAIL INVENTORY MANAGEMENT1. INTRODUCTION

The development and implementation of a merchandise plan is one of the mostimportant phases in any retail strategy, because, the primary objective of any retail businessis to ensure the sale of its merchandise.

1.1 DEFINITION

‘Merchandise Management’ may be defined as ‘planning and implementation of theacquisition, handling and monitoring of merchandise categories for an identified retailorganization’. This implies that forward planning of merchandise is required, as merchandisehas to be acquired for future purchase opportunities which should reflect the changingconsumption tastes and demand. Thus, it can be opined that the efficient acquisition ofmerchandise as well as its proper handling ensures the sale of merchandise.

Merchandise management involves balancing the financial requirements of the companywith a strategy for merchandising purchase. The main function of retailing is to sellmerchandise. The strategy involved in this is the decision regarding the balance betweenmerchandise mix and quantity to be purchased. Merchandise management is the processby which a retailer attempts to offer the right quantity of the right product at the right placeand time while meeting the retail firm’s financial goals. In other words, Merchandisemanagement is the analysis, planning, procurement, handling and control of the merchandiseinvestments of a retail operation.

1.2 COMPONENTS OF MERCHANDISE MANAGEMENT

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2. LEARNING OBJECTIVES:


1. Understand what is merchandise management2. Understand the meaning of inventory budget and the method of preparing it3. Understand the various forecasting techniques4. Understand inventory order management5. Understand material issue management6. Understand the meaning and process of pricing of inventory7. Understand the various inventory management practices such as – ABC analysis,

VED analysis etc.

3. INVENTORY BUDGET:

The various phases in developing a merchandise plan are given below.

Merchandise Plan Considerations

Merchandise budget is a financial tool for planning and controlling the retailer’sinvestment in merchandise inventory. It is also referred to as the financial plan that indicateshow much to invest in product inventories, usually stated in rupees per month. Earmarkingof merchandising budget is considered to be a vital component of the planning phase. Thisbudget states the amount allocated for each product, based on the pre-set profitability orother performance measures.

Merchandise budget / Inventory budget is also known as a financial plan that indicatesinvestment in inventories (in rupee value) per month. Preparation of merchandise budget isconsidered as vital for planning phase of a retailer. It can also be said that merchandisebudgeting is a financial tool for controlling the retailer’s merchandise inventory investment.


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While planning and controlling his merchandise mix to meet the customer – orientedobjectives, the retailer also has to provide for the profitability aspect. To ensure profitableoperations, the retailer can use a merchandise budget in which information related to his -sales volume, stock levels, retail reductions, purchase orders and profit margins are plannedand controlled.

Budget planning starts with the development of a sales plan, which shows the expectedor projected rupees volume of sales for each merchandise or department. Sales forecastinghelps the retailer in forecasting the purchase requirement for his merchandise. In India,most of the retail shops in the unorganized sector prepare a sales forecast, irrespective ofproduct category they are in, on the basis of the past experiences, intuition, trends inrelated products / services’ markets, information from the suppliers or co-retailers andcustomers.

Usually product categories experience an expected sales pattern, based on therespective stage in their life cycle. This cycle varies form one product category to another.Hence, while preparing the budget or forecast, a retailer should be aware of many importantfactors like - the consumer segment for the offer, expected drivers of variety, nature ofcompetition, promotion and price range. Here, the classification of various merchandiseitems into various types such as – staple, fad, fashion or seasonal merchandise is veryhelpful. The various product lifecycle related strategies the retailer should be aware of.This awareness helps a retailer in examining the sales pattern variations among fad, fashion,staple, and seasonal merchandise.

3.1 LIFE CYCLE STAGES OF PRODUCTS

The understanding of category lifecycle stage helps in predicting sales. It is an acceptedfact that the lifecycle stage a particular product category enjoys will indicate the salesexpected in future. Retailers are expected to incorporate the variations in the category lifecycle while developing the sales forecast, the point of interest in this analysis being theability to find out – whether the category passes through all the four stages or many seasons,whether a specific style sells for many seasons, and whether sales vary from one season toanother etc.

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4. FORECASTING TECHNIQUES

Forecasts are nothing but projections of expected retail sales for the periods underconsideration. They form the base for merchandise plans and include – overall companyprojections, product category projections, item-by-item projections, and store-by-storeprojections. Many of the global retail giants are seeking unified sourcing solutions fordemand forecasting, which they consider as too important. These unified planning solutionsare expected to derive a system which would forecast demand at a macro level and thenwork it out to the micro level, across continents, countries, states and down to the storelevel.

4.1 TYPES OF RETAIL OUTLETS

The most common types of retailers include – Department stores, Discount / massmerchandisers, Specialty stores, factory outlets etc.

Retail is evolving, and with the implementation of new technologies, it is growing andchanging every day. Consumers are interested in 24/7, non store retailing (online and TVhome shopping). To reach and keep customers, retailers have to refine and plan newshopping environments. Progressive retailers of all sizes nowadays are rethinking the roleof the conventional retail store. To meet customer expectations and outpace the competition,retailers also have to reshape many essential functions, such as marketing, distribution,customer satisfaction etc.

In spite of all these developments, the basics of retailing stand unchanged. The samerules on which retailing is based still stand, which are - Understand your customers andtheir needs and expectations, utilize past history and current trends to accurately forecastfuture customer demand, plan inventory levels to meet that demand, flow receipts in atimely manner based on those inventory plans, plan end of season inventory levels tominimize markdown exposure, and keep an eye on the whole thing day in and day out,updating plans continually as the season progresses. And to do all this effectively, alwayskeep in mind that the technology that helps you do this is a tool, not a “solution”.

4.2 TYPES OF MERCHANDISE

Knowledge about the various types of merchandise sported by a retailer greatlyhelps to increase the precision of the merchandise plan. Some of the different types ofmerchandise usually found in retail outlets are – (i) Staple merchandise (ii) Assortmentmerchandise (iii) Fashion merchandise (iv) Seasonal Merchandise (v) Fad merchandiseetc.

(i) Staple merchandise refers to the regular products carried by a retailer such as – milk,bread, jam, etc, which depends on the type of retail outlet. The demand for these items isrelatively stable over time and sometimes may be seasonal. A retailer can clearly estimate


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the demand for these products through a basic stock list, which specifies the inventorylevel, color, brand, style, category, size, package, etc for every staple item in the retailoutlet.

(ii) Assortment Merchandise refers to apparel, furniture and all other products for whichthe retailer usually carries a variety in order to give his customers a proper selection.Compared to Staple merchandise, this type of merchandise is difficult to forecast as variationsare common in customer demand, style, sizes, color preferences etc. For these products,the specific product lines, styles, designs, colors etc are projected by the retailer and heprepares a model stock plan to give projections for specific popular items. With thismodel stock plan, many items are ordered for popular sizes and colors, and small amountsof less popular sizes and colors fill out the assortment.

(iii) Fashion Merchandise refers to those products that may have cyclical sales due tovariations in changing tastes and lifestyles. Forecasting demand for these products is veryhard as obviously fashion changes with changing styles, preferences etc.

(iv) Seasonal Merchandise refers to those products that sell well over nonconsecutivetime periods, such as – air conditioners sale and service. Forecasting for these products iseasy as the demand happens more or less at the same time every year.

(v) In case of Fad Merchandise, highest sales take place for a short time. The majorexamples for this category of merchandise include specific toys such as – Barbie, powerrangers etc, whose demand (sales) goes up whenever a related program comes in the TV.Forecasting demand for this merchandise is difficult as there is no predictability of purchase.

There are several factors to consider in devising merchandise plans, some of whichinclude – the innovativeness, the assortment, the brands, the timing, the allocation, theforecasts etc of the plan.

The four important components of the merchandise budget are – projected sales,inventory plan, estimated reductions and estimated purchases.

4.3 PROJECTED SALES

Budget planning starts with the preparation of a sales plan, which gives the expected/ projected rupee value of sales volume for each merchandise and department. Salesforecasting helps the retailer in forecasting his merchandise purchases. In India, most ofthe retail outlets in the unorganized sector forecasts their sales based on past experiences,intuition, trends in related goods markets, information from their suppliers or competitorsand customers etc. Forecasting of sales requires an understanding of the product / servicethey are trading in.

Usually product categories experience an expected sales pattern (Product life cycle),where sales start at low, then increase gradually, stabilize, and finally decline. This pattern

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might vary from product to product. While forecasting his sales, a retailer should be awareof the consumer segment, expected drivers of variety, nature of competition, promotion,price range etc, and has to categorise merchandise as a fashion, a fad, a staple, or seasonalmerchandise. Apart from this, the retailer has to understand the life cycle stage of theproduct(s) / service(s) he is dealing with. This is because, the product category life cyclestage affects the retail marketing mix such as target market, variety, place, price, andadvertising.

4.4 INVENTORY PLAN

Inventory management plan provides information to the retailer regarding his salesvelocity, availability of inventory, ordered quantity, inventory turnover, sales forecast, andquantity to order for specific SKU (stock keeping unit). This inventory plan helps theretailer in scheduling his orders to vendors after considering the trade off between carryingcost and the cost of ordering and handling the inventory. The more they purchase at onetime, the higher the carrying costs, but the lower the buying and handling costs.

The inventory plan also helps the retailer in devising his stock support levels for aspecific sales period. Most widely used methods to determine the stock support levelsare: beginning-of-the-month ratios, weeks’ supply method, the percentage variation methodand the basic stock method.

4.5 ESTIMATED REDUCTIONS

Retailers are usually required to provide for retail reductions along with their salesforecasts and inventory support levels. Retail reduction is the anticipated sales below thelist price. Retail reductions may be classified into three types - markdowns, discounts, andshortages. A markdown is defined as reduction in the original list price to encourage thesales of the product. Discounts are reductions in the original retail price given to specialcustomer groups, such as loyal customers to encourage increased shop patronage and asan appreciation of their loyalty. Shortages are reductions in the total value of inventorythat results from damages to merchandise, shoplifting, or pilferage. The retailers on thebases of their past experience on retail reductions make adequate arrangements whileevolving merchandise budgets.

4.6 ESTIMATED PURCHASE LEVELS

The retailer is expected to prepare an actual budget at this stage for planned purchase.In other words, planned purchases refer to regular purchases that must be made at thebeginning of each month. Here a retailer or planner uses the information compiled at theinitial stages of merchandise budget planning.


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Planned purchases may be calculated by using the following format.

Planned monthly sales + Planned monthly reductions + Desired end-of-the-month stock = Total stock needs for the month - Planned BOM stock = Planned monthly purchases

The planned monthly purchases figure informs the buyers as to how much they need tospend to support anticipated sales levels considering the existing inventories.

A retailer in the process of budgeting his performance outlines his expenses for a givenperiod of time. He links the costs to goals specific to his target market, employees and themanagement. By preparing his budget, he derives many benefits such as –

i) He can enhance his productivity by relating the expenditures to expected performanceand adjusting the costs to the revised goals.ii) He can allocate the resources to the right departments, product categories, etciii) He can ensure coordination in spending for various departments, product categoriesetc.iv) He can ensure achieving the goals by making his plans in a structured and integratedwayv) He can set cost standardsvi) He can prepare his firm to face the future rather than reacting to it.vii) He can monitor his expenses during the budget cycleviii) He can compare his firm’s performance with the industry performance, etc

While setting his budget, a retailer has to be aware that it might not be accurate andhas to provide for flexibility and has to revise it from time to time whenever a change in thebudget variables happens. Before finalizing the budget, he has to take certain decisionssuch as the following.

1. He has to specify the budgeting authority: There are two approaches in budgeting – atop-down approach and a bottom-up approach. According to the top-down approach ofbudgeting, senior executives make centralized financial decisions and communicate themdown the line to succeeding levels of managers. According to the bottom-up approach ofbudgeting, lower-level executives develop the departmental budget requests, and theserequests are assembled, and a company budget is designed. This approach includes variedperspectives, holds managers more accountable, and enhances employee morale. Manyfirms combine both the approaches.

2. He has to specify the time frame of the budget: He has to specify whether his budget isan annual budget, semi-annual budget, quarterly budget, monthly budget, weekly budgetor daily budget. Depending on the item of expenditure budgeted, the time span varies.

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3. He should determine the frequency of budgeting: Many retailers review budgets on anongoing process and review them every year / month etc. Sometimes, several months maybe set aside by the retailer to finish the budgeting process.

4. He should establish the cost categories: Costs can be categorized into – capitalexpenditures, fixed costs, direct costs, natural account expenses etc. Based on the natureand their treatment, a retailer should categorize his expensed into appropriate cost groups.

5. He should set the level of detail: Spending may be assigned department wise, productcategory wise, product subcategory wise or product item wise. Every expense sub categorymust be covered in the detailed budget.

6. He should ensure budget flexibility: The budget finalized by a retailer should be rigidenough to aid implementation of it and flexible enough to amend and revise it wheneverthere is any change in the external or internal conditions affecting the firm’s performance.

4.7 BUDGET PROCESS

After making the preliminary budgeting decisions, the retailer starts his on going processof budgeting, which usually takes the following steps.

• Goals are set based on the needs of the stakeholders such as - customers,employees, management etc

• Specifications as to the performance standards are made, in relation to the salesforecast prepared for the future specified period and includes the customer servicelevels to be maintained, the compensation needed to pay the supporting staff formotivating them, and the sales and profits needed to satisfy the management. Theseare broken department wise or product wise.

• Performance goals act as the basis for planning the expenditures. In this process,a retailer may use the concept of Zero base budgeting technique or an incrementalbudgeting technique for doing this. Most of the retailers use incremental budgetingtechnique as it is easier, less time consuming and less risky.

• Actual expenditure for payment of expenses such as– rent, salaries, purchase ofmerchandise, advertisements etc is met.

• Monitoring of results is done where actual expenditures are compared withbudgeted/ planned ones and reasons for deviations are analyzed if any. Then theretailer concludes as to whether his performance standards have been met or not.

• Wherever required, budget is adjusted and revised, based on the observeddeviations between actual and planned performance.

Forecasts are projections of expected sales / demand for given periods for specifiedproducts / services. They are the foundations of merchandise plans and include projectionsof various components such as – overall company projections, product category projections,item-by-item projections, and store-by-store projections.


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Modern demand-forecasting systems provide new opportunities to improve retailperformance. Even though the art of the individual merchant may never be replaced, it canbe supported by an efficient, objective and scientific approach to forecasting retail demand.Large-scale systems are now capable of handling the mass of retail transaction data –organizing it, mining it and projecting it into future customer behavior. This new approachto demand forecasting in retail is contributing to the accuracy of future plans, the satisfactionof future customers and the overall efficiency and profitability of retail operations.

4.8 CHALLENGES FACED BY RETAILERS WHILE PREPARING DEMANDFORECASTS

Retailers are facing several challenges when they are preparing their demand forecastssuch as -

• Scale of the problem (large number of stores and items to forecast).• Intermittent demand (slow and erratic sales for many items at the store level).• Assortment instability (frequent new-item introductions and seasonal assortment

changes).• Pricing and promotional activity.• Stock outs• Large Inventory levels• Huge variety of lead times etc.

Store-level stock outs, which are the bane of any retailer’s planning, have manypossible causes. A poor forecast of demand (resulting in the item selling out) is one possibility,but there are others:

• Poor replenishment policy (failure to account for demand variability, supplyvariability, forecast error, etc. in making inventory plans).

• Poor replenishment practice (failure to properly execute inventory plans).• Shrinkage (loss of sellable inventory due to theft, damage or misplacement).

Given these challenges, it is very important to recognize where forecasting leads tobetter retail processes, and where forecasting alone will not solve the business problem(s).

A good replenishment policy takes into account the uncertainties of supply and demand,and makes store-level inventory less dependent on a highly accurate forecast. Accurateforecasting at the store/item level is inherently difficult due to the amount of volatility andrandomness in demand at this level of granularity. Sporadic or intermittent demand canalso be a major problem. Pooling demand across stores and generating forecasts at aregion or warehouse level can help solve this problem. Forecasts will be more accurate atthe aggregated level, and attention can be focused on maintaining the appropriate level ofinventory at the warehouse. Good replenishment policy and execution will allow stores tomaintain appropriate stock levels, without overdependence on store- or item-specificforecasts.

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Hence, to ensure reliability in forecasting, a retailer may have to consider each productindependently or cluster similar products into groups and follow the routine given belowwith each product.

• Analyze their past sales history• Look at any seasonal variations they had• Consider their potential minimum re order quantities and determine if they would

give an excessive stock commitment• Determine if there have been any extraordinary usages such as a special order

item for one customer etc• Determine how many customers are now purchasing the product (and any new

customers who have the potential to adversely effect the item)

4.9 LARGE-SCALE AUTOMATED FORECASTING

The objective of any business is to ensure that the right product is there in the rightplace at the right time – and in the appropriate quantity. Achieving this objective can be asignificant challenge for any retailer because of the sheer number of items he carries andthe number of stores where the items are stocked. A large retailer may have tens of millionsof store/item combinations.

Given this situation, it is highly impractical to attempt to manually forecast demand foreach item at each store. It is not economically viable also to employ the hundreds (orthousands) of demand analysts necessary to manage each forecast individually. Fortunately,it is neither necessary nor advisable to manually create or intervene in each forecast at thestore/item level. Large-scale automated forecasting software which is available in the markettoday can address this problem. In most situations a quality forecast can be created withlittle or no human involvement. This automation minimizes the staffing requirements of theretailer, while permitting the forecasters to focus on the “high value” forecasts that have thegreatest impact on customer satisfaction and financial performance.

4.10 FORECASTABILITY OF RETAIL DEMAND

Forecasts may never be perfect, and sometimes they may not even be very good.The goal of forecasting in retail should not be a wrong pursuit for perfection, but to generateforecasts that are as accurate and unbiased as may reasonably be expected given thedynamic nature of the market, and to do this as efficiently as possible. Large-scaleautomation helps solve the problem of generating forecasts at granular levels of detail(such as store, item or week). However, there must still be a realistic assessment of thelikely accuracy of forecasts at that level, and consideration of other strategies that can beused in conjunction with forecasting to best solve the business problem.


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4.11 SALES / DEMAND FORECASTING

When a retailer is estimating / forecasting his future period sales, it is always better tobase them on monthly schedule of income and expenditure account as it gives a morerealistic information. The regular accounts prepared by him will give this information. Thisis possible only when the firm is an existing one.

A retailer, to this end, can prepare three cash flow projections, where the percentageof sales or other figures are varied slightly, to arrive at three different scenarios: pessimistic,optimistic, and realistic. The pessimistic view should be the “worst case” situation, whenhe should plan to have enough capital and patience to get through that scenario. If it turnsout that the actual results are better than that then he can relax.

4.12 METHODS OF SALES FORECASTING WHEN A FIRM IS A NEWLYSTARTED FIRM

Forecasting of a future sales figure is very difficult when a firm doesn’t have anyprevious sales history to guide it. In such scenario, there are many ways of estimating thesales revenues for the purpose of forecasting the sales. If a firm is forecasting its sales asa part of making the financing decision, it has to do multiple estimates so as to have moreconfidence in the sales forecasts. This may be done through the following methods.

Sales Forecasting Method 1

As a first step, the retailer has to analyze, for his type of business, what is the averagesales volume per square foot for similar stores in similar locations and similar size. Thismay not be the final answer for adequate sales forecasting, since a new business won’t hitthat target for perhaps a year.


Then, he should analyze, for his specific location, how many households needing hisproducts or services live within a mile. How much will they spend on these items annually,and what percentage of their spending will he get, compared to his competitors? After that,he has to do the same for within five miles (with lower sales forecast figures). (He can usedistances that make sense for his location.)


If a retailer offers say, three types of goods plus two types of extra cost services, hehas to estimate sales revenues for each of the five product/service lines. He has to make anestimate of where he thinks he will be in six months (such as “I should be selling five ofthese items a day, plus three of these, plus two of these.”) and calculate the gross sales perday. Then multiply by 30 for the month.

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Then, the retailer has to scale proportionately from month one to month six; that is,build up from no sales (or few sales) to his six month sales level, and carry it out frommonths six through 12 for a complete annual sales forecast. It can be concluded that salesforecasting by multiple methods is most accurate.

4.13 SOME DOS AND DON’TS OF SALES FORECASTING

Instead of forecasting annual sales as a single figure, a retailer should use one or twoof the sales forecasting methods mentioned above and generate three figures: pessimistic,optimistic, and realistic. Then he can put the figures in by month, depending on his business,there could be huge variations by month. (Some retail firms do 50 percent of their grosssales around some of the popular religious festivals such as Deevali, Christmas etc, duringwhich they have very high level of sales and they barely get by during the rest of the year).

The retailer has to then put in his expenses by month, including big purchases byseason (or however he buys materials/goods). But, he should keep in mind that he maybuy materials or inventory in July, for Christmas, yet not get all of his receipts until 45 daysafter Christmas. There can be big cash flow implications. Also, in case he is going to investin assets such as vehicles, capital equipment etc, he has to show depreciation expense.

In his expenses, he also has to provide for an allowance for bad debts. For this, heshould figure how much of his sales are by cash, how much by credit card, how much byhis extending credit. He should deduct say four percent or more for credit card expensefor that portion sold by credit card. For payroll expenses, he should put in estimated taxwithholding payments quarterly that must be paid to the government.

If he is not going for bank financing, he may have to answer questions such as, did hemake an allowance for a reserve cash account, for his slower months, but also in case hehas to quickly replace a vehicle or equipment? Another scenario is when his competitioncuts their price by app.33% and still is able to make profit, what happens to the pricecharged by him for his product or service?

How specifically he wants to grow his business— selling more to existing customers,selling existing products to new customers, selling new products to existing customers, andselling new products in order to attract new customers? He may have to satisfy them all,for which he has to prepare a realistic plan.

It is always to be remembered that it is acceptable (and realistic) to have a negativecash flow projection for the early months of the firm’s cash flow projection period.

4.14 EQUATIONS TO CALCULATE RETAIL SALES AND STOCK

To evaluate inventory purchasing plans, analyze sales figures, add on markup andapply markdown pricing to plan stocks, etc, generally some equations are used by storeowners, managers, retail buyers and other retailing employees, in various ways. Even


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though many computer programs are available along with other tools for evaluating inventorypurchasing plans, analyzing sales figures etc, these calculations often require familiaritywith formulas. The following equations may be used to track merchandise, measure salesperformance and help create pricing strategies.

1) Acid-Test Ratio

Acid-Test Ratio = Current Assets - Inventory ÷ Current Liabilities

Average Inventory

Average Inventory (Month) = (Beginning of Month Inventory + End of Month Inventory)÷ 2

2) Basic Retailing Formula

Cost of Goods + Markup = Retail PriceRetail Price - Cost of Goods = MarkupRetail Price - Markup = Cost of Goods

3) Break-Even Analysis

Break-Even (Rs) = Fixed Costs ÷ Gross Margin Percentage

4) Contribution Margin

Contribution Margin = Total Sales - Variable Costs

5) Cost of Goods Sold

COGS = Beginning Inventory + Purchases - Ending Inventory

6) Gross Margin

Gross Margin = Total Sales - Cost of Goods

7) Gross Margin Return on Investment

GMROI = Gross Margin (Rs) ÷ Average Inventory Cost

8) Initial Markup

Initial Markup % = (Expenses + Reductions + Profit) ÷ (Net Sales + Reductions)

9) Inventory Turnover (Stock Turn)

Turnover = Net Sales ÷ Average Retail Stock

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10) Maintained Markup

MM (Rs) = (Original Retail - Reductions) - Cost of Goods SoldMM % = Maintained Markup (Rs) ÷ Net Sales Amount

11) Margin %

Margin % = (Retail Price - Cost) ÷ Retail Price

12) Markup

Markup (Rs) = Retail Price - Cost

Markup % = Markup Amount ÷ Retail Price

13) Net Sales

Net Sales = Gross Sales - Returns and Allowances

14) Open to Buy

OTB (retail) = Planned Sales + Planned Markdowns + Planned End of MonthInventory - Planned Beginning of Month Inventory

15) Percentage Increase/Decrease

% Increase/Decrease = Difference between Two Figures ÷ Previous Figure

16) Quick Ratio

Quick Ratio = Current Assets - Inventory ÷ Current Liabilities

17) Reductions

Reductions = Markdowns + Employee Discounts + Customer Discounts + StockShortages

18) Sales per Square Foot

Sales per Square Foot = Total Net Sales ÷ Square Feet of Selling Space

19) Stock to Sales Ratio

Stock-to-Sales = Beginning of Month Stock ÷ Sales for the Month

4.15 ESTIMATION OF STORE SALES WHEN A FIRM IS AN EXISTINGFIRM

Apart from the above mentioned ratios and methods, a retailer with some pastexperience in the same merchandise line for which a store is planned can make a reasonablyaccurate estimate of sales volume if the following information is available.


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• Profiles of individuals who are most likely to frequent the stores, which can be collectedthrough interviewing the pedestrians

• An approximate number of such individuals passing the site during the store’s workinghours, which may be derives from traffic counts

• An approximate proportion of passers-by who might enter the store may be collectedfrom pedestrian interviews

• An approximate proportion of those individuals who are entering the shop, who willbecome purchasers, may be collected from pedestrian interviews

• An approximate amount of average transaction, which may be calculated from pastexperience, trade associations, and trade publications.

Some retailers may divide the people who pass a given site into three categories:

(i) Those who enter a store;(ii) Those who, after looking at the windows, may become customers;(iii) Those persons who pass the store without entering or looking.

Owing to past experience, these retailers are able to estimate from the percentagefalling into each classification, the number who will make purchases and also how much theaverage purchase will be. If out of 1,000 passers-by each day 5% (fifty) enter the storeand each spends an average of Rs 200, a store at that site, which operates 300 days a yearwill have an annual sales volume of Rs 3,00,000.

4.16 HOW TO MAKE A TRAFFIC COUNT

Knowledge of the volume and character of passing traffic is a very essential parameterfor the selection of a retail location. Flow of traffic along with several factors such asparking facilities, operating costs, location of competitors, etc. are important determinantsof a retail store’s success. To evaluate the traffic available to competitors, traffic counts atcompetitor’s sites may also be conducted. Information from a traffic count will show howmany people pass by, but generally indicate what kinds of people they are. Analysis of theprofiles of the passing traffic often reveals patterns and variations which are not visiblyobvious from casual observations.

For counting of traffic purposes, the passing traffic is divided into different classificationsaccording to the profiles of the customers who may frequent the store. This may vary fromproduct to product and store to store. For example, whereas a medical store is interestedin the total volume of passing traffic, a gents’ textile store is obviously more concerned withthe amount of male traffic, especially men between the ages of sixteen and sixty-five. It isalso important to classify the passing traffic based on the purpose of visit. A woman on theway to a beauty parlor may be a poor prospect for a paint store, but she may be a goodprospect for a chemist. The hours at which individuals pass by usually indicate their purpose.In the early morning, people are generally on their way to work. In the late afternoon thesesame people are usually going home from work.

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To determine what proportion of the passing traffic represents potential shoppers,some of the pedestrians may be interviewed about the origin of their trip, their destination,and the stores in which they plan to shop. This sort of information may provide a betterestimate of the number of potential customers.

For any retailer, his store image will guide the number of lines to carry, the price andquality range of merchandise within these lines, the lines that will be considered major lines,the complementary line or minor lines that should be carried, and so on. Space limitationand lack of funds for the investment in the inventories may be the major limitations to anexpanded product offering. For example, in India most of the traditional eating joints facedwith unexpected competition from the multinational chains, particularly McDonald’s andPizza Hut. In order to meet the competition they have added new product lines other thanIndian cuisine, such as Chinese, Italian, Thai preparations, etc. In the same manner, mostof the grocery stores in India started keeping the over the counter (OTC) medicinesdemanded by their customers and also provided them good margin in comparison to existingproduct mix. This has also enlarged the retail network for the pharmaceutical companies todistribute their products to immediate customers.

4.17 IMPLEMENTING MERCHANDISE PLANS

The merchandise plans a retailer has finalized as above can be implemented (usually)in eight sequential steps.

STEPS IN THE IMPLEMENTATION OF MERCHANDISE PLANS

Step IGathering information

Step IISelecting and interacting with merchandise sources

Step IIIEvaluation

Step IVNegotiation

Step VConclusion of purchases

Step VIReceiving and stocking merchandise

Step VIIReordering

Step VIIIReevaluation


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Step I - Gathering Information

After setting or finalizing the overall merchandising plan, the retailer has to collectmore information about his target market needs and prospective suppliers, before buyingor re-buying the required merchandise. In gathering data about the market place, a retailerhas several possible sources to draw it from. The most valuable source of information ishis consumer. A retailer can directly learn a lot about consumer demand, any potentialchanges in it, etc by regularly researching his target market demographics, lifestyles andpotential shopping plans. Consumer loyalty programs, which are the most popular positioningtools for many sellers, are especially useful in tracking consumer purchases and interests.

Other information sources which can be used when direct consumer data are insufficientinclude - Suppliers (manufacturers and wholesalers) who usually do their own salesforecasts and marketing research (such as test marketing etc). They also know how muchoutside promotional support every retailer gets. In closing a deal with a retailer, a suppliermay present many charts and graphs, showing forecasts and promotional support. Yet,the retailer always has to remember that he has direct access to the target market and itsneeds.

By using observation technique, retail sales and display personnel, who interactwith consumers directly, can pass their observations to the management. Outside ofcustomers, sales people are in a position to provide useful information for merchandisingdecisions of a retailer.

Competitors represent another information source for a retailer. A conservativeretailer may not start stocking any item until his competitors do and he may employcomparison shoppers to study the offerings and prices of his competitors. In addition to allthis, certain reliable and authentic publications such as - trade publications, Governmentdata, report on trends in each aspect of retailing etc might prove to be yet another way ofgathering data from competitors.

In addition, government sources also indicate unemployment, inflation and productsafety data. Independent news sources conduct their own consumer polls and doinvestigative reporting and commercial data can be purchased to learn about the attributesof specific suppliers and their merchandising plans. Retailers can:

• Talk to suppliers, get specification sheets, read trade publication and seek references• Attend trade shows with numerous exhibitors (suppliers)• Search the web

Whatever information is acquired, a retailer should feel comfortable that it is sufficientfor making good decisions. For routine decisions limited information may be adequate.

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Step II - Selecting and interacting with the sources of merchandise

The next step of the retailer is to select sources of merchandise and to interact with them.There are three major options available to him, which include the following.

(1) Company owned(2) Outside, regularly used supplier and(3) Outside, new supplier.

Thus, a retailer may rely on any one type of supplier or may use a combination (thebiggest retailers often use all three formats), the details of which are given below.

Outside Sources of Supply

(Source: ‘Retail Management – A strategic approach’, Barry Berman & Joel R. Evans,Prentice Hall India)


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A retailer has to be very cautious while selecting his supplier. There are various issueswhich have to be clearly outlined before any agreement if formally made between theretailer and the supplier. Supplier or vendor selection is a specialized arena, which needsaddressing and specifying the various potential problem areas. Some of the areas which aretailer has to be aware of are given below in the form of a check list which might help theretailer in selecting the supplier scientifically so that he can avoid lot of problems later.

Check list of points to review in choosing vendors

1. Reliability - Will a supplier constantly fulfill all written promises?2. Price-quality - Who provides the best merchandise at the lowest prices?3. Order processing time – How fast will deliveries be made?4. Exclusive rights – Will a supplier give exclusive selling rights or customize products?5. Functions provided – Will a supplier undertake shipping, storing and other functions ifneeded?6. Information – Will a supplier pass along important data?7. Ethics – Will a supplier fulfill all verbal promises and not engage in unfair business orlabor practices?8. Guarantee – Does a supplier stand behind its offerings?9. Credit – Can credit purchases be made from a supplier? On what terms?10. Long term relationships – Will a supplier be available over an extended period?11. Reorders – Can a supplier promptly fill reorders?12. Markup – Will markup (price margin) be adequate?13. Innovativeness – Is a supplier’s line innovative or conservative?14. Local advertising – Does a supplier advertise in local media?15. Investment – How large are total investments costs with a supplier?16. Risk – How much risk is involved in dealing with a supplier?

(Source: ‘Retail Management – A strategic approach’, Barry Berman & Joel R. Evans,Prentice Hall India)

Step III - Evaluation of the Merchandise

Whatever information source is chosen, the retailer has to develop a procedure to evaluatethe merchandise under consideration. He can follow the following three procedures.

InspectionSampling andDescription

The technique selected depends on the item’s cost, its attributes and its purchase regularity.

Inspection / examination may be done of every single unit before purchase and afterdelivery. Sampling is used with when large quantities of breakable, perishable or expensiveitems are regularly purchased. Usually, when inspection is inefficient, items are sampledfor quality and condition. An unsatisfactory sample might cause a whole shipment to be

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rejected, which might turn out to be very expensive to the retailer. Sampling may alsooccur upon receipt of the merchandise. Description buying is used when standardized,non-breakable and non-perishable merchandise is purchased. Items are neither inspectednor sampled because, they are ordered based on a verbal, written or pictorial description.

Step IV - Negotiation of the purchase

After evaluating the merchandise, a retailer negotiates his purchase. Usually, whenevera new or special order results in a negotiated contract, the retailer and the supplier carefullydiscusses all aspects of that purchase. A regular order or re-order of an invoice involves auniform contract, as the terms are standardized and the order is handled routinely.

Retailers who offer price offs and other deep discounters may require negotiatedcontract for most their purchases. Their firms enjoy opportunistic buying by which especiallylow prices are negotiated for a merchandising whose sales have not lived up to expectations,end of season goods, items consumers have returned to the manufacturer or another retailer,and close outs.

Whenever a negotiated or a uniform contract is involved, several purchase termsmust be specified, such as - the delivery date, quantity purchase, price and paymentarrangements, discounts, delivery form and point of transfer of title as well as specialclauses.

The delivery date and the quantity purchased must be very clear. If any provision isnot carried our, a retailer must be in a position to cancel the order. The purchase price,payment arrangements, and permissible discounts must also be addressed in depth. Eventhe point of transfer of title when ownership changes from supplier to buyer must be statedin a contract, which is clear.

Special clauses may be inserted by either party. Sometimes they may be beneficial toboth the parties, and some times, the clauses might have been inserted by the more powerfulparty.

Step V - Conclusion of purchases

Majority of the medium sized and large retailers are using computers to complete andprocess orders (based on electronic data interchange [EDI] and quick response [QR]inventory planning), where every purchase data is fed into a computer data bank (database). Mostly, the smaller retailers write up and process their orders manually, and purchaseamounts are added to their inventory in the same way. Yet, with the advances in computerizedordering software, even small retailers now have the capability of placing orders electronically– especially if they buy from large wholesalers that use EDI and QR systems.


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Multi-unit retailers have to determine whether the final purchase decision is made bycentral or regional management or by local managers. Each approach has its respectiveadvantages and disadvantages..

Several alternatives are possible regarding the transfer of title between both the involvedparties. The retailer’s responsibilities and rights differ in each of such case, some of whichare as follows.

• The retailer may take the title immediately on purchase• The retailer may assume ownership after the items are loaded onto whatever the

mode of transportation.• The retailer may take title when a shipment is received• The retailer may not take title until the end of a billing cycle, when the supplier is paid.• The retailer may accept the ordered merchandise on consignment and does not own

the items. The supplier is paid after the merchandise is sold.

A consignment or memorandum deal is possible when a vendor is in a weak positionand wants to persuade his retailers to carry his items. In a consignment purchase, aretailer has no risk because the title for the merchandise is not taken; the supplier owns thegoods until sold. An electronic version (scan-base trading) is being tried in somesupermarkets. It saves both time and money for all parties involved, due to the paperlesssteps involved in a purchase. In a memorandum purchase, risk is comparatively lower,but a retailer takes the title on delivery and is responsible for damages if any. In both theabove options, retailers do not pay for the items until they are sold and can return items.

Step VI - Receiving and Stocking of Merchandise

The task of receiving and stocking of merchandise involves receiving and storing,checking and paying invoices, price and inventory marking, setting up of displays, figuringon-floor assortments, completing the transactions, arranging delivery or pickup, processingthe returns and damaged goods if any, monitoring of pilferage, and controlling of themerchandise.

Merchandise may be shipped from suppliers to warehouses (for storage anddisbursement) or directly to the retailers’ store(s). In some outlets, the entire process isautomated, which will speed up their delivery to the stores. Limited Brands may ordersome apparel by satellite and computer, using common and contract carriers to pick it upfrom manufacturers in one country (using chartered jets), ship those to its own warehousesand then delivers them to stores.

One technology which is emerging and may greatly advance the merchandise trackingand handling process for retailers involves RFID (radio frequency identification) systems.RFID “is a method of remotely storing and retrieving data using devices called RFID tagsor transponders. An RFID tag is a small object, such as an adhesive sticker, that can beattached to or incorporated into a product or its shipping package. RFID tags contain tiny

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antennas to enable them to receive and respond to radio frequency queries from an RFIDtransceiver.”

At present, RFID utilization is very limited. To quote, the utility of RFID is

RFID, with its more sophisticated tags and readers, can tell retailers and supplierswhat’s in a case, what’s on a pallet, and where products are at any point alongwith supply chain. Recognizing that majority of inventory is stuck at some pointwithin the supply chain at any given point in time, there’s massive room forimprovement. According to one expert, “Wal-Mart, as any retailer, is basically adistributor of products. It has to be able to get products in and get them outextremely effectively and track them while it is doing that. And RFID is its attemptto track them better.”

Whenever orders are received, they must be checked for their completeness andproduct condition. Invoices must be reviewed for their accuracy and payments made, asper the specifications.

By now, the prices and inventory information are marked on the merchandise. Usuallysupermarkets estimate that the price marking on individual merchandise costs them anamount equal to their annual profits. Marking can be done in many ways. Small firms mayhand-post and manually keep inventory records; some other retailers may use their owncomputer generated price tags and may rely on pre-printed UPC data on packages tokeep records; some other retailers may buy tags, with computer-and-human-readableprice and inventory data, from outside suppliers. Still other retailers may expect vendorsto provide source tagging.

Coming to the merchandise display, stone displays and on-floor quantities andassortments depend on the retailer and products involved and may differ from retailer toretailer. Supermarkets usually have the old system of bin and rack displays which mayplace most of its inventory on the sales floor. Many of the traditional department storessport all kinds of interior displays and place a lot of inventory in the back room and off thesales floor.

The task of merchandise handling is not treated as complete till the customer buysand receives it from a retailer, which may involve the steps of order taking, credit or cashtransactions, packaging, and delivery or pickup. Automation has improved the performanceof the retailer in many cases, and in each of the above mentioned areas.

The retailer has to draft a procedure for processing the customer returns and damagedgoods. The retailer has to determine the party (supplier of retailer) responsible for customerreturns and has to decide the situations under which damaged goods would be acceptedfor refund or exchange.


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Merchandise control involves assessing the sales, profits, turnover, inventory shortages,seasonality and costs for each product category and item carried by the retailer. Controlis usually achieved by preparing computerized inventory data and also by doing physicalinventories. A physical inventory must be adjusted to reflect the value of damaged goods,pilferage, customer returns and other factors.

Step VII - Reordering Merchandise

In reordering merchandise, there are four factors which are very critical for the retailerto purchase more than once - order and delivery time, inventory turnover, financial outlaysand inventory versus ordering costs.

Every retailer has to calculate - how long it takes for him to process an order and forhis supplier to fulfill and deliver it. It might be possible for the delivery time to be so lengthythat a retailer must reorder while having a full inventory. On the other hand, overnightdelivery may be available for some items on request.

Another point which the retailer has to find out is - how long does it take for a retailerto sell out his inventory? A fast-selling product gives retailer two choices - either order asurplus of items and spread out reorder periods, or keep a low inventory and orderfrequently. A slow-selling item may enable a retailer to reduce his initial inventory andspread out reorders.

A retailer then has to find out - what are the financial outlays under various purchaseoptions? A large order, with a quantity discount, may require a big cash outlay, and a smallorder, even though more expensive item wise may result in lower total costs at any givenpoint of time, as less inventory is held.

A retailer has to understand the trade-offs existing between cost of holding the inventoryand ordering costs. Where a large inventory fosters customer satisfaction, volume discounts,low per-item shipping costs, and easier handling, it also entails high investments; greaterobsolescence and damages; and storage, insurance and opportunity costs. Placing manyorders and keeping a small inventory result in low investment, low opportunity cost, lowstorage costs and little obsolescence. But, there may be higher unit costs, adverse effectsfrom order delays, a need for partial shipments, service charges, complex handling, anddisappointed customers (if items are out of stock). Retailers must always try to holdenough stock to satisfy customers while not having a high surplus. Quick response inventoryplanning lowers inventory and ordering costs via close retailer-supplier relationships.

Step VIII – Re-evaluating on a regular basis

The retailer has to regularly re-evaluate his merchandising plan, with the managementreviewing the buying organization and its implementation. The overall procedure, alongwith the handling of individual goods and services is to be closely monitored. Conclusionsarrived at this stage become part of the information gathering stage for future efforts.

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4.18 RETAIL LOGISTICS MANAGEMENT

The word ‘Logistics’ implies the total process of planning, implementing, andcoordinating the physical movement of merchandise from manufacturer (wholesaler) toretailer, to customer in the most timely, effective, and cost efficient manner that is possible.Retail logistics regards order processing and fulfillment, transportation, warehousing,customer service and inventory management as interdependent functions in the firm’s valuedelivery chain. If a logistics system works well, firms reduce their stock out situations,hold down their inventories, and improve their customer service.

Retailers’ major logistics goals include the below mentioned goals.

• To match the costs incurred by him to specific logistics activities, thereby finishingall the activities as economically as possible, given the firms’ other performanceobjectives.

• To place and receive orders as easily, accurately and satisfactorily as possible.• To minimize the time between ordering and receiving their merchandise.• To coordinate shipments from various suppliers• To stock enough merchandise on hand to satisfy the customer demand, without

overstocking the same• To place the merchandise on the sales floor efficiently• To process the customers’ orders in the most efficient manner possible.• To work collaboratively and communicate regularly with other supply chain

members.• To handle the returns effectively and thus minimize the value of returned and

damaged products• To monitor the firm’s logistics performance• To make back up plans in case of breakdowns in the system

In any working partnership between a supplier and a retailer, it is very important todefine both their expectations very clearly, which may be related to - Product quality,shipping windows, production and product availability etc. The role of international logisticstakes on significant importance in producing higher levels of productivity, in improving theproduct flow to the selling floor, in reducing the inventories and in reducing the overall costfor both the retailer and supplier. There are clear and concise expectations consistent withstandard practices prevalent throughout the retail industry. While critical to their mutualsuccess, these contractual provisions allow the retailer to minimize his costs and to receiveand process merchandise in the most timely and cost-effective manner, thereby assuring acontinuous flow of merchandise to the store.

4.19 RETAIL SUPPLY CHAIN MANAGEMENT

The term ‘supply chain’ refers to the logistics aspect of a value delivery chain. Itcomprises of all the parties that participate in the retail logistics process: manufacturers,wholesalers, third-party specialists (shippers, order-fulfillment houses, and so forth), and


NOTES


the retailer. Now a days, many retailers and suppliers are seeking closer logisticalrelationships. One technique for larger retailers is collaborative planning, forecastingand replenishment (CPER) – which is a holistic approach to the study and applicationof supply chain management among a network of trading partners. Also, now a days,third-party logistics (outsourcing) is becoming popular. Logistics specialists work withretailers of all sizes to ship and warehouse their merchandise.

The latest trend these days is for organizations to blend their operational functionsunder the umbrella known as supply chain management. Often, the first two functions tomerge are purchasing and inventory management.

Stock Management in the retail supply chain follows the following sequence

1. Request for new stock from stores to head office2. Head office issues purchase orders to the vendor3. Vendor ships the goods4. Warehouse receives the goods5. Warehouse stocks and distributes to the stores6. Stores receive the goods7. Goods are sold to customers at the stores

The management of the inventory in the supply chain involves managing the physicalquantities as well as the costing of the products as it flows through the supply chain.

5. ORDER PROCESSING AND FULFILLMENT IN RETAIL BUSINESSES

The next task for the retailer to perform is - to optimize his order processing andfulfillment, where many firms today are engaging in quick response (QR) inventoryplanning, by which a retailer reduces the amount of inventory he holds by ordering morefrequently and in lower quantity. A QR system requires that a retailer has to have goodrelationships with his suppliers, coordinate his shipments, monitor the inventory levels closelyto avoid stock outs, and regularly communicate with his suppliers by electronic datainterchange (via the web or direct PC connections) and other means.

The many benefits of a QR system to a retailer include – it reduces his inventorycosts, minimizes the space required for storage, and lets the firm match orders with marketconditions in a better way – by replenishing the stock more quickly. For a manufacturer, aQR system may also improve his inventory turnover and better match supply and demandby giving the vendor the data to track the actual sales. In addition, an effective QR systemreduces the risk of supplier switching by a retailer.

A QR system works best in combination with floor-ready merchandise, lowerminimum order sizes, properly formatted store fixtures and electronic data interchange(EDI). Floor-ready merchandise refers to those items that are received at the store incondition to be put directly on display without any preparation by retailer. Quick responsealso implies that the suppliers need to rethink the minimum order sizes they will accept.

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Electronic data interchange, EDI lets retailers do their QR inventory planning efficiently– via a paperless, computer-to-computer relationship between retailers and vendors.Research suggests that retail prices could be reduced by an average of 10 percent with theindustry wide usage of QR and EDI.

A number of firms in the food sector of retailing are striving to use efficient consumerresponse (ECR) planning, which permits the supermarkets to incorporate the variousfeatures of QR inventory planning, EDI and logistics planning. To quote, the main goal is“to develop a responsive, consumer-driven system in which manufacturers, brokers anddistributors work together to maximize consumer value and minimize supply chain cost.To meet this goal, we need a smooth, continual product flow matched to consumerconsumption. And to support the flow of products, we need timely, accurate data flowingthrough a paperless system between the retail checkout and the manufacturing line”.Although ECR has enabled many of the supermarkets to cut their distribution costs, applyingit has not been easy because, many supermarkets are still unwilling to trade their ability tonegotiate short-term purchase terms with vendors in return for routine order fulfillmentwithout special deals.

Today, retailers are also addressing two other aspects of order processing andfulfillment.

(1) With advanced ship notices, retailers that utilize QR and EDI receive an alert whenbills of lading are sent electronically as soon as a shipment leaves the vendor. This givesthe retailers more time to efficiently receive and allocate their merchandise.(2) As more retailers are buying merchandise from multiple suppliers, from multi locationsources, and from overseas, they must better coordinate order placement and fulfillment.

Sometimes the order-processing and fulfillment process can be quite challenging to theretailer.

5.1 RETAIL TRANSPORTATION AND WAREHOUSING DECISIONS

The retailer may have to take several transportation decisions, which are veryessential for the firm, which are necessary:

• How often is the merchandise shipped to the retailer?• How to handle the small order quantities?• Which shipper is to be used (the manufacturer, the retailer, or a third-party

specialist)?• What transportation form is to be used?• What special conditions are to be considered for perishables and expensive

merchandise?• How often special shipping arrangements such as are rush orders are

necessary?• How are shipping terms negotiated with suppliers?• What delivery options will be available for the retailer’s customers?


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The effectiveness of transportation is influenced by the quality of the logisticsinfrastructure (including access to refrigerated trucks, airports, and waterway docking andsuper highways), traffic congestion, parking, and other factors. Retailers operating in onecountry (whether developed, developing or under developed) must come to grips with thelogistical problems existing in other countries, where the transportation network and theexistence of modern technology may be severely lacking.

In relation to warehousing, some retailers may focus on warehouses as central orregional distribution centers. Products are shipped from suppliers to their warehouses andthen allotted and shipped to individual outlets. There are several advantages to the practiceof central warehousing, which includes - efficiency in transportation and storage, mechanizedprocessing of goods, improved security, efficient merchandise marking, ease of returns,and coordinated merchandise flow. Its main disadvantages include - excessive centralizedcontrol, extra handling of perishables, high costs for small retailers, and potential orderingdelays. Centralized warehousing may also reduce the capability of QR systems by addinganother step.

5.2 RETAIL INVENTORY MANAGEMENT

As part of its logistics efforts, a retailer uses inventory management to acquire andmaintain a proper merchandise assortment while ordering; shipping, handling, storing,displaying, and selling costs are kept in check. In the first step, the retailer places an orderbased on a sales forecast or actual customer behavior. At the time of ordering, both thenumber of items and their variety are requested. Order size and frequency depend onquantity discounts and inventory costs. In the second step, a supplier fills the order andsends the merchandise to his warehouse or directly to the store(s). In the third step, theretailer receives the merchandise, makes them available for sale - (by removing them frompacking, marking prices, and placing them on the sales floor), and completes customertransactions. Some transactions are not concluded till the merchandise items are deliveredto the customer. The cycle starts again when the retailer places another order.

These days, a retailer is expected to know the general inventory management principles,which even today remain valuable. Some of them include the following.

First, he must know how much inventory to have on hand to ensure continuity of supply inthe event of an uncharacteristic increase in either demand and/or lead time. This quantity ofinventory is called the safety stock. There is no universally used formula for determiningsafety stock quantity.

Second, he must know when to reorder materials for inventory. Generally, this point intime is determined when the quantity of materials in stock decreases to a certain level,called the reorder point. The reorder point is determined by the following formula.

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ROP = SSQ + (QUD x ALT)

Where,

ROP = Reorder Point

SSQ = Safety Stock Quantity

QUD = Quantity Used Daily

ALT = Average Lead Time (in days)

Third, he must know how much to order. A complex mathematical equation determinesthe Economic Order Quantity, or EOQ. This equation recognizes the tug of war betweenacquisition costs and inventory carrying costs: when he orders bigger quantities lessfrequently, his aggregate acquisition costs are low but his inventory costs are high due tohigher inventory levels. Conversely, when he orders smaller quantities more often, hisinventory costs are low but his acquisition costs are higher because he is expending moreresources on ordering (unless EDI and a QR inventory system are used). The EOQ is theorder quantity that minimizes the sum of these two costs.

Thus, EOQ is a mathematical formula designed to minimize the combination of annualholding costs and ordering costs. There is a lot of hype about just in time inventory systems(JIT), which achieve smaller inventories through very frequent orders, but frequent orderingcan often result in an over-spending on ordering costs. Even though companies oftenmiscalculate their ordering costs, which make frequent ordering seem costly, EOQ is animportant tool for determining what inventory should be.

Economic order quantity (EOQ) can be defined as the quantity per order (in units)that minimizes the total costs of order processing (which include computer time, orderforms, labor, and handling new goods) and inventory holding (which include warehousing,inventory investment, insurance, taxes, depreciation, deterioration, and pilferage). EOQcalculations can be done by large and small firms.

Order-processing costs drop as the order quantity (in units) goes up because fewerorders are needed for the same total annual quantity, and inventory-holding costs rise asthe order quantity goes up because more units must be held in inventory and they are keptfor longer periods. The two costs are summed into a total cost curve. Mathematically, theeconomic order quantity is

Where,

EOQ — quantity per order (in units)


NOTES


D — annual demand (in units)

S = costs to place an order (in dollars)

I = percentage of annual carrying cost to unit cost

C = unit cost of an item (in dollars)

Illustration: XYZ Ltd estimates it can sell 150 power tool sets per year. They cost s.90 each. The cost incurred on several aspects include – on breakage, insurance, held-upcapital, and pilferage, which equals 10 percent of the costs of the sets (or Rs 9 each).Order costs are Rs.25 per order. When calculating EOQ, the above mentioned formula isused.

Thus, the economic order quantity is 29.

The retailer has to change / modify the EOQ formula quite often to reflect the accountchanges in demand, quantity discounts, and variable ordering and holding costs.

A graphical representation of EOQ is as follows.

(Source – ‘Retail Management A strategic approach – Barry Berman & Joel R.Evans,Prentice Hall, India)

5.3 RETAIL INVENTORY LEVELS

Another problem area for a retailer is - maintaining proper inventory on hand, whichin itself is a difficult balancing act.

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1. The retailer wants to be appealing to the customer and never want to lose a sale bybeing out of stock. But, he does not want to overstock himself that must bemarked down drastically.

2. This situation is more complicated for many retailers who carry fad merchandise,who handles new merchandise items for which there is no track record, and whooperate in new business formulae where demand estimates are often inaccurate.In these cases, their inventory levels must be planned in relation to the productsinvolved. - Staples, assortment merchandise, fashion merchandise, fads, and bestsellers.

3. Customer demand is never completely predictable, even for regular products suchas staples. Thus, weather, special sales, and other factors may have an impact oneven the most stable of items.

4. Shelf space allocations for retail merchandise must be linked to the current revenues,which entail that allocations must be regularly reviewed and adjusted.

One of the major advantages of QR and EDI is that they enable the retailers to hold‘leaner’ inventories as they receive new merchandise more often. Still, stock outs mayhappen even when merchandise is popular or the supply chain breaks down.

When to reorder is a question every retailer must attempt to know the answer to.Because, the one way to control investment in inventory is - to systematically fix inventorylevels at which new orders must be placed. Such an inventory level is known as a reorderpoint, and it is based on three factors – i) order lead time, ii) usage rate and iii) safetystock.

i) Order lead time refers to the period from the date an order is placed by a retailer to thedate merchandise is ready for sale, which covers the time taken for the merchandise to bereceived, price-marked and put on the selling floor.

ii) Usage rate refers to average sale(s) of merchandise per day, in units.

iii) Safety stock is the extra inventory that is maintained to protect the retailer against out-of-stock conditions due to unexpected demand and delays in delivery. It depends on theretailer’s policy toward running out of items.

There are retailers who do not believe in maintaining safety stock. The formula forsuch a retailer, who does not plan to carry safety stock, is given below. This is based onthe assumption that customer demand is stable and that the orders are promptly filled bysuppliers.

Reorder point = Usage rate x Lead time

For example, if Annai Hardware sells 10 paintbrushes a day and needs 8 days toorder, receive, and display them, it will have a reorder point of 80 brushes. It wouldreorder brushes once its inventory on hand reaches 80. By the time brushes from that


NOTES


order are placed on its shelves (8 days later), its stock on hand will be 0, and the newstock will replenish the inventory.

This strategy is suitable only when Annai Hard wares is having a steady customerdemand of 10 paintbrushes daily and it takes exactly 8 days to complete all stages in theordering process. This in real life, most of the time, does not take place. If customers buy15 brushes per day during the month, Annai Hard wares will face stock out situation runout of stock in 5-1/3 days and be without brushes for 2-2/3 days. If an order takes 10days to process, Annai Hard wares would have no brushes for 2 days, despite correctlyestimating demand. This situation is graphically represented below.

(Source – ‘Retail Management A strategic approach – Barry Berman & Joel R.Evans,Prentice Hall, India)

When a retailer is interested in keeping a safety stock, the reorder formula is as below.

Reorder point = (Usage rate x Lead time) + Safety stock

Suppose Annai Hardwares decide on a safety stock of 30 percent for paintbrushes;its reorder point is (10 x 8) + (.30 X 80) = 80 + 24 = 104. Annai Hardwares still expectto sell an average of 10 brushes per day and receive orders in an average of 8 days. Thesafety stock of 24 extra brushes is kept on hand to protect against unexpected demand ora late shipment.

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Ordering can be computerized by combining a perpetual inventory system and reorderpoint calculations, and an automatic reordering system can be mechanically activatedwhenever stock-on-hand reaches the reorder point. However, a retailer must ensure thatif necessary, a buyer or a manager may intervene if monthly sales fluctuate greatly.

5.4 REVERSE LOGISTICS

The term reverse logistics encompasses all merchandise flows from the retailer backthrough the supply channel to the retailer. It typically involves items returned by the customersdue to damages, defects, or less than anticipated sales, or any other reason. Sometimes,retailers may even use closeout firms that buy back unpopular merchandise at a fraction ofthe original cost, that suppliers will not take back, and then these firms resell the goods ata deep discount. The conditions for reverse logistics must be specified in advance, toavoid channel conflicts. Some of them are as follows.

1. Acceptance of customer returns: Under what conditions pertaining to terms ofsales like - the permissible time, the condition of the product etc are customerreturns accepted by the retailer and by the manufacturer?

2. Return Fee / penalty: What is the customer refund policy regarding a fee forreturning an opened package?

3. Responsibility: What party is responsible for shipping a returned product to themanufacturer?

4. Documentation required: What customer documentation is required to provethe date of purchase and the price paid?

5. Repair Handling: How are the customer repairs handled? Is it an immediateexchange, a third-party repair, or a refurbished product sent by the manufacturer?

6. Employee empowerment: To what extent are employees empowered to processcustomer return?

5.5 RETAIL INVENTORY ORDER MANAGEMENT

Inventory Visibility or Purchase order creation

The various steps involved in retail order management include the following.

1. The retailer has to view the status of on hand, on order, reserved and backorderedquantity for single or grouped SKUs (stock keeping units)

2. The retailer then has to drill down into purchasing and customer buying history perSKU

3. The retailer has to support integration into third party suppliers4. The retailer has to receive inventory directly from PO5. The retailer has to send POs in multiple formats including printed fax, eFax and email6. The retailer has to drop ship POs are created directly from order7. The retailer has to support unit and case purchasing8. The retailer has to allow for automatic reordering9. The retailer has to create stock purchase orders from defined stock level reorder

points


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5.6 COMMUNICATIONS TRACKING IN RETAILING

This phase of retail management deals with the retailer’s decisions to ensure theeffective and efficient tracking of communications, and includes the following activities.

The retailer has to track and manage his email communications to vendorsThe retailer has to track the receipt of a PO, by Receiving a PO notifies user oforders awaiting inventoryThe retailer can easily request inventory status using system generated emails listingopen PO line itemsThe retailer can record and track notes on vendors and POs

5.7 RETAIL WAREHOUSE LOCATION MANAGEMENT

This phase of retail management deals with an important decision of the retailer – thewarehouse and location management and includes the following activities of the retailer.

The retailer supports one or more multiple warehouses, where each warehousecan have its own unique ‘topography’ including unlimited locations and depth.The retailer can see that SKUs are stored in multiple warehouse locationsThe retailer can mark the warehouse locations as unavailable for fulfillmentThe retailer can design and print unlimited warehouse location labels directly fromthe back office

5.8 PHYSICAL INVENTORY COUNT MANAGEMENT IN RETAIL

This phase of the retail management deals with the inventory inspection whichis a very crucial activity, and entails the following activities of the retailer.

The retailer has to ensure that the physical inventory/cycle counts are performedby respective locationThe retailer has to prepare his report on inventory shrinkage and coverage

5.9 RETAIL INVENTORY TRANSFER MANAGEMENT

This phase of retail management deals with several retailer activities which include thefollowing.

The retailer has to make decisions which supports warehouse-to-warehouse andintra-warehouse transfersThe retailer has to make decisions which Support the barcode receivingThe retailer has to make decisions which automatically create/save put-awaydocuments upon receivingThe retailer has to make decisions which override put-away locations upon receivingThe retailer has to make decisions which ensures posting of comments andmanagement of transfer email correspondence

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5.10 RETAIL DECISION MAKING

This phase of the retail management deals with retailer’s decision making and

The retailer has to ensure that he makes the most cost effective purchase decisionsbased on average vendor fulfillment time and rate of saleThe retailer has to make sure that the system recommended reorder quantitiesThe retailer has to quickly determine the low level and backordered SKUsThe retailer has to make decisions which supports ordering from multiple vendorsfor a single SKUThe retailer has to ensure the tracking and reporting of open POs

6. MATERIAL ISSUE MANAGEMENT

In managing the cost prices of the products through out the supply chain, several costingmethods are employed. They include the following.

(i) Retail method(ii) Weighted average price method(iii) FIFO (First in first out) method(iv) LIFO (Last in first out) method(v) LPP (Last purchase price) method etc.

The calculation can be done for different time periods. If the calculation is done on amonthly basis, then it is referred to the periodic method. Under this method, the availablestock is calculated by

Add: Stock at the beginning of the periodAdd: Stock purchased during the periodAverage total cost by total quantity to arrive at the average cost of goods for the period.

On the quantity, total all movements and adjustments during the period to arrive at theending stock in quantity for the period.

Multiplying the stock balance in quantity by the average cost gives the stock cost at theend of the period.

By using the perpetual method, the calculation is done on every purchase transaction.Thus, the calculation is the same based on the periodic calculation whether by period(periodic) or by transaction (perpetual).

6.1 RETAIL INVENTORY METHOD

This method/technique uses the cost method of accounting. Similar types ofmerchandise are pooled for purposes of estimating an average percentage of cost to retailprice. That percentage is applied to the inventory to estimate cost of inventory. The retailinventory method, also called cost method, can use either the physical inventory of countingmerchandise on hand or the book inventory system (perpetual inventory system).


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Retail inventory accounting systems may be complex as they involve a great deal ofdata. A typical retailer’s rupee control system must provide data on the sales and purchasesmade by that firm during a budget period, the value of beginning and ending inventory,markups and markdowns, and merchandise shortages.

Retailers have different data needs compared to that of manufacturers. Theirassortments are larger. Their costs may not be printed on cartons unless coded, becauseof customer inspection. Their stock shortages may be higher. Their sales are more frequent.Hence, retailers require monthly profit data.

There are two inventory accounting systems which are available to the retailers. (1)The cost accounting system values merchandise at cost plus inbound transportation charges.(2) The retail accounting system values merchandise at current retail prices.

6.2 THE COST METHOD

Under the cost method of accounting, the cost paid by the retailer for each item isrecorded on an accounting sheet and/or is coded on a price tag or merchandise container/ bin. Whenever a physical inventory is undertaken, every item costs is known, the quantityof every item in stock is counted, and total inventory value at cost is calculated by theretailer. One way of coding the merchandise cost is to use a 10-letter equivalency system,such as M = 0, N = 1, 0 = 2, P = 3, Q = 4, R = 5, S = 6, T = 7, U - 8, and V – 9, etc. Anitem coded with STOP has a cost value of Rs.67.23. This technique is useful as an accountingtool and for retailers who allow price bargaining by customers, as it is easy for them tocalculate profit per item.

A retailer can use the cost method because it entails physical inventory (actualmerchandise count) or book inventory (record keeping).

6.3 A PHYSICAL INVENTORY SYSTEM USING THE COST METHOD

Under a physical inventory system, the closing inventory, which is recorded at cost, ismeasured by counting the merchandise in stock at the end of a selling period. Gross profitis computed after valuing the closing inventory. A retailer using the cost method along witha physical inventory system will be able to calculate gross profit only after he counts andvalues the merchandise. As most of the firms do the physical count only once or twice ayear, this physical inventory system imposes limits on planning. In addition, a firm might beunable to compute inventory shortages (due to pilferage and unrecorded breakage) asclosing inventory value is set by adding the costs of all items in stock. It does not computewhat the closing inventory should be.

6.4 A BOOK INVENTORY SYSTEM USING THE COST METHOD

A book or perpetual inventory system keeps a running total of the value of all inventorieson hand at cost at a given period of time. Thus, it avoids the problem of infrequent financial

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analysis. Under this method, end-of-month inventory values can be computed without aphysical inventory, and frequent financial statements can be prepared. In addition, a bookinventory lets the retailer uncover stock shortages by comparing projected inventory valueswith actual inventory values through a physical inventory.

A book inventory is kept by regularly recording purchases and adding them to existinginventory value; sales are subtracted to arrive at the new current inventory value (all atcost).

6.5 THE RETAIL METHOD

Under the retail method of accounting, closing inventory value is determined bycalculating the average relationship between the cost and the retail value of merchandiseavailable for sale at a given period. Even though the retail method overcomes thedisadvantages of the cost method, it still requires detailed records and is considered asmore complex as closing inventory is first valued in retail (rupee value) and then is convertedto compute the gross margin (gross profit).

There are three basic steps to determine closing inventory value by the retail method:

1. Calculating the cost complement.2. Calculating deductions from retail value.3. Converting retail inventory value to cost.

1. Calculating the Cost Complement

The value of beginning inventory, net purchases, additional markups, and transportationcharges are all included in the retail method. Beginning inventory and net purchase amounts(purchases less returns) are recorded at both cost and retail levels. Additional markupsrepresent the extra revenues received when a retailer increases selling prices, either due toinflation or unexpected higher demand. Transportation charges represent the retailer’sshipping costs for the purchased goods.

2. Calculating closing merchandise Retail Value

The closing retail value of inventory must incorporate all deductions from the totalmerchandise available for sale at retail. Besides sales, deductions include markdowns (forspecial sales and end-of-season goods), employee discounts, and stock shortages (due topilferage and unrecorded breakage). Even though sales, markdowns, and employeediscounts can be recorded throughout an accounting period, a physical inventory is requiredto identify the stock shortages. For identifying the stock shortages, the retail book value ofclosing inventory is compared with the actual physical closing inventory at retail. If bookinventory exceeds physical inventory, it implies that a shortage exists. Sometimes, a physicalinventory might reveal a stock overage (excess of physical inventory value over bookvalue). This stock overage may be due to errors committed during a physical inventory or


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during keeping a book inventory. If overages exist, closing retail book value is adjustedupward. Because a retailer has to conduct a physical inventory to identify shortages /overages, and a physical inventory is usually taken only once or twice a year, shortages/overages are often estimated while preparing monthly merchandise budgets.

3. Converting book value of inventory into Cost

Then, the retailer has to convert the adjusted closing retail book value of inventory tocost for calculating the gross profit / gross margin. The closing inventory at cost is equal tothe adjusted closing retail book value multiplied by the cost complement.

6.6 ADVANTAGES OF RETAIL METHOD

Retail method has several advantages compared to other methods. Some of themare as follows.

1. Under this method, as merchandise value is recorded at retail, and there is no necessityfor decoding the costs, valuation errors are reduced while conducting a physical inventory.2. Under this method, a firm becomes more aware of slow-moving items and stock shortages.This is because, the process is simpler and a physical inventory can be completed moreoften.3. The physical inventory method at cost necessitates the conduction of a physical inventoryprior to preparing the profit-and-loss statement. The retail method allows a firm to preparea profit- and-loss statement based on its book inventory. Then, it is possible for the retailerto estimate the stock shortages between physical inventories and study departmental profittrends.4. A complete record of closing book values helps the retailer in determining its insurancecoverage and also while settling the insurance claims. The retail book method gives anestimate of inventory value throughout the year. As physical inventories are usually takenwhen merchandise levels are low, the book value at retail allows the retailers to plan forinsurance coverage during peak time and shows the values of closing merchandise on theother hand. This retail method is accepted in insurance claims.

6.7 LIMITATIONS OF THE RETAIL METHOD

Even though there are many advantages to this method, it is not fully without anylimitations. Some of them are as follows.

1. One of the greatest weaknesses of this method is the bookkeeping burden of recordingdata. Closing book inventory figures can be correctly computed only if the following areaccurately noted: the value of beginning inventory (at cost and at retail), purchases (at costand at retail), shipping charges, markups, markdowns, employee discounts, transfers fromother departments or stores, returns, and sales, etc. Although employees are not requiredto take many physical inventories, closing book value at retail may be inaccurate, unless allthe required data are precisely recorded. With computerization, this potential problemmay be reduced.

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2. Another major limitation of this method is that the cost complement is an average basedon the total cost of merchandise available for sale and total retail value. The closing costvalue only approximates the true inventory value. This may give misinformation if fast-selling items have different markups from slow-selling items or if there are wide variationsamong the markups of different goods.3. One should be familiar with the retail and cost methods of inventory for understandingthe financial merchandise management.

6.8 WEIGHTED AVERAGE COST METHOD:

This method is a perpetual weighted average system where the issue price isrecalculated every time after each receipt taking into consideration both the total quantitiesand total cost while calculating weighted average price. For example, if three batches ofmaterial are received in quantities of 1000 units @ Rs.15, 1,300 units @ Rs.16 and 800units @ Rs.14,

The weighted average price is calculated as follows.

= {(1,000 x 15) + (1,300 x 16) + (800 x 14)}1,000+1,300+800

= {15,000+20,800+11,200} = {47,000} = Rs.15.16 per unit. 3,100 3,100

6.9 FIRST IN FIRST OUT METHOD OF PRICING THE ISSUES (FIFO)

Under this method materials are issued out of stock in the order in which they werefirst received into stock. It is assumed that the first material to come into stores will be thefirst material to be used. CIMA defines FIFO ‘a method of pricing the issue of materialusing the purchase price of the oldest unit in the stock’.

Advantages:

• It is easy to understand and simple to price the issues.• It is a good store keeping practice which ensures that raw material leaves the

stores in a chronological order based on their age.• It is straight forward method which involves less clerical cost than other methods

of pricing.• This method of inventory valuation is acceptable under standard accounting

practice.• It is a consistent and realistic practice in valuation of inventory and finished stock.• The inventory is valued at the most recent market prices and it is near to the

valuation based on replacement cost.


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Disadvantages:

• There is no certainty that materials which have been in stock longest will beused. If they are mixed up with other materials purchased at a later date atdifferent price.

• If the price of the materials purchased fluctuates considerably it involves moreclerical work and there is possibility of errors.

• In a situation of rising prices, production cost is understated.• In the inflationary market there is a tendency to under pricing of material issues

and deflationary market this the tendency to overprice such issues.• Usually more than one price has to be adopted for a single issue of materials.• The makes cost comparison difficult of different jobs when they are charged

with varying prices for the same materials.

This method is more suitable where the size of the raw materials is large andbulky and its price is high and can be easily identified in the stores separately. Thismethod is useful when the frequency of material receipts is less and the market price ofthe material are stable and steady.

6.10 LAST IN FIRST OUT METHOD OF PRICING THE ISSUES (LIFO)

Under this method most recent purchase will be first to be issued. The issues arepriced out at the most recent batch received and continue to be charged until a new receivedis arrived into stock. It is a method of pricing the issue of material using the purchase priceof the latest unit in the stock.

Advantages:

• Stocks issued at more recent price represent the current market value based onthe replacement cost.

• It is simple to understand easy to apply.• Product cost will tend to be more realistic since material cost is charged at more

recent price.• It times of rising prices, the pricing of issues will be at a more recent current

market price.• It minimizes unrealized inventory gains and tends to show the conservative profit

figure by valuation of inventory at value before price rise and provides a hedgeagainst inflation.

Disadvantages:

• Valuation of inventory is not acceptable in preparation of financial accounts.• It is an assumption of a cost flow pattern and is not intended to represent the

true physical flow of materials from the stores.• More than one may have to be adopted for an issue.• It renders cost comp0arison between jobs difficult.

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• It involves more clerical work and sometimes valuation may go wrong.• In times of inflation, valuation of inventory under will not represent the current

market prices.

6.11 DISTINCTION BETWEEN FIFO AND LIFO

FIFO and LIFO are two ways of valuing the inventory. The FIFO (first-in-first-out)method logically assumes old merchandise is sold first, while newer items remain in inventory.The LIFO (last-in-first-out) method assumes new merchandise is sold first, while olderstock remains in inventory. Under the FIFO method, the inventory value matches with thecurrent cost structure or the market price, as the goods in inventory are the ones boughtmost recently, whereas under LIFO method, the current sales value matches with thecurrent cost structure, as the goods sold first are the ones bought most recently. Wheninventory values rise, LIFO offers retailers a tax advantage as it shows lower profits.

The FIFO method presents a more accurate picture of the cost of goods sold and thetrue cost value of ending inventory. The LIFO method indicates a lower profit, leading tothe payment of lower taxes but an understated closing inventory value at cost.

6.12 DISADVANTAGES OF COST-BASED INVENTORY SYSTEMS

* Both the systems under cost-based methods (physical and book systems) have significantdisadvantages. First, they both require that a cost is assigned to each item in stock or sold.Cost-based valuation systems work best for firms with low inventory turnover, limitedassortments, and high average prices, when merchandise costs change.

* Second, neither of the cost-based methods ((physical or book systems) adjusts inventoryvalues to reflect the changes in style, end-of-season markdowns, or sudden surges ofdemand, which may lead to raising prices. Thus, closing inventory value, based onmerchandise cost may not reflect its actual worth.

Despite these problems, retailers who manufacture the products they sell, often keeprecords on cost basis. A department store which is engaged in these operations can use thecost method for those activities and the retail method for other areas.

7. PRICING OF INVENTORY

Price may be defined as – ‘the monetary value assigned by the seller to somethingpurchased, sold or offered for sale, and on transaction by a buyer, as their willingness topay for the benefits of the product and channel service delivers’. Pricing of merchandisehas to accomplish three objectives – market acceptance of the product, market sharemanagement and improved profits.

One of the most crucial areas for retailers is developing a successful pricing strategy.Setting the right price can influence the sales, which in turn determines the total revenueand profit of the retail store. In this context, right price may be defined as – the price that


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the consumer is willing to pay for the product/service. The pricing policy selected by theretail firm will usually be directly related to the level of demand over a period of time andwith the right margins, to the profitability of the firm. For the firm, pricing decisions arevery crucial because without adequate margins, the firm may not survive for long. The firmhas to seek cash flow, profitability and growth in order to have a long life. The differencebetween the cost of the merchandise and the retail price is known as – mark-up. The twofactors which influence the profitability of a retail firm are – the profit margin on the offeringsthat are sold and the cost involved in the selling of merchandise. These two factors directlyinfluence the pricing of the merchandising firm, which in turn influences the profitability ofthe firm. A retail firm has to be very careful while pricing its merchandise because – overpricingwill make it branded as an expensive firm and under pricing will brand it as a firm whosequality is low in the minds of customers. Price of merchandise plays an important role inattracting and retaining customers. Hence, a pricing policy which takes into account thecustomer needs is a best one to adopt. It should also reflect the firm’s mission, merchandisingpolicies and the firm decisions.

7.1 OBJECTIVES OF PRICING POLICY

The firm should establish certain objectives before developing the pricing policy. Theobjectives might be related to –

i) Sales objectives (sales volume objectives, market share objectives etc.ii) Profit objectives (profit maximization, target ROI, net sales etc)iii) Competitive objectives (meeting competitors’ prices, controlling the competitors’ entry,non-price competition, etc)

Profitability of a retailer’s business is influenced by two factors - the profit margin onthe offerings that are sold, and the cost involved in the selling of merchandise. These twofactors directly influence the pricing of the merchandise store, which in turn influences theprofitability of the store.

From consumers’ point of view, price is always considered as a very important featureof his purchase decision. Retailers have to understand everything about the customerswho frequent their shops, their characteristics, the reasons for their shopping, the degreeof consistency between the price perception of consumers and the store’s price philosophyetc.

Understanding of the customer segment is very crucial and essential for the retailersfor evolving their pricing strategy. Pricing strategy contributes to the positioning of the retailoutlet in the market and gives it its image, and provides it with an identity distinct from therest of the competitors in the market.

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7.2 CLASSIFICATION OF CUSTOMERS

A retailer needs to understand the price sensitivity of his target customers. The pricesensitivity of customers is based on various personal, social, or geographical factors andpresents a major challenge for retailers while selling prices. Based on price sensitivity,customers can be divided into various segments such as – i) economy oriented, ii)convenience oriented, iii) image/ status oriented, iv) variety oriented, v) loyalty orientedetc.

i) Economy-conscious consumers will look for low-price merchandise; they shop aroundfor the lowest price available and do not differentiate between various retailers on factorssuch as store image and service, other than price.ii) Convenience Oriented: They do not find the activity of shopping enjoyable. Theyshop when they have to. So, they prefer nearby locations, or minimum effort and time tobe spent in shopping and, therefore, prefer Web shopping or shopping through catalogues.They are willing to pay higher prices or premiums for reduction in the shopping effort andfor such benefits as - the location of the store, time taken to reach the shop, etc.iii) Image Oriented: These customers are not price conscious. They buy prestigiousbrands from value stores that offer high degree of customer service because they areattracted by prestige brands with higher prices and customer services more than the price.So, they differentiate between various stores on the basis of image and the products theystock. They look for prestige value from their shopping.iv) Variety Oriented: These customers look for diversity in the product category theypurchase. So, they tend to prefer retailers who have a wide range and assortment tochoose from. They look for fair prices.v) Loyalty Oriented These customers purchase from familiar stores, where the owneror the retail personnel recognizes them. They prefer recognition and also look for strongrelationships with the establishment or the personnel. They will pay slightly above averageprices or on the contrary look for discounts since they have been loyal to that retailer.Indian customers, generally, look for personalized transactions while buying expensiveproducts such as jewellery. One reason for choosing known retailers is the trust thatcomes with it. Such customers believe that if the retailer is known to them, he will notprovide inferior or spurious products. Moreover, the price charged would also be fair.This aspect of consumer behavior is somewhat peculiar to India because of the huge grayand duplicate goods market. It is not easy for the consumer to find out whether theproduct he is purchasing is authentic or not.

Also, retailers tend to charge different prices for different customers as most goodsare unbranded and the customer cannot compare prices. Even when goods are unbranded,most of them are not widely available for the prices to be compared easily. Products suchas toys, playing cards, plastic ware, etc. are mostly sold below MRP. Another reason whycustomers prefer known retailers is that such retailers are aware of their target customer’stastes and preferences.


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Also, the retailer knows the price band within which that customer would like to buy.Sometimes, the relationship may be with the retail personnel and the customer may changethe firm from which she/he purchases if that particular employee moves to a different shop.This is quite common in the case of personalized services such as hair dressing, where thecustomer is generally more concerned with the personnel than with the firm.

Another thing that a retailer needs to understand is the price elasticity of demand.Price elasticity is a measure of the responsiveness of demand to a change in price. Ifdemand for a product (as percentage change) changes more than its price (as percentagechange), the product is said to be price-elastic. If demand for a product changes (aspercentage change) less than the price change (as percentage change), it is said to beprice-inelastic.

7.3 PRICING PHILOSOPHIES

A retailer patronizing high-end pricing philosophy assumes and believes that pricesmust be set at above-average market levels in order to attract his customers and mayprovide attractive décor, grand atmospherics, distinctive products, super customer service,etc.

In low-end pricing philosophy, a retailer focuses on below-market average pricesdue to many reasons such as - limited capital investment, low operating costs, specialbuys, right controls, etc.

A retailer following medium-pricing philosophy considers price factors as notinfluential in their retail marketing mix in comparison to the relevance of other factors suchas site of the store, operational hours, additional services, variety, etc.

Retailers depend on various alternatives to calculate prices of their products. Whereretailers from the organized sector in developed countries depend on data from NationalRetail Federation books, and Progressive Grocer, a large section of retailers in theunorganized sector in India adopt the average mark-up for their products. Another importantelement in retail price is competition. Retailers have to consider their competitors whiledetermining their pricing strategy.

7.4 PRICING STRATEGY: CONSUMERS-RELATED FACTORS

• Is the price of the item very important to the target consumers? It is important toknow the customers’ desires for different products and whether price is animportant issue in their purchasing decision?

• Is there any established price range that people will pay for the product? Whatis the high and low price that the merchandise will have to fall within for someoneto buy?

• What would be compatible with the retail store’s overall retail marketing mix,which includes merchandise, location, promotion, and services?

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• Will trade-ins be accepted as part of the purchase price on items such asappliances and television sets?

7.5 EXTERNAL FACTORS INFLUENCING THE RETAIL PRICINGSTRATEGY

A retailer’s price is influenced by several factors, apart from factors like costs, desiredprofit margin, etc. Using Porter’s model to analyse these factors for strategic pricing, theycan be broadly segregated into four ‘forces’- customers, suppliers (manufacturers,wholesalers and other suppliers), competitors, and government. These four factors or‘forces’ have to be considered while determining the pricing strategy. In some cases, theirinfluence may be inconsequential, while in others, the retailer may be totally constrained, asin the case of government regulations. The extent of influence may vary from industry toindustry.

7.5.1 Influence of Demand on retail pricing

Law of demand in this context refers to the tendency of the customers to buy productsin a greater quantity when the price is low, and buy less or reduce the consumption of theproduct when the price is high. Hence, a retailer has to study the change in the demand fora product or service at different prices with the help of price elasticity of demand. Theprice elasticity of demand is a measure of the effect of a price change on consumer demandand also gives the relationship between the percentage change in quantity demanded andthe percentage change in price. The elasticity of demand is higher for stock-up items (non-perishable products) than for perishable products. Demand for a product or service issaid to be inelastic when a change in its price has no influence on the demand for theproduct or service. This concept will help the retailer in deciding his pricing policy for hismerchandise.

Elasticity = Percentage change in quantity demanded Percentage change in any demand determinant

7.5.2 Influence of Competition on retail pricing

The retail firm has to monitor the pricing strategies of its competitors very carefullyand make sure that the price it is fixing for its products or services is in line with thatcharged by its competitors. And variation in price should reflect only the quality of theproduct or service, nature of the location etc which differentiate its product or service fromthat of its competitors. The pricing strategy of a retailer also depends to a larger extent onhis competitive position in the market. The stronger the competitive position, the greaterwill be the freedom in deciding the price of the merchandise.


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7.5.3 Influence of Cost on retail pricing

Cost of a product or a service covers the cost of the product or service along with thecost of getting it to the store and preparing it for sale. This becomes the basis for thoseretailers who adopt cost-oriented pricing.

7.5.4 Influence of Product characteristics on retail pricing

Product characteristics such as – perishability (physical perishability / style or fashionperishability / seasonal perishability), durability, quality, availability, seasonal appeal etcalso influences the pricing of a product or a service of a retailer, as they impact the demandfor a product or a service. Retailers have to be alert as to the various product characteristicsand their impact on the customers’ buying process when pricing their products or services.Hence, the retailer has to build in appropriate markups into the initial product or serviceprice to setoff the cost of markdowns whenever required.

7.5.5 Influence of Legal considerations on retail pricing

The pricing decisions / strategies of a retailer are highly influenced by the legal systemof the respective country.

7.6 RELATIONSHIP BETWEEN DEMAND AND TOTAL REVENUE(ELASTICITY AND REVENUE)

As elasticity decreases in the elastic range, revenue increases, but in the inelasticrange, revenue decreases.

When the price elasticity of demand for a product is inelastic (|Ed| < 1), the percentagechange in quantity is smaller than that in price. Hence, when the price is raised, the totalrevenue of producers rises, and vice versa.

When the price elasticity of demand for a product is elastic (|Ed| > 1), the percentagechange in quantity demanded is greater than that in price. Hence, when the price is increased,the total revenue of ther retailer falls, and vice versa.

When the price elasticity of demand for a product is unit elastic (or unitary elastic)(|Ed| = 1), the percentage change in quantity is equal to that in price.

When the price elasticity of demand for a product is perfectly elastic (Ed is undefined),any increase in the price, however small, will cause the demand for the product to drop tozero. Hence, when the price is increased, the total revenue of producers falls to zero. Inthis case, the demand curve is a horizontal straight line.

When the price elasticity of demand for a product is perfectly inelastic (Ed = 0),changes in the price do not affect the quantity demanded. In this case, the demand curve isa vertical straight line; this violates the law of demand.

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Interpretation of elasticity

For all normal products and most inferior products, a decrease in the price results inan increase in the quantity demanded by consumers. The demand for a product isrelatively inelastic when the quantity demanded does not change much with the pricechange. Products and services for which no substitutes exist are generally inelastic.

Inelastic demand is commonly associated with “necessities,” although there are many morereasons why a product or service may have inelastic demand other than the fact thatconsumers may “need” it.

Substitution serves as a much more reliable predictor of elasticity of demand than “necessity.”For example, few substitutes for oil and gasoline exist, and as such, demand for thesegoods is relatively inelastic. However, products with a high elasticity usually have manysubstitutes.

It may be possible that quantity of products demanded increases as its price increases,even under conventional economic assumptions of consumer rationality. Two such classesof goods are known as Giffen goods or Veblen goods. Another case is the price inflationduring an economic bubble. Consumer perception plays an important role in explaining thedemand for products in these categories.

PED is determined by a number of factors that essentially all fall under the umbrella of“choice”. By choice we mean the power of choice that the consumers of a given productholds to give up the consumption of the said product. The greater this choice the moreprice elastic the product will be and, by contrast, as the balance of this power falls infavour of the supplier, the more inelastic the product will be. This is due to the consumer’s“Perceived Value”. A product which is difficult to replace or give up consuming will have ahigher perceived value than that which is more easily replaced thus the consumer will bewilling to pay more for such a product. Perceived Value represents the absolute maximumprice a consumer is willing to pay for a product. When the price exceeds this level, theconsumer will give up consumption of this product.

Availability of Good Quality Substitutes: Easily substitutable products will enable thebuyers to switch to an alternative product and thus such products will exhibit greater elasticitythan products that do not have substitutes available, ceteris paribus (assuming all other


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variables are equal). It is important to understand that a given product is in essence, uniqueand thus the comparability of the available substitute(s) in terms of quality to the originalproduct is an important sub-variable. The better the substitute(s) can replace the originalproduct in terms of desirability, affordability, practicality etc, the more elastic the productwill become.

Whether the product is habit forming or obligatory: Addictive drugs, whetherpsychologically addictive or physically addictive, and other products where dependencyplays a key role will naturally exhibit inelastic properties. At aggregate level, rising costs ofsuch products are unlikely to reduce the demand significantly.

The proportion of the consumer’s income the product represents: Products whichtypically make up a small proportion of people’s income will exhibit inelastic qualities.Conversely, products which form a large proportion of people’s income will cause greaterresponses in demand to comparable % increases or decreases in price.

How closely the product is defined: In general, the exact type of good will affect itsPED properties.

How closely the consumer (end-user) is defined?: This is an important factor intrinsicallyrelated to most of the preceding variables. “Choice” is very subjective and factors 1,2 and3 vary relative to the individual consumer because every single consumer can potentiallyhave a different Perceived Value of a product. A product that is easily replaceable or habitforming or expensive for one person may well not be for another and thus how well theconsumer is defined will affect the PED. A driver faced with rising petrol bills may opt toswitch to using the train. However an airline company has no choice but to absorb risingfuel costs and will according have a much more inelastic demand curve for essentially thesame good.

How closely the time period is defined: Generally the greater the time period, themore possible it may be for a product to be replaced with a substitute. Likewise, pricesare dynamic. Over short time periods, prices of substitutes maybe static, over longer periods,the price of substitutes may drop, making them more appealing. [Puiatti, 18:3610-Nov-07]

A retailer should also consider the cross elasticity of demand for a particular productor service. Cross elasticity of demand signifies that the change in the price of a particularproduct or service may reduce the demand for other products or services (complementaryproducts).

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7.7 THE VARIOUS FACTORS THAT INFLUENCE THE PRICE SENSITIVITYOF A PRODUCT OR A SERVICE ARE –

1. Perceived substitutes effect: The customers may choose a substitute or forgo thepurchase if they believe that the overall value is unacceptable. Higher the product ofservice’s price, higher is the sensitivity of the buyers in relation to another product orservice or substitute they could purchase.

2. Unique value effect: Customers are less sensitive to a product’s price when theyvalue the product or service’s attributes more and differentiate it from competingproducts or services.

3. Importance of purchase effect: The greater the importance of the product or service,(risk of the purchase Vs price) the less price sensitive (more inelastic) the purchase isgoing to be.

4. Difficult comparison effect: When the customers find it difficult to comparecompeting products or services, they tend to select more established brands or storeetc to reduce their perception of risk. Customers are more sensitive to price when itis easy for them to compare competing offerings. A retailer cannot command higherprices on well known brands, which are widely available and customers can easilycompare prices. Retailers try to store unique offerings whose prices cannot becompared and, which, give them the chance to charge higher prices. Many retailershave developed their own private-label merchandise, which means that the brandname identifying the product is owned by the retailer rather than the manufacturer.

5. Expenditure effect: When the expenditure is large, the customers become moreprice sensitive (especially during recession and in case of low income customers)either in absolute money amounts or as a percentage of their income.

6. Fairness effect: The customers may become price sensitive if they feel that the priceof a product or service is falling outside a band which is considered as reasonablyfair.

7. Benefits/Price Effect: This effect defines the relationship between customer’sperception of the product benefits they derive and the price they pay for it. For some‘image’ products, the customers are ready to pay higher prices even if the functionalbenefits are no different from other products. The benefit derived is in terms of ego-gratification and the recognition of the ‘image’ the product brings.

Sometimes, a product may fail even if it is priced lower because customers perceiveit as lacking in quality. They feel that since the product is available at a cheaper price, themanufacturer might have compromised with the quality. Similarly, a high-price label maylead to better sales because customers believe that high price is often associated with highquality.8. Situation Effect: Customers’ sensitivity to price can differ depending on various

other factors. Retailers who wish to portray a ‘high price high quality’ image alsotake advantage of this effect by concentrating on the atmospherics, by creating aplush atmosphere which gives a rich look to the shopping environment. On the otherhand, ‘low price’ retailers maintain a utilitarian environment with sparse decorations.Thus, it is important for retailers to understand how various situations influence theprice sensitivity of the customers.


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7.8 SETTING RETAIL PRICES

To set the retail prices, it is important to understand some of the concepts andcalculations employed for setting prices, and factors such as price elasticity and pricesensitivity, which impact the effectiveness of the pricing strategy.

7.8.1 Concepts and Calculations for Setting Retail Prices

The price that a customer pays for an offering comprises two main components: thecost of the offering or the price that retailers pay to a supplier/manufacturer, and the grossprofit margin, which is, the selling price minus the cost of the product.

The retail selling price

In the retail business, the cost of goods or the cost(s) of acquiring the products includesthe price paid for the product(s), handling, freight charges, and import duties. Operatingexpenses include rent, wages, advertising, utilities, and supplies.

Mark-up is the difference between the price paid for the product and the sellingprice. The mark-up can be established as a percentage of the cost or as a percentage ofthe retail price. A price based on mark-up percentage on cost is determined by adding apercentage of cost to the cost of goods.

Cost of shirt Rs 20.00 x Mark-up 25%= Mark-up amount Rs 05.00Cost of shirt Rs 20.00 + Mark-up amount 5.00-Sellingprice Rs 25.00

Mark-up percentage is expressed as a percentage of cost, that is,(Mark-up amount Cost of goods) x 100

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A more common mark-up strategy in retail is to base the mark-up on the retail price.Divide the cost of the product by the mark-up percentage.

A retailer can decide to use a standard mark-up percentage for all the products orhave different mark-ups for different products. The key is to make sure the average mark-up or gross margin is enough to cover the operating expenses and meet its target profitmargins. When establishing the mark-up for a particular product, the retailer should notetwo points.

• The cost of the products used in calculating the markup consists of the base invoiceprice for the product plus any transportation charges minus any quantity and cashdiscounts given by the seller.

• Retail price, rather than cost, is ordinarily used in calculating percentage markup.This is because, when other operating figures such as wages, advertising, and profitsare expressed as a percentage, all are based on retail price rather than on the cost ofthe product being sold.

Traditionally, price has been determined by adding a bit of profit to the cost of products.However, more often than not, pricing is not as simplistic as that. While fixing the prices ofproducts, some terms which are frequently encountered are – cost of goods sold, netsales, gross margin, percentage gross margin, markups, margins and markdowns.

7.8.2 Cost of Goods Sold

Cost of goods sold (COGS) includes all costs spent to bring the products to a saleablecondition. Only costs that relate to products actually resold are considered. In other words,COGS does not consider costs relating to unsold stock of products. Since COGS takesinto consideration every expense incurred to bring the goods to the point of sale, it includesother expenses besides the invoice cost of products moved out of stock. COGS is thelargest expense incurred by a retailer and the price is generally determined by adding amargin for other expenses plus profit to service and replace the capital. COGS wouldtypically include:

(a) The purchase cost of all the products that have moved out of stock (This movementmay be the result of sales, or theft, breakage and other losses. This purchase cost is theprice charged in the purchase invoice. Trade discounts given in the invoice are consideredand therefore subtracted from the purchase price. However, cash discounts are notconsidered.)(b) Taxes charged in the invoice(c) Expenses incurred to bring the goods to the point of sale such as carriage inwards(freight), traveling expenses incurred by the buyer to purchase the goods, etc.(d) Depreciation on the remaining stock at the end of the period(e) Transfers from other departments or branches


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Therefore, (COGS) can be calculated by the formula:

Opening stock (at cost or market price, whichever is lower)+ Purchases and additions during the year (after including the costs as detailed above)- Closing stock (valued on the same basis as opening stock)

The stock is valued at cost or market price, whichever is lower, because prudence isobserved in accounting for profits. Even if the market price is above the cost, stock isalways valued at cost, thereby ignoring the unearned profit to be realized on sales notbeing considered. If the market price of the stock has fallen below cost, it is assumed thatthe stock would have to be sold at the lower market price, and the potential loss is accountedfor immediately.

The method of valuation for opening and closing stock has to be the same to ensureconsistency.

7.8.3 Net Sales

This is the total sales figures adjusted for goods returned by customers and allowances.Net sales are, therefore, gross sales less returns and allowances.

7.8.4 Gross Margin (or Gross Profit)

It is the difference between net sales and the cost of goods sold. Net sales meanssales adjusted for any goods returned.

7.8.5 Percentage Gross Margin (or Gross Profit Percentage)

This is the gross margin expressed as a percentage of net sales:

(Gross margin^ Net sales) x 100

7.8.6 Mark-ups and Margins

Mark-up is a percentage of the cost. Margin is the same rupee amount as mark-up,but expressed as a percentage of the selling price. For example, if an item costs Rs 20.00,and sells for Rs 25.00, mark-up is Rs 5.00 or 25% of the cost, and margin is Rs 5.00 or20% of the selling price.

Another pricing practice among retailers is to price the products according to theretail price recommended by the manufacturer. Even though this is the easiest way todetermine prices, it might cause trouble if the margin between the cost of products and thesuggested retail price is not enough to cover the retailer’s operating costs. The income ofthe retail business is determined on the basis of the gross profit margins and number ofproducts sold.

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This provides resources to incur expenditure towards the stock purchases, meetingoperating costs, and investing funds for the expansion of the retail business. In order toachieve the goals set, setting of prices by retailers is important. The factors which theretailers are expected to take into account while setting prices of their products include thefollowing.

• Owner’s returns• The portion of rent going for storage space• Maintenance and repairs• The costs of business services (such as accounting and legal services)• Advertising and promotion costs, insurance premiums, interest payments, etc.

7.8.7 Mark-downs

Mark-down refers to a reduction on the normal selling price of a retailer. Sometimes,a particular line of products may not be moving, and to move them, the retailer may reducethe price on such products to make them more attractive to the customers.

Mark-down = (Normal selling price - reduced selling price).

Margins vary from product to product. On products such as furniture, margins tendto be high. These products have low turnover and high margins are required to cover thestocking costs. On the other hand, lower margins are charged on high turnover products,such as convenience goods.

It is an undisputed fact that mark-downs very important to the retailer. There is atendency for a retailer to use mark-downs indiscriminately to clear non-moving stocks.The various uses of mark-downs and factors that ultimately result in a mark-down are asfollows.

Use of Mark-downs

• Correctional mark-downs are used to encourage customers to respond moresatisfactorily to a line. For example, if a new product has been launched, it may besold at a reduced price to induce customers to purchase it. This type of mark-downsmay also be used to correct errors resulting from wrong pricing, buying, or selling.

• Operational mark-downs are used to sell off obsolete, end-of-season goods, orgoods that are damaged, shopworn, and broken. For example, if a lot of crockeryhas been chipped, then it can be sold at a reduced price.

• Promotional mark-downs are used to increase sales by offering the customers theincentive of lower prices.


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Causes of Mark-downs

Mark-downs may result from buying errors such as the following.

• Overbuying caused due to incorrect demand forecasting, or buying more than thecurrent stock requirement.

• Wrong buying: The color, style, sizes, etc. of the products purchased may not be intune with the customer preferences, or the retailer might have bought novelty productsthat failed to click.

• Buying at the wrong moment: Products might have been purchased too early ortoo late, or they are received too late for sale.

• Individualistic or pet buying: A person in charge of purchases may buy someproducts just because he has a liking for them, even though such products may not bepopular.

• Failure to examine incoming stock for defects.

Mark-downs resulting from pricing errors:

• The initial price has been set too high.• Competitors’ prices have not been considered while setting the initial prices.• The initial markdown has been too small.

Mark-downs resulting from selling errors:

• Failure to display the products properly, i.e., in the right location, with properdecoration

• Careless handling of the products resulting in their deterioration.

Mark-downs are not only due to errors, but also because of I uncontrollable causessuch as the following.

• Weather conditions: A warm winter may drastically reduce the sales of sweatersresulting in a huge unsold stock.

• Economic conditions: Sales of expensive products and consumer durables maydecline during an economic recession.

• Display items that have been kept on display for a long time tend to becomediscolored and unattractive.

7.8.8 Methods for Setting Retail Prices

Generally, there are three popular methods for setting the retail prices. They are –i) cost-oriented, ii) competition-oriented, and iii) demand-oriented methods.

i) Cost-based Method: This is the most fundamental method of setting retail prices.Under this method, the retailer adds a standard markup to the cost of products to arrive attheir selling price. This is a fairly simple approach and easy to implement. However, itignores the prices set by competitors and the demand for the product.

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ii) Competition-based Method: This method implies closely matching the prices of thecompeting retailers. This method is very easy to implement, as it does not necessitatepreparation of demand forecasts as in the case of demand-oriented pricing. Also unlikecost-oriented pricing, it does not require cost figures or their analysis.

However, competition-oriented pricing is reactive rather than proactive. A retailermerely follows his competitors and cannot or will not differentiate his pricing from that ofhis peers. Hence, the retailer depends on his competitors for his pricing decisions. Thismethod does not allow a retailer to maximize profits because demand and costs are notconsidered while pricing.

Retailers can price either above, below, or at parity with their competition. A low-cost provider would try to price below his competition while a retailer with high qualityimage, unique merchandise, etc., would price above his competition.

iii) Demand oriented method: This method takes into consideration the factors ofdemand rather than the level of costs when setting price. In times of shortage of products,prices are usually raised to take advantage of higher demand and scarcity of supply.

7.8.9 Retail Pricing Strategies and Practices

Many pricing strategies exist for a retailer to choose from and each strategy is usedbased on particular a set of circumstances. Some of them are as follows.

a) Cost-oriented pricing

Cost oriented pricing is related to the costs a retailer incurs when he is purchasing aproduct or service for selling them to his customers. This method of pricing refers tosetting the prices on the basis of an understanding of costs to the retailer.

b) Cost-plus pricing or Mark-up on cost

Under this method, selling price is achieved by adding a pre-determined profit marginto the cost of the merchandise. The retailer should make sure that the initial mark-up islarge enough to cover anticipated expenses and reductions and still produce a satisfactoryprofit. If he has diverse selection of products, he can use different mark-ups on the productlines with different characteristics. Key stoning is not used as often as it once was.Doubling the cost paid for the products was once the rule of pricing products, but very fewproducts these days allow a retailer to keystone the price.

c) Rate of return pricing

This method is another variation of the cost-oriented method, which provides theretailer with an agreed rate of return on his investment. Where the cost-plus methodconcentrates on the costs associated with the running of the business, the rate of returnmethod concentrates on the profits generated in relation to the capital invested. Both cost-


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plus and rate of return methods of pricing are not appropriate for those retail productswhich have to survive in a highly competitive market place.

d) Demand-oriented Pricing Method

Demand-oriented pricing should ideally be used along with cost-oriented pricing.When these two methods are used in combination, the retailers can not only consider theirprofit structure but also the impact of their price changes on sales. For example, if thecustomers are insensitive to price (the demand is price inelastic), an increase in priceswould result in higher profits, as sales would decrease insignificantly. Similarly, if customersare price sensitive, a decrease in prices would actually result in greater profits, as salesincrease much more to offset the decrease in prices. Demand-oriented pricing, therefore,seeks to maximize profits.

e) Discrimination pricing

Discrimination pricing, which is sometimes called variable or flexible pricing, is popularlyused when products are sold at two or more different prices. This method is often timerelated. Quite often, students, the unwaged, known or loyal customers and older peopleare charged lower prices than other consumer segments at attractions or events. For pricediscrimination to be successful, it is required to be able to identify those segments which,without the price differentials, would not purchase the product(s). To obtain a high flow ofbusiness, a retailer may give discount to those customers who offer significant sales demand,which means that small businesses may benefit from volume discount rates and thoseindividual customers building their own extension, for example, may be offered a specialone-off discount rate. Discrimination may also be based upon increasing the price ofproducts which have higher potential demand.

f) Backward pricing

Backward pricing is a market-based method of pricing which focuses on what theconsumer is willing to pay for. Under this method, in the first step, an acceptable margin isagreed upon, and then costs are closely monitored so that the price, which is deemed to beacceptable, is able to be matched. Whenever necessary, adjustments are made to thequality of the product or service on offer, to meet the cost-led needs of this method. Aretailer, who sells on a price-led basis often insist that his suppliers meet specified costs,even if this compromises some aspects of the quality. This method is somewhat similar toprice lining, which is a method of simplifying the product comparisons for the customers byestablishing a number of lines within price points for each classification. Once the pricelines are determined, the retailers purchase products which fit into each line.

g) Skimming pricing

Skimming method of pricing is used when there is a shortage of supply of the product,or brand has been associated with added value, and therefore, demand will not be dampened

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by charging a premium price. This method of pricing usually is adopted only when there isa healthy potential demand for the product on offer.

h) Market penetration pricing

This method is similar to competitive pricing, but is used when a company or brand isto be established quickly in the market. Prices are usually set below those of the competitionin order to create high initial acceptance for the company’s retail offer. A company sellingfast moving consumer products may use market penetration pricing in the initial years anthen, when the product is established, it may slowly increase the prices.

i) Leader pricing

Some retail products may be priced very competitively in order to sacrifice profit onthose products, but to generate more overall demand for other products. These are oftenknown as ‘loss leaders’, if they are sold below cost, but in reality, retailers rarely make acash loss on these products even though they are heavily discounted. The leader productsare normally sold near to cost rather than at a loss. In other words, Loss leaders aregoods or services offered at steep discounts (generally below cost) in order to attract newcustomers to a store. It is a time-honored practice that has been met with much success,especially by large discount retailers. The purpose behind using this pricing strategy is tonot only have the customer buy the (loss leader) sale item, but other products that are notdiscounted also.

This method is used to – i) move non-moving or overstocked inventory, so that theshelf space is freed, inventory is reduced and will increase the cash flow, ii) creating brandawareness, in case the retailer likes to be known for having low prices, iii) as marketingtool to gain new customers and increase return visits, by giving good bargains.

Success can be achieved by using loss leader pricing, but the retailer must be awareof some obstacles to the process. If done incorrectly, loss leaders can actually cause thebusiness to lose money. Also, not all manufacturers and suppliers will allow their productsto be priced under their minimum advertised price or less than what their other dealers areselling the same product for. It is also limited or forbidden to sell products below cost insome states. In recent years, lawsuits have emerged (not all successful) claiming some lossleader pricing strategies are equivalent to illegal business practices. Apart from this, theretailer should make sure that the lost profit can be countered by the sales of other productsor services.

j) Competitive Markup Method for Pricing

The competitive markup method is used to price the products similar to those of thecompetitors. In effect, the markup is controlled by the competitors and it fluctuates as aconsequence of what the competitors are charging for their products and services. This isa method which requires knowledge of actual costs as matching the prices of a more


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efficient retailer may lead to losses on particular products. It also necessitates anunderstanding of the importance of the competitors’ pricing policies for a consumer’sperspective.

k) Psychological pricing

Psychological pricing, which is sometimes referred as odd pricing, is a strategy whereprice is based on popular price points and what the consumer perceives to be fair. Themost common method is odd pricing using figures that end in 5, 7 and 9. It is believed thatconsumers tend to round down a price of Rs.19.95 to Rs.19, rather than Rs.20. However,there is no conclusive evidence that such pricing policies make any significant difference toprofits.

l) Everyday low price (EDLP)

This EDLP stresses the use of a pricing policy with the continuity of prices at a levelbetween the normal own store price and the price of the deep discount competitors. Theterm ‘low’ refers to a price position which is competitive and therefore, can remain stable.A number of retailer who use EDLP do not believe in markdown policies and sales, butattempt to generate all the year round demand by setting the prices at the right level.

The EDLP is a pricing strategy which is open to large operators who have significanteconomies of scale and buying power. The some of the numerous benefits of EDLP are asfollows.

* EDLP allows retailers to withdraw from sale period pricing wars and to concentrate oncreating a market position that creates a perception of fairness of pricing.* The stable price policy of EDLP eliminates the need for communication of sale or specialprice offers, reduces the spending on advertising.* If the purpose of opting for EDLP is to banish sale periods, then the demand created isless seasonal and volatile, and sales staff is able to spend adequate time in servicing thecustomers, which will improve the customer service management.* EDLP reduces the large variations in demand (as demand is even) and leads to reducedstock outs and improved inventory management.* EDLP may lead to increased profit margins.

EDLP does not suit all retailers. Some retailers might find it difficult to maintain lowprices for a long period of time due to lack of economies of scale in buying or due to thecompetitive nature of their business. Retailers selling products which have strong fashioncontent are more likely to want to set initial prices at a high level as this is good businesspractice.

m) Suggested retail price

Suggested retail price is a common strategy used by smaller retail shops to avoidprice wars and still maintain a stable level of profit. Some suppliers have minimum advertised

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prices, but also suggest the retail pricing. By pricing products with the suggested retailprices supplied by the manufacturer, the retailer is out of the decision-making process.

One problem with using pre-set prices is that it doesn’t give an advantage over thecompetition. Another way would be to price the products just like the competitors. But theretailer should ensure that he is comparing prices with other retailers comparable in sizeand sales volume.

n) Competitive pricing below competition

Competitive pricing below competition simply means beating the competitor’s price.This strategy works well if the retailer follows an inventory plan, buys at the best prices anddesigns a marketing plan to concentrate on price specials.

o) Competitive pricing above competition

Competitive pricing above competition should only be considered when location,exclusivity or special service considerations can justify higher prices. For example, a retailermay stock merchandise of well-known brand names that are not available at any otherlocation. This would allow the retailer to price above his competitors.

p) Multiple pricing

Multiple pricing is a method which involves selling a number of units for one price,such as three for Rs.10.00. Retailers find this an attractive pricing strategy for encouraginglarger commitments. It is also a desirable strategy for clearance sales.

q) Discount pricing

Discount pricing and price reductions are integral parts of retailing. Discounting caninclude coupons, rebates, buying clubs, markdowns or seasonal prices. The decision ofwhen and what type of discounting will vary greatly with the type of merchandise, theamount of competition and the stock on hand.

As the best pricing model is being developed by the retailer for his business, he has tounderstand that the optimal pricing strategy will depend on more than his costs. It is difficultto say which component of pricing is more important than another. It should be kept inmind that the right product price is the price the consumer is willing to pay.

8. ABC ANALYSIS

In inventory or stock management, it’s a method of stock control. Its basic assumptionis that not all stock is equally valuable, therefore doesn’t need the same kind of attention.


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The various assumptions of ABC analysis are as follows-

1. That there is a known, constant stock holding cost2. That there is a known, constant ordering cost3. That the rates of demand are known and constant4. That there is a known constant price per unit, i.e, there are no price discounts5. That replenishments are made instantaneously i.e, the whole batch is delivered at

once.

Hence, all the stock is categorized according to its cost and quantity - and a graph iscreated with cost shown on Y axis and quantity shown on X. From left to right, stock isplaced from highest value to lowest. Typically, it can be seen that a small portion of stockis the most valuable, and therefore needs maximum attention and resources - that’s called‘A’. The next most valuable section of stock is B, the next is C and so on.

Basically it shows which stocks need more attention and which need less. It helps inutilizing resources for stock management more effectively.

In this technique, the items of inventory are classified according to their value ofusage. The higher value items have lower safety stocks, because the cost of production isvery high in respect of higher value items. The lower value items carry higher safety stocks.ABC analysis divides the total inventory into three classes – A, B and C.

Items in A class constitute the most important class of inventories so far as theproportion in the total value of the inventory. The ‘A’ items consist of approximately 15%of the total items and account for 80% of the total material usage. This class is made up ofinventory items which are either very expensive or used in massive quantities. Under anABC regime for minimum stock value A should be managed by JIT since its value makesthis close management cost-effective

The ‘B’ items constitute an intermediate position, which constitute approximately35% of the total items and account for approximately 15% of the total material consumption.This class is made up of inventory items which are not so few in number, but also they arenot too many either. Value wise also, they are neither very expensive, nor very cheap.Moreover, they are used in moderate quantities. Under an ABC regime for minimumstock value B should be managed by Kanban pulling- the micromanagement by JIT is notcost effective for this project but it should still be tracked methodically.

Items in ‘C’ class are quite negligible. It consists of the remaining 50% items andaccount for only 5% of the monetary value of total material usage. Class C items containa relatively large number of items which are either inexpensive items or used in very smallquantities so that they do not constitute more than a negligible fraction of the total value ofinventories. Under an ABC regime for minimum stock value C should be managed by 2bins- whereby two huge bins of (eg screws) item are kept and one is used at a time- whenone runs out another is ordered and the next bin is used. The low value does not justify

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management- and any downtime because of running out would cost much more than theproduct itself. The control of inventory through ABC analysis is exercised as follows.

• ‘A’ class items merit a tightly controlled inventory system with constant attentionby the purchase and stores management. A larger effort per item on only a fewitems will cost only moderately, but the effort can result in large savings. Theinventory policy (re-order quantity and re-order point) should be carefullydetermined and the close control over the usage of materials is desirable.

• ‘B’ class items merit a formalized inventory system and periodic attention by thepurchase and stores management. The economic order quantities and re-orderlevel calculations can be done and larger stocks can be maintained. The reviewof these items may be done quarterly or half-yearly.

• ‘C’ class items still relaxed inventory procedures are used. For these items,generally, one year supply can be maintained. Periodic review once a year maybe sufficient.

The numbers are just indicative and actual break up will vary from situation to situation.

This technique tries to analyze the distribution of any characteristics by stock valuesof importance in order to determine its priority.

ABC analysis helps a retailer to decide the items that should never be out of stock,items that can go out of stock occasionally and the items that should be eliminated from thestock. This is done by ranking the merchandise on the basis of some performanceparameters. This not only provides information about relevance of merchandise to theretail store, but also helps in the placement of merchandise or shelf space, budgeting, andrevising the merchandise mix. It depends on the retailer or planner to select the unit ofmeasurement such as a department of SKU (stock keeping unit).

ABC analysis uses Pareto Principle of 80-20 (principle of “Vital few and trivialmany” based on the capital investment of the item.), where approximately 80% of thestore’s sales of profits are derived from 20% of the products. A retailer has to decide onthe measurement criteria – which might vary from contribution margin, sales in terms ofmoney, sales in units, gross margin and gross margin return on investment, before rankingeach SKU, category, or department.


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The usage of measurement criterion might be influenced by various factors such as –unit of measurement. For example, the sales figures of a Jewellery shop cannot be comparedwith the sales figures of a grocery store. Hence, the best measurement criterion to measurethe performance of merchandise (SKU) is contribution margin, where,

Contribution margin = Net sales – Cost of goods sold – Other variable expenses.

After ranking the entire merchandise mix either on the basis of contribution margin ofsales volume, the retailer should plan for the respective category (A/B/C) of his merchandise.For example, the sales volume of various brands of shampoo and their respective SKUs,following the Pareto’s Principle, might be grouped as follows.

Category’ A’ may comprise of those 5% of shampoo SKUs which contribute toabout 70% of sales. These SKUs should never be out of stock. This category representsthe most significant amount of investment in inventory.

Category ‘B’ may represent 10% of shampoo SKUs and an additional 20% of sales.This category comprises of shampoos of secondary importance or demand. Occasionally,these items will run out of stock because of limited investment made towards managingbackup stock.

Category ‘C’ may represent the balance 85% of SKUs, but contribute only 10% ofsales. This category consists of those shampoo SKUs which hold meager value in relationto the total value of inventory investment.

8.1 PROCEDURE SUGGESTED FOR DEVELOPING AN ABC ANALYSIS:

1.List each item carried in inventory by number or some other designation.2.Determine the annual volume of usage and rupee value of each item.3.Multiply each item’s annual volume of usage by its rupee value.4.Compute each item’s percentage of the total inventory in terms of annual usage inrupees.5.Select the top 10% of all items which have the highest rupee percentages and classifythem as ‘A’ items.6.Select the next 20% of all items with the next highest rupee percentages and designatethem as ‘B’ items.7.The next 70% of all items with the lowest rupee percentages are ‘C’ items.

In essence, the various steps in ABC analysis include the following.

1. Rank the SKUs using one or more parameters. The most significant parameterbeing Contribution margin. As measuring different performance parameters providesdifferent types of information, a retailer has to use multiple performance measurewhile conducting an ABC analysis, which may be – sales volume, sales units, grossmargins or GMROI.

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2. Measure sales or gross margin per square foot. This helps the retailer to estimatethe profitability. This directly helps the retailer in shelf spacing the various brands/ models / products.

3. Develop criteria to sort items into the three categories – A,B and C, based on theirprofit levels of sales volumes. Sometimes, a forth category ‘D’ also might befound, which represents those SKUs which do not contribute to any sales. Iffound, the retailer has to get rid of such D category merchandise as quickly aspossible, either by marking it down, or by giving it away. Otherwise, it distractsthe consumers’ attention form the main inventory and may indeed clutter the storespace.

9. VED ANALYSIS

VED analysis is another technique of inventory control, where the inventory is dividedinto three categories – V (vital), E (essential) and D (desirable), based on their importanceor demand or criticality. This analysis is highly useful to a retailer in planning his merchandiseand shelf spacing. The three categories of merchandise according to this technique can bedescribed as follows.

‘V’ stands for vital– SKUs or departments. The stock analysis of these SKUs requiresmore attention because out of stock situation in these SKUs might lead to customer attrition,customer shift and ultimately might result in loss of consumers. Thus, ‘V’ SKUs must bestored adequately to ensure smooth running of the business.

‘E’ stands for essential SKUs or departments. These SKUs are essential for runningthe business, but without these SKUS, the business won’t incur huge losses. Care must betaken to see that these SKUs are adequately stocked.

‘D’ stands for desirable SKUs or departments, which do not affect the goodwill ofthe retailer in the immediate future, but non availability of these SKUs, might result ineroding the goodwill in the long run.

VED Analysis can be defined as the analysis of maintenance spares in to

V Items – Items of vital importance,

E Items – Items of essential importance,

D Items – Items of desirable importance.

• Vital importance in the way of indicating the fact that m/c can’t run without ‘V’Item.

• Essential importance in the sense impart that m/c can run but without parametersas such efficiency, noise reduction etc.

• Desirable importance in the way denotes m/c can run but factor of safety, industrialformalities can’t be satisfied.


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While in ABC, classification inventories are classified on the basis of their consumptionvalue and in HML analysis the unit value is the basis, criticality of inventories is the basis forvital, essential and desirable categorization.

The VED analysis is done to determine the criticality of an item and its effect onproduction and other services. It is specially used for classification of spare parts. If a partis vital it is given ‘V’ classification, if it is essential, then it is given ‘E’ classification and if itis not so essential, the part is given ‘D’ classification. For ‘V’ items, a large stock of inVEDAnalysis means - Vital, Essential and Desirable analysis. It is the Analysis for monitoringand control of stores and spares inventory by classifying them into 3 categories viz., Vital,Essential and Desirable. The mechanics of VED analysis are similar to those of ABCAnalysis.

10. SUMMARY

* The development and implementation of a merchandise plan is one of the most importantphases in any retail strategy, because, the primary objective of any retail business is toensure the sale of its merchandise.

* ‘Merchandise Management’ may be defined as ‘planning and implementation of theacquisition, handling and monitoring of merchandise categories for an identified retailorganization’. This implies that forward planning of merchandise is required, as merchandisehas to be acquired for future purchase opportunities which should reflect the changingconsumption tastes and demand. Thus, it can be opined that the efficient acquisition ofmerchandise as well as its proper handling ensures the sale of merchandise.

* Merchandise management involves balancing the financial requirements of the companywith a strategy for merchandising purchase. The main function of retailing is to sellmerchandise. The strategy involved in this is the decision regarding the balance betweenmerchandise mix and quantity to be purchased. Merchandise management is the processby which a retailer attempts to offer the right quantity of the right product at the right placeand time while meeting the retail firm’s financial goals. In other words, Merchandisemanagement is the analysis, planning, procurement, handling and control of the merchandiseinvestments of a retail operation.

* Components of merchandise management are – analysis, planning, acquisition, handlingand control.

* The various phases in developing a merchandise plan are – marketing considerations,merchandise strategy options, type of customer base, financial considerations andmerchandise assortment search.

* Merchandise budget is a financial tool for planning and controlling the retailer’s investmentin merchandise inventory. It is also referred to as the financial plan that indicates how muchto invest in product inventories, usually stated in rupees per month. Earmarking of

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merchandising budget is considered to be a vital component of the planning phase. Thisbudget states the amount allocated for each product, based on the pre-set profitability orother performance measures.

* Budget planning starts with the development of a sales plan, which shows the expectedor projected rupees volume of sales for each merchandise or department. Sales forecastinghelps the retailer in forecasting the purchase requirement for his merchandise. In India,most of the retail shops in the unorganized sector prepare a sales forecast, irrespective ofproduct category they are in, on the basis of the past experiences, intuition, trends inrelated products / services’ markets, information from the suppliers or co-retailers andcustomers.

* Usually product categories experience an expected sales pattern, based on the respectivestage in their life cycle. This cycle varies form one product category to another. Hence,while preparing the budget or forecast, a retailer should be aware of many importantfactors like - the consumer segment for the offer, expected drivers of variety, nature ofcompetition, promotion and price range. Here, the classification of various merchandiseitems into various types such as – staple, fad, fashion or seasonal merchandise is veryhelpful. The various product lifecycle related strategies the retailer should be aware of.This awareness helps a retailer in examining the sales pattern variations among fad, fashion,staple, and seasonal merchandise.

* The various life cycle stages of products are – introduction stage, growth stage, maturitystage and declining stage. The understanding of category lifecycle stage helps in predictingsales. It is an accepted fact that the lifecycle stage a particular product category enjoyswill indicate the sales expected in future.

* Forecasts are nothing but projections of expected retail sales for the periods underconsideration. They form the base for merchandise plans and include – overall companyprojections, product category projections, item-by-item projections, and store-by-storeprojections.

* The most common types of retailers include – Department stores, Discount / massmerchandisers, Specialty stores, factory outlets etc.

* Some of the different types of merchandise usually found in retail outlets are – (i) Staplemerchandise (ii) Assortment merchandise (iii) Fashion merchandise (iv) SeasonalMerchandise (v) Fad merchandise etc.

* Staple merchandise refers to the regular products carried by a retailer such as – milk,bread, jam, etc, which depends on the type of retail outlet. Assortment Merchandiserefers to apparel, furniture and all other products for which the retailer usually carries avariety in order to give his customers a proper selection. Fashion Merchandise refers tothose products that may have cyclical sales due to variations in changing tastes and lifestyles.


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Seasonal Merchandise refers to those products that sell well over nonconsecutive timeperiods, such as – air conditioners sale and service. In case of Fad Merchandise, highestsales take place for a short time. The major examples for this category of merchandiseinclude specific toys such as – Barbie, power rangers etc, whose demand (sales) goes upwhenever a related program comes in the TV.

* There are several factors to consider in devising merchandise plans, some of whichinclude – the innovativeness, the assortment, the brands, the timing, the allocation, theforecasts etc of the plan.

* The four important components of the merchandise budget are – projected sales, inventoryplan, estimated reductions and estimated purchases.

* Budget planning starts with the preparation of a sales plan, which gives the expected /projected rupee value of sales volume for each merchandise and department. Forecastingof sales requires an understanding of the product / service they are trading in.

* Usually product categories experience an expected sales pattern (Product life cycle),where sales start at low, then increase gradually, stabilize, and finally decline. This patternmight vary from product to product. While forecasting his sales, a retailer should be awareof the consumer segment, expected drivers of variety, nature of competition, promotion,price range etc, and has to categorise merchandise as a fashion, a fad, a staple, or seasonalmerchandise. Apart from this, the retailer has to understand the life cycle stage of theproduct(s) / service(s) he is dealing with. This is because, the product category life cyclestage affects the retail marketing mix such as target market, variety, place, price, andadvertising.

* Inventory management plan provides information to the retailer regarding his sales velocity,availability of inventory, ordered quantity, inventory turnover, sales forecast, and quantityto order for specific SKU (stock keeping unit). This inventory plan helps the retailer inscheduling his orders to vendors after considering the trade off between carrying cost andthe cost of ordering and handling the inventory. The more they purchase at one time, thehigher the carrying costs, but the lower the buying and handling costs.

* Retail reduction is the anticipated sales below the list price. Retail reductions may beclassified into three types - markdowns, discounts, and shortages. A markdown is definedas reduction in the original list price to encourage the sales of the product. Discounts arereductions in the original retail price given to special customer groups, such as loyal customersto encourage increased shop patronage and as an appreciation of their loyalty. Shortagesare reductions in the total value of inventory that results from damages to merchandise,shoplifting, or pilferage. The retailers on the bases of their past experience on retail reductionsmake adequate arrangements while evolving merchandise budgets.

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* The retailer is expected to prepare an actual budget for planned purchases, which referto regular purchases that must be made at the beginning of each month. Here a retailer orplanner uses the information compiled at the initial stages of merchandise budget planning.

Planned purchases may be calculated by using the following format.

Planned monthly sales + Planned monthly reductions + Desired end-of-the-month stock = Total stock needs for the month - Planned BOM stock = Planned monthly purchases

* A retailer in the process of budgeting his performance outlines his expenses for a givenperiod of time. He links the costs to goals specific to his target market, employees and themanagement. By preparing his budget, he derives many benefits.

* While setting his budget, a retailer has to be aware that it might not be accurate and hasto provide for flexibility and has to revise it from time to time whenever a change in thebudget variables happens. Before finalizing the budget, he has to take certain decisionssuch as – specifying the budgeting authority, specifying the time frame of the budget,specifying whether his budget is an annual budget, semi-annual budget, quarterly budget,monthly budget, weekly budget or daily budget, determine the frequency of budgeting,establish the cost categories, set the level of detail and ensure budget flexibility.

* After making the preliminary budgeting decisions, the retailer starts his on going processof budgeting, which usually takes certain steps, which makes the budget(s) a successfulone.

* Forecasts are projections of expected sales / demand for given periods for specifiedproducts / services. They are the foundations of merchandise plans and include projectionsof various components such as – overall company projections, product category projections,item-by-item projections, and store-by-store projections.

* Retailers are facing several challenges when they are preparing their demand forecastssuch as – i) Scale of the problem (large number of stores and items to forecast); ii)Intermittent demand (slow and erratic sales for many items at the store level); iii) Assortmentinstability (frequent new-item introductions and seasonal assortment changes); iv) Pricingand promotional activity; v) Stock outs; vi) Large Inventory levels; vii) Huge variety oflead times etc.

* Store-level stock outs, which are the bane of any retailer’s planning, have many possiblecauses. A poor forecast of demand (resulting in the item selling out) is one possibility, butthere are others, such as - Poor replenishment policy (failure to account for demandvariability, supply variability, forecast error, etc. in making inventory plans); Poor


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replenishment practice (failure to properly execute inventory plans); Shrinkage (loss ofsellable inventory due to theft, damage or misplacement) etc.

* A good replenishment policy takes into account the uncertainties of supply and demand,and makes store-level inventory less dependent on a highly accurate forecast. Accurateforecasting at the store/item level is inherently difficult due to the amount of volatility andrandomness in demand at this level of granularity. Sporadic or intermittent demand canalso be a major problem. Pooling demand across stores and generating forecasts at aregion or warehouse level can help solve this problem.

* To ensure reliability in forecasting, a retailer may have to consider each productindependently or cluster similar products into groups and follow a routine which goes like- analyze their past sales history; look at any seasonal variations they had; consider theirpotential minimum re order quantities and determine if they would give an excessive stockcommitment; determine if there have been any extraordinary usages such as a specialorder item for one customer etc; and determine how many customers are now purchasingthe product (and any new customers who have the potential to adversely effect the item)

* The objective of any business is to ensure that the right product is there in the right placeat the right time – and in the appropriate quantity. Large-scale automated forecastingsoftware which is available in the market today can make this happen. This automationminimizes the staffing requirements of the retailer, while permitting the forecasters to focuson the “high value” forecasts that have the greatest impact on customer satisfaction andfinancial performance.

* When a retailer is estimating / forecasting his future period sales, it is always better tobase them on monthly schedule of income and expenditure account as it gives a morerealistic information. A retailer can prepare three cash flow projections, where thepercentage of sales or other figures are varied slightly, to arrive at three different scenarios:pessimistic, optimistic, and realistic. The pessimistic view should be the “worst case”situation, when he should plan to have enough capital and patience to get through thatscenario. If it turns out that the actual results are better than that then he can relax.

* Forecasting of a future sales figure is very difficult when a firm doesn’t have any previoussales history to guide it. In such scenario, there are many ways of estimating the salesrevenues for the purpose of forecasting the sales. If a firm is forecasting its sales as a partof making the financing decision, it has to do multiple estimates so as to have more confidencein the sales forecasts.

* Instead of forecasting annual sales as a single figure, a retailer should use one or two ofthe sales forecasting methods mentioned above and generate three figures: pessimistic,optimistic, and realistic. Then he can put the figures in by month, depending on his business,there could be huge variations by month.

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* In his expenses, the retailer also has to provide for an allowance for bad debts. If he isnot going for bank financing, he may have to answer questions such as, did he make anallowance for a reserve cash account, for his slower months, but also in case he has toquickly replace a vehicle or equipment.

* The retailer has to prepare a realistic plan incorporating how specifically he wants togrow his business— selling more to existing customers, selling existing products to newcustomers, selling new products to existing customers, and selling new products in orderto attract new customers.

* To evaluate inventory purchasing plans, analyze sales figures, add on markup and applymarkdown pricing to plan stocks, etc, generally some equations are used by store owners,managers, retail buyers and other retailing employees, in various ways. Even though manycomputer programs are available along with other tools for evaluating inventory purchasingplans, analyzing sales figures etc, these calculations often require familiarity with formulas.

* Apart from ratios and methods, a retailer with some past experience in the samemerchandise line for which a store is planned can make a reasonably accurate estimate ofsales volume if the following information is available. Profiles of individuals, who are mostlikely to frequent the stores, can be collected through interviewing the pedestrians. Anapproximate number of such individuals passing the site during the store’s working hours,may be derived from traffic counts. An approximate proportion of passers-by who mightenter the store may be collected from pedestrian interviews. An approximate proportionof those individuals who are entering the shop, who will become purchasers, may becollected from pedestrian interviews. An approximate amount of average transaction,which may be calculated from past experience, trade associations, and trade publications

* Knowledge of the volume and character of passing traffic is a very essential parameterfor the selection of a retail location. Flow of traffic along with several factors such asparking facilities, operating costs, location of competitors, etc. are important determinantsof a retail store’s success. To evaluate the traffic available to competitors, traffic counts atcompetitor’s sites may also be conducted. Information from a traffic count will show howmany people pass by, but generally indicate what kinds of people they are. Analysis of theprofiles of the passing traffic often reveals patterns and variations which are not visiblyobvious from casual observations.

* For counting of traffic purposes, the passing traffic is divided into different classificationsaccording to the profiles of the customers who may frequent the store. This may vary fromproduct to product and store to store.

* To determine what proportion of the passing traffic represents potential shoppers, someof the pedestrians may be interviewed about the origin of their trip, their destination, andthe stores in which they plan to shop


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* For any retailer, his store image will guide the number of lines to carry, the price andquality range of merchandise within these lines, the lines that will be considered major lines,the complementary line or minor lines that should be carried, and so on. Space limitationand lack of funds for the investment in the inventories may be the major limitations to anexpanded product offering.

* The merchandise plans a retailer has finalized as above can be implemented (usually) ineight sequential steps, which are – i) gathering information ii) selecting and interacting withmerchandise sources iii) evaluation iv) negotiation v) conclusion of purchases vi) receivingand stocking merchandise vii) reordering viii) re-evaluation.

* After setting or finalizing the overall merchandising plan, the retailer has to collect moreinformation about his target market needs and prospective suppliers, before buying or re-buying the required merchandise. The most valuable source of information is his consumer.Other information sources which can be used when direct consumer data are insufficientinclude - Suppliers (manufacturers and wholesalers) who usually do their own salesforecasts and marketing research (such as test marketing etc By using observation technique,retail sales and display personnel, who interact with consumers directly, can pass theirobservations to the management. Outside of customers, sales people are in a position toprovide useful information for merchandising decisions of a retailer. Competitors representanother information source for a retailer. In addition to all this, certain reliable and authenticpublications such as - trade publications, Government data, report on trends in eachaspect of retailing etc might prove to be yet another way of gathering data from competitors.In addition, government sources also indicate unemployment, inflation and product safetydata. Independent news sources conduct their own consumer polls and do investigativereporting and commercial data can be purchased to learn about the attributes of specificsuppliers and their merchandising plans.

* The next step of the retailer is to select sources of merchandise and to interact with them.There are three major options available to him, which include - (1) Company owned (2)Outside, regularly used supplier and (3) Outside, new supplier.

* A retailer has to be very cautious while selecting his supplier. There are various issueswhich have to be clearly outlined before any agreement if formally made between theretailer and the supplier. Some of the check points for choosing a vendor are – reliability,price-quality, and order processing time, exclusive rights, functions provided, information,ethics, guarantee, credit, long term relationships, reorders, markup, innovativeness, localadvertising, investment and risk.

* Whatever information source is chosen, the retailer has to develop a procedure to evaluatethe merchandise under consideration. He can follow three procedures, which are –inspection, sampling and description.

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* After evaluating the merchandise, a retailer negotiates his purchase. Usually, whenever anew or special order results in a negotiated contract, the retailer and the supplier carefullydiscusses all aspects of that purchase. A regular order or re-order of an invoice involves auniform contract, as the terms are standardized and the order is handled routinely.

* Majority of the medium sized and large retailers are using computers to complete andprocess orders (based on electronic data interchange [EDI] and quick response [QR]inventory planning), where every purchase data is fed into a computer data bank (database). Mostly, the smaller retailers write up and process their orders manually, and purchaseamounts are added to their inventory in the same way

* The task of receiving and stocking of merchandise involves receiving and storing, checkingand paying invoices, price and inventory marking, setting up of displays, figuring on-floorassortments, completing the transactions, arranging delivery or pickup, processing the returnsand damaged goods if any, monitoring of pilferage, and controlling of the merchandise.

* One technology which is emerging and may greatly advance the merchandise trackingand handling process for retailers involves RFID (radio frequency identification) systems.RFID “is a method of remotely storing and retrieving data using devices called RFID tagsor transponders. An RFID tag is a small object, such as an adhesive sticker, that can beattached to or incorporated into a product or its shipping package. RFID tags contain tinyantennas to enable them to receive and respond to radio frequency queries from an RFIDtransceiver.” At present, RFID utilization is very limited.

* The prices and inventory information are marked on the merchandise. Usuallysupermarkets estimate that the price marking on individual merchandise costs them anamount equal to their annual profits. Marking can be done in many ways. Small firms mayhand-post and manually keep inventory records; some other retailers may use their owncomputer generated price tags and may rely on pre-printed UPC data on packages tokeep records; some other retailers may buy tags, with computer-and-human-readableprice and inventory data, from outside suppliers. Still other retailers may expect vendorsto provide source tagging.

* Regarding the merchandise display, stone displays and on-floor quantities and assortmentsdepend on the retailer and products involved and may differ from retailer to retailer.Supermarkets usually have the old system of bin and rack displays which may place mostof its inventory on the sales floor. Many of the traditional department stores sport all kindsof interior displays and place a lot of inventory in the back room and off the sales floor.

* The task of merchandise handling is not treated as complete till the customer buys andreceives it from a retailer, which may involve the steps of order taking, credit or cashtransactions, packaging, and delivery or pickup. Automation has improved the performanceof the retailer in many cases, and in each of the above mentioned areas.


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* The retailer has to draft a procedure for processing the customer returns and damagedgoods. The retailer has to determine the party (supplier of retailer) responsible for customerreturns and has to decide the situations under which damaged goods would be acceptedfor refund or exchange.

* Merchandise control involves assessing the sales, profits, turnover, inventory shortages,seasonality and costs for each product category and item carried by the retailer. Controlis usually achieved by preparing computerized inventory data and also by doing physicalinventories. A physical inventory must be adjusted to reflect the value of damaged goods,pilferage, customer returns and other factors.

* In reordering merchandise, there are four factors which are very critical for the retailer topurchase more than once - order and delivery time, inventory turnover, financial outlaysand inventory versus ordering costs.

* The retailer has to regularly re-evaluate his merchandising plan, with the managementreviewing the buying organization and its implementation. The overall procedure, alongwith the handling of individual goods and services is to be closely monitored.

* The word ‘Logistics’ implies the total process of planning, implementing, and coordinatingthe physical movement of merchandise from manufacturer (wholesaler) to retailer, tocustomer in the most timely, effective, and cost efficient manner that is possible. Retaillogistics regards order processing and fulfillment, transportation, warehousing, customerservice and inventory management as interdependent functions in the firm’s value deliverychain. If a logistics system works well, firms reduce their stock out situations, hold downtheir inventories, and improve their customer service.

* In any working partnership between a supplier and a retailer, it is very important todefine both their expectations very clearly, which may be related to - Product quality,shipping windows, production and product availability etc. The role of international logisticstakes on significant importance in producing higher levels of productivity, in improving theproduct flow to the selling floor, in reducing the inventories and in reducing the overall costfor both the retailer and supplier.

* The term ‘supply chain’ refers to the logistics aspect of a value delivery chain. It comprisesof all the parties that participate in the retail logistics process: manufacturers, wholesalers,third-party specialists (shippers, order-fulfillment houses, and so forth), and the retailer.One technique for larger retailers is collaborative planning, forecasting andreplenishment (CPER) – which is a holistic approach to the study and application ofsupply chain management among a network of trading partners. Also, now a days, third-party logistics (outsourcing) is becoming popular.

* The next task for the retailer to perform is - to optimize his order processing and fulfillment,where many firms today are engaging in quick response (QR) inventory planning, by

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which a retailer reduces the amount of inventory he holds by ordering more frequently andin lower quantity

* The many benefits of a QR system to a retailer include – it reduces his inventory costs,minimizes the space required for storage, and lets the firm match orders with marketconditions in a better way – by replenishing the stock more quickly. For a manufacturer, aQR system may also improve his inventory turnover and better match supply and demandby giving the vendor the data to track the actual sales. In addition, an effective QR systemreduces the risk of supplier switching by a retailer.

* A QR system works best in combination with floor-ready merchandise, lower minimumorder sizes, properly formatted store fixtures and electronic data interchange (EDI). Floor-ready merchandise refers to those items that are received at the store in condition to beput directly on display without any preparation by retailer.

* Electronic data interchange, EDI lets retailers do their QR inventory planning efficiently– via a paperless, computer-to-computer relationship between retailers and vendors.Research suggests that retail prices could be reduced by an average of 10 percent with theindustry wide usage of QR and EDI.

* A number of firms in the food sector of retailing are striving to use efficient consumerresponse (ECR) planning, which permits the supermarkets to incorporate the variousfeatures of QR inventory planning, EDI and logistics planning.

* Today, retailers are also addressing two other aspects of order processing and fulfillment,which are - (1) With advanced ship notices, retailers that utilize QR and EDI receive analert when bills of lading are sent electronically as soon as a shipment leaves the vendor;(2) As more retailers are buying merchandise from multiple suppliers, from multi locationsources, and from overseas, they must better coordinate order placement and fulfillment.

* The retailer may have to take several transportation decisions, which are very essentialfor the firm, which are - How often is the merchandise shipped to the retailer? How tohandle the small order quantities? Which shipper is to be used (the manufacturer, theretailer, or a third-party specialist)? What transportation form is to be used? What specialconditions are to be considered for perishables and expensive merchandise? How oftenspecial shipping arrangements such as are rush orders are necessary? How are shippingterms negotiated with suppliers? What delivery options will be available for the retailer’scustomers?

* The effectiveness of transportation is influenced by the quality of the logistics infrastructure(including access to refrigerated trucks, airports, and waterway docking and superhighways), traffic congestion, parking, and other factors.


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* In relation to warehousing, some retailers may focus on warehouses as central or regionaldistribution centers. Products are shipped from suppliers to their warehouses and thenallotted and shipped to individual outlets.

* As part of its logistics efforts, a retailer uses inventory management to acquire andmaintain a proper merchandise assortment while ordering; shipping, handling, storing,displaying, and selling costs are kept in check.

* First, he must know how much inventory (safety stock) to have on hand to ensurecontinuity of supply in the event of an uncharacteristic increase in either demand and/orlead time. Second, he must know when to reorder materials for inventory, which can becalculated by using a formula. Third, he must know how much to order. A complexmathematical equation determines the Economic Order Quantity, or EOQ. This equationrecognizes the tug of war between acquisition costs and inventory carrying costs: when heorders bigger quantities less frequently, his aggregate acquisition costs are low but hisinventory costs are high due to higher inventory levels. Conversely, when he orders smallerquantities more often, his inventory costs are low but his acquisition costs are higherbecause he is expending more resources on ordering (unless EDI and a QR inventorysystem are used). The EOQ is the order quantity that minimizes the sum of these twocosts.

* EOQ is a mathematical formula designed to minimize the combination of annual holdingcosts and ordering costs. There is a lot of hype about just in time inventory systems (JIT),which achieve smaller inventories through very frequent orders, but frequent ordering canoften result in an over-spending on ordering costs. Even though companies oftenmiscalculate their ordering costs, which make frequent ordering seem costly, EOQ is animportant tool for determining what inventory should be.

* Economic order quantity (EOQ) can be defined as the quantity per order (in units) thatminimizes the total costs of order processing (which include computer time, order forms,labor, and handling new goods) and inventory holding (which include warehousing, inventoryinvestment, insurance, taxes, depreciation, deterioration, and pilferage). EOQ calculationscan be done by large and small firms.

* Order-processing costs drop as the order quantity (in units) goes up because fewerorders are needed for the same total annual quantity, and inventory-holding costs rise asthe order quantity goes up because more units must be held in inventory and they arekept for longer periods. The two costs are summed into a total cost curve.

* Another problem area for a retailer is - maintaining proper inventory on hand, which initself is a difficult balancing act. Customer demand is never completely predictable, evenfor regular products such as staples. Thus, weather, special sales, and other factors mayhave an impact on even the most stable of items.

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* Shelf space allocations for retail merchandise must be linked to the current revenues,which entail that allocations must be regularly reviewed and adjusted.

* One of the major advantages of QR and EDI is that they enable the retailers to hold‘leaner’ inventories as they receive new merchandise more often. Still, stock outs mayhappen even when merchandise is popular or the supply chain breaks down.

* When to reorder is a question every retailer must attempt to know the answer to. Because,the one way to control investment in inventory is - to systematically fix inventory levels atwhich new orders must be placed. Such an inventory level is known as a reorder point,and it is based on three factors – i) order lead time, ii) usage rate and iii) safety stock.

* Ordering can be computerized by combining a perpetual inventory system and reorderpoint calculations, and an automatic reordering system can be mechanically activatedwhenever stock-on-hand reaches the reorder point. However, a retailer must ensure thatif necessary, a buyer or a manager may intervene if monthly sales fluctuate greatly.

* The term reverse logistics encompasses all merchandise flows from the retailer backthrough the supply channel to the retailer. It typically involves items returned by the customersdue to damages, defects, or less than anticipated sales, or any other reason. The conditionsfor reverse logistics must be specified in advance, to avoid channel conflicts.

* There are various steps involved in retail order management

* Effective and efficient tracking of communications includes several activities.

* The warehouse and location management and includes various activities of the retailer.

* Inventory count management deals with the inventory inspection which is a verycrucial activity, and entails the various activities of the retailer to ensure that thephysical inventory/cycle counts are performed by respective location; preparing his reporton inventory shrinkage and coverage, supporting warehouse-to-warehouse and intra-warehouse transfers; supporting the barcode receiving; automatically creating/saving put-away documents upon receiving; overriding put-away locations upon receiving; ensuringthe posting of comments and management of transfer email correspondence, etc.

* In managing the cost prices of the products through out the supply chain, several costingmethods are employed, which include - Retail method; Weighted average price method;FIFO (First in first out) method; LIFO (Last in first out) method; LPP (Last purchaseprice) method etc.

* The calculation can be done for different time periods. If the calculation is done on amonthly basis, then it is referred to the periodic method. Under this method, the availablestock is calculated by Adding: Stock at the beginning of the period, Stock purchasedduring the period and calculating average total cost by total quantity to arrive at the average


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cost of goods for the period. On the quantity, total all movements and adjustments duringthe period to arrive at the ending stock in quantity for the period. Multiplying the stockbalance in quantity by the average cost gives the stock cost at the end of the period.

* By using the perpetual method, the calculation is done on every purchase transaction.Thus, the calculation is the same based on the periodic calculation whether by period(periodic) or by transaction (perpetual).

* Retail inventory method uses the cost method of accounting. Similar types of merchandiseare pooled for purposes of estimating an average percentage of cost to retail price. Thatpercentage is applied to the inventory to estimate cost of inventory. The retail inventorymethod, also called cost method, can use either the physical inventory of countingmerchandise on hand or the book inventory system (perpetual inventory system).

* Retail inventory accounting systems may be complex as they involve a great deal of data.A typical retailer’s rupee control system must provide data on the sales and purchasesmade by that firm during a budget period, the value of beginning and ending inventory,markups and markdowns, and merchandise shortages.

* Retailers have different data needs compared to that of manufacturers. Their assortmentsare larger. Their costs may not be printed on cartons unless coded, because of customerinspection. Their stock shortages may be higher. Their sales are more frequent. Hence,retailers require monthly profit data.

* There are two inventory accounting systems which are available to the retailers. (1) Thecost accounting system values merchandise at cost plus inbound transportation charges.(2) The retail accounting system values merchandise at current retail prices.

* Under the cost method of accounting, the cost paid by the retailer for each item isrecorded on an accounting sheet and/or is coded on a price tag or merchandise container/ bin. Whenever a physical inventory is undertaken, every item costs is known, the quantityof every item in stock is counted, and total inventory value at cost is calculated by theretailer. A retailer can use the cost method because it entails physical inventory (actualmerchandise count) or book inventory (record keeping).

* Under a physical inventory system, the closing inventory, which is recorded at cost, ismeasured by counting the merchandise in stock at the end of a selling period. Gross profitis computed after valuing the closing inventory. A retailer using the cost method along witha physical inventory system will be able to calculate gross profit only after he counts andvalues the merchandise.

* A book or perpetual inventory system keeps a running total of the value of all inventorieson hand at cost at a given period of time, thereby avoiding the problem of infrequentfinancial analysis. Under this method, end-of-month inventory values can be computedwithout a physical inventory, and frequent financial statements can be prepared. In addition,

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a book inventory lets the retailer uncover stock shortages by comparing projected inventoryvalues with actual inventory values through a physical inventory.

* Under the retail method of accounting, closing inventory value is determined by calculatingthe average relationship between the cost and the retail value of merchandise available forsale at a given period.

* There are three basic steps to determine closing inventory value by the retail method,which are - Calculating the cost complement; Calculating deductions from retail value andConverting retail inventory value to cost.

* Weighted average cost method is a perpetual weighted average system where the issueprice is recalculated every time after each receipt taking into consideration both the totalquantities and total cost while calculating weighted average price.

* CIMA defines FIFO ‘a method of pricing the issue of material using the purchaseprice of the oldest unit in the stock’. This method is more suitable where the size of theraw materials is large and bulky and its price is high and can be easily identified in thestores separately. This method is useful when the frequency of material receipts is less andthe market price of the material are stable and steady.

* Under the last in first out method of pricing the issues (LIFO), most recent purchase willbe first to be issued. The issues are priced out at the most recent batch received andcontinue to be charged until a new received is arrived into stock. It is a method of pricingthe issue of material using the purchase price of the latest unit in the stock.

* FIFO and LIFO are two ways of valuing the inventory. The FIFO (first-in-first-out)method logically assumes old merchandise is sold first, while newer items remain in inventory.The LIFO (last-in-first-out) method assumes new merchandise is sold first, while olderstock remains in inventory. Under the FIFO method, the inventory value matches with thecurrent cost structure or the market price, as the goods in inventory are the ones boughtmost recently, whereas under LIFO method, the current sales value matches with thecurrent cost structure, as the goods sold first are the ones bought most recently. Wheninventory values rise, LIFO offers retailers a tax advantage as it shows lower profits.

* The FIFO method presents a more accurate picture of the cost of goods sold and thetrue cost value of ending inventory. The LIFO method indicates a lower profit, leading tothe payment of lower taxes but an understated closing inventory value at cost.

* Both the systems under cost-based methods (physical and book systems) have significantdisadvantages. First, they both require that a cost is assigned to each item in stock or sold.Cost-based valuation systems work best for firms with low inventory turnover, limitedassortments, and high average prices, when merchandise costs change.


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* Neither of the cost-based methods ((physical or book systems) adjusts inventory valuesto reflect the changes in style, end-of-season markdowns, or sudden surges of demand,which may lead to raising prices. Thus, closing inventory value, based on merchandise costmay not reflect its actual worth.

* Despite these problems, retailers who manufacture the products they sell, often keeprecords on cost basis. A department store which is engaged in these operations can use thecost method for those activities and the retail method for other areas.

* Price may be defined as – ‘the monetary value assigned by the seller to somethingpurchased, sold or offered for sale, and on transaction by a buyer, as their willingness topay for the benefits of the product and channel service delivers’. Pricing of merchandisehas to accomplish three objectives – market acceptance of the product, market sharemanagement and improved profits.

* One of the most crucial areas for retailers is developing a successful pricing strategy.Setting the right price can influence the sales, which in turn determines the total revenueand profit of the retail store. For the firm, pricing decisions are very crucial because withoutadequate margins, the firm may not survive for long. The firm has to seek cash flow,profitability and growth in order to have a long life. The difference between the cost of themerchandise and the retail price is known as – mark-up. A retail firm has to be very carefulwhile pricing its merchandise because – overpricing will make it branded as an expensivefirm and under pricing will brand it as a firm whose quality is low in the minds of customers.Price of merchandise plays an important role in attracting and retaining customers. Itshould also reflect the firm’s mission, merchandising policies and the firm decisions.

* The firm should establish certain objectives before developing the pricing policy. Theobjectives might be related to – i) Sales objectives (sales volume objectives, market shareobjectives etc; ii) Profit objectives (profit maximization, target ROI, net sales etc); iii)Competitive objectives (meeting competitors’ prices, controlling the competitors’ entry,non-price competition, etc)

* Profitability of a retailer’s business is influenced by two factors - the profit margin on theofferings that are sold, and the cost involved in the selling of merchandise.

* From consumers’ point of view, price is always considered as a very important feature ofhis purchase decision. Retailers have to understand everything about the customers whofrequent their shops, their characteristics, the reasons for their shopping, the degree ofconsistency between the price perception of consumers and the store’s price philosophyetc.

* Understanding of the customer segment is very crucial and essential for the retailers forevolving their pricing strategy. Pricing strategy contributes to the positioning of the retail

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outlet in the market and gives it its image, and provides it with an identity distinct from therest of the competitors in the market.

* The price sensitivity of customers is based on various personal, social, or geographicalfactors and presents a major challenge for retailers while selling prices. Based on pricesensitivity, customers can be divided into various segments such as – i) economy oriented,ii) convenience oriented, iii) image/ status oriented, iv) variety oriented, v) loyalty orientedetc.

* A retailer patronizing high-end pricing philosophy assumes and believes that pricesmust be set at above-average market levels in order to attract his customers and mayprovide attractive décor, grand atmospherics, distinctive products, super customer service,etc.

* In low-end pricing philosophy, a retailer focuses on below-market average prices dueto many reasons such as - limited capital investment, low operating costs, special buys,right controls, etc.

* A retailer following medium-pricing philosophy considers price factors as not influentialin their retail marketing mix in comparison to the relevance of other factors such as site ofthe store, operational hours, additional services, variety, etc.

* Retailers depend on various alternatives to calculate prices of their products. Whereretailers from the organized sector in developed countries depend on data from NationalRetail Federation books, and Progressive Grocer, a large section of retailers in theunorganized sector in India adopt the average mark-up for their products. Another importantelement in retail price is competition. Retailers have to consider their competitors whiledetermining their pricing strategy.

* A retailer’s price is influenced by several factors, apart from factors like costs, desiredprofit margin, etc. Using Porter’s model to analyse these factors for strategic pricing, theycan be broadly segregated into four ‘forces’- customers, suppliers (manufacturers,wholesalers and other suppliers), competitors, and government. These four factors or‘forces’ have to be considered while determining the pricing strategy. In some cases, theirinfluence may be inconsequential, while in others, the retailer may be totally constrained, asin the case of government regulations. The extent of influence may vary from industry toindustry.

* Law of demand in this context of retail pricing refers to the tendency of the customers tobuy products in a greater quantity when the price is low, and buy less or reduce theconsumption of the product when the price is high. Hence, a retailer has to study thechange in the demand for a product or service at different prices with the help of priceelasticity of demand. The price elasticity of demand is a measure of the effect of a pricechange on consumer demand and also gives the relationship between the percentage change


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in quantity demanded and the percentage change in price. The elasticity of demand ishigher for stock-up items (non-perishable products) than for perishable products. Demandfor a product or service is said to be inelastic when a change in its price has no influence onthe demand for the product or service.

* The retail firm has to monitor the pricing strategies of its competitors very carefully andmake sure that the price it is fixing for its products or services is in line with that charged byits competitors. The pricing strategy of a retailer also depends to a larger extent on hiscompetitive position in the market. The stronger the competitive position, the greater willbe the freedom in deciding the price of the merchandise.

* Cost of a product or a service covers the cost of the product or service along with thecost of getting it to the store and preparing it for sale. This becomes the basis for thoseretailers who adopt cost-oriented pricing.

* Product characteristics such as – perishability (physical perishability / style or fashionperishability / seasonal perishability), durability, quality, availability, seasonal appeal etcalso influences the pricing of a product or a service of a retailer, as they impact the demandfor a product or a service.

* The pricing decisions / strategies of a retailer are highly influenced by the legal system ofthe respective country.

* As elasticity decreases in the elastic range, revenue increases, but in the inelastic range,revenue decreases. When the price elasticity of demand for a product is inelastic (|Ed| <1), the percentage change in quantity is smaller than that in price. Hence, when the price israised, the total revenue of producers rises, and vice versa.

* When the price elasticity of demand for a product is elastic (|Ed| > 1), the percentagechange in quantity demanded is greater than that in price. Hence, when the price is increased,the total revenue of ther retailer falls, and vice versa.

* When the price elasticity of demand for a product is unit elastic (or unitary elastic)(|Ed| = 1), the percentage change in quantity is equal to that in price.

* When the price elasticity of demand for a product is perfectly elastic (Ed is undefined),any increase in the price, however small, will cause the demand for the product to drop tozero. Hence, when the price is increased, the total revenue of producers falls to zero. Inthis case, the demand curve is a horizontal straight line.

* When the price elasticity of demand for a product is perfectly inelastic (Ed = 0),changes in the price do not affect the quantity demanded. In this case, the demand curve isa vertical straight line; this violates the law of demand.

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*For all normal products and most inferior products, a decrease in the price results in anincrease in the quantity demanded by consumers. The demand for a product is relativelyinelastic when the quantity demanded does not change much with the price change. Productsand services for which no substitutes exist are generally inelastic.

* Inelastic demand is commonly associated with “necessities,” although there are manymore reasons why a product or service may have inelastic demand other than the fact thatconsumers may “need” it.

* Substitution serves as a much more reliable predictor of elasticity of demand than“necessity.” However, products with a high elasticity usually have many substitutes.

* It may be possible that quantity of products demanded increases as its price increases,even under conventional economic assumptions of consumer rationality. Two such classesof goods are known as Giffen goods or Veblen goods. Another case is the price inflationduring an economic bubble. Consumer perception plays an important role in explaining thedemand for products in these categories.

* PED is determined by a number of factors that essentially all fall under the umbrella of“choice”. A product which is difficult to replace or give up consuming will have a higherperceived value than that which is more easily replaced thus the consumer will be willing topay more for such a product. Perceived Value represents the absolute maximum price aconsumer is willing to pay for a product. When the price exceeds this level, the consumerwill give up consumption of this product.

* Availability of Good Quality Substitutes: Easily substitutable products will enable thebuyers to switch to an alternative product and thus such products will exhibit greater elasticitythan products that do not have substitutes available, ceteris paribus (assuming all othervariables are equal).

* Whether the product is habit forming or obligatory: Addictive drugs, whether psychologicallyaddictive or physically addictive, and other products where dependency plays a key rolewill naturally exhibit inelastic properties. At aggregate level, rising costs of such productsare unlikely to reduce the demand significantly.

* Products which typically make up a small proportion of people’s income will exhibitinelastic qualities. Conversely, products which form a large proportion of people’s incomewill cause greater responses in demand to comparable % increases or decreases in price.

* How closely the product is defined: In general, the exact type of good will affect its PEDproperties.

* Generally the greater the time period, the more possible it may be for a product to bereplaced with a substitute. Likewise, prices are dynamic. Over short time periods, prices


NOTES


of substitutes maybe static, over longer periods, the price of substitutes may drop, makingthem more appealing. [Puiatti, 18:36 10-Nov-07]

* A retailer should also consider the cross elasticity of demand for a particular product orservice. Cross elasticity of demand signifies that the change in the price of a particularproduct or service may reduce the demand for other products or services (complementaryproducts).

* The various factors that influence the price sensitivity of a product or a service are –Perceived substitutes effect: Unique value effect: Importance of purchase effect: Difficultcomparison effect: Expenditure effect: Fairness effect: Benefits/Price Effect; SituationEffect etc.

* To set the retail prices, it is important to understand some of the concepts and calculationsemployed for setting prices, and factors such as price elasticity and price sensitivity, whichimpact the effectiveness of the pricing strategy.

* The price that a customer pays for an offering comprises two main components: the costof the offering or the price that retailers pay to a supplier/manufacturer, and the gross profitmargin, which is, the selling price minus the cost of the product.

* In the retail business, the cost of goods or the cost(s) of acquiring the products includesthe price paid for the product(s), handling, freight charges, and import duties. Operatingexpenses include rent, wages, advertising, utilities, and supplies.

* Mark-up is the difference between the price paid for the product and the selling price.The mark-up can be established as a percentage of the cost or as a percentage of the retailprice. A price based on mark-up percentage on cost is determined by adding a percentageof cost to the cost of goods. A more common mark-up strategy in retail is to base themark-up on the retail price. Divide the cost of the product by the mark-up percentage.

* A retailer can decide to use a standard mark-up percentage for all the products or havedifferent mark-ups for different products. When establishing the mark-up for a particularproduct, the retailer should note two points – i) The cost of the products used in calculatingthe markup consists of the base invoice price for the product plus any transportation chargesminus any quantity and cash discounts given by the seller; ii) Retail price, rather than cost,is ordinarily used in calculating percentage markup. This is because, when otheroperating figures such as wages, advertising, and profits are expressed as a percentage, allare based on retail price rather than on the cost of the product being sold.

* Traditionally, price has been determined by adding a bit of profit to the cost of products.However, more often than not, pricing is not as simplistic as that. While fixing the prices ofproducts, some terms which are frequently encountered are – cost of goods sold, netsales, gross margin, percentage gross margin, markups, margins and markdowns.

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* Generally, there are three popular methods for setting the retail prices. They are –i) cost-oriented, ii) competition-oriented, and iii) demand-oriented methods.

* Many pricing strategies exist for a retailer to choose from and each strategy is usedbased on particular a set of circumstances. Some of them are – i) Cost-oriented pricing;ii) Cost oriented pricing is related to the costs a retailer incurs when he is purchasing aproduct or service for selling them to his customers. iii) Cost-plus pricing or Mark-up oncost

* The Rate of return pricing is another variation of the cost-oriented method, which providesthe retailer with an agreed rate of return on his investment. Where the cost-plus methodconcentrates on the costs associated with the running of the business, the rate of returnmethod concentrates on the profits generated in relation to the capital invested. Both cost-plus and rate of return methods of pricing are not appropriate for those retail productswhich have to survive in a highly competitive market place.

* Demand-oriented pricing should ideally be used along with cost-oriented pricing. Whenthese two methods are used in combination, the retailers can not only consider their profitstructure but also the impact of their price changes on sales.

* Discrimination pricing, which is sometimes called variable or flexible pricing, is popularlyused when products are sold at two or more different prices. This method is often timerelated. For price discrimination to be successful, it is required to be able to identify thosesegments which, without the price differentials, would not purchase the product(s).Discrimination may also be based upon increasing the price of products which have higherpotential demand.

* Backward pricing is a market-based method of pricing which focuses on what the consumeris willing to pay for. Under this method, in the first step, an acceptable margin is agreedupon, and then costs are closely monitored so that the price, which is deemed to beacceptable, is able to be matched. Whenever necessary, adjustments are made to thequality of the product or service on offer, to meet the cost-led needs of this method. Aretailer, who sells on a price-led basis often insist that his suppliers meet specified costs,even if this compromises some aspects of the quality. This method is somewhat similar toprice lining, which is a method of simplifying the product comparisons for the customers byestablishing a number of lines within price points for each classification. Once the pricelines are determined, the retailers purchase products which fit into each line.

* Skimming method of pricing is used when there is a shortage of supply of the product, orbrand has been associated with added value, and therefore, demand will not be dampenedby charging a premium price. This method of pricing usually is adopted only when there isa healthy potential demand for the product on offer.


NOTES


* The market penetration pricing is similar to competitive pricing, but is used when acompany or brand is to be established quickly in the market. Prices are usually set belowthose of the competition in order to create high initial acceptance for the company’s retailoffer.

* Loss leaders are goods or services offered at steep discounts (generally below cost) inorder to attract new customers to a store. It is a time-honored practice that has been metwith much success, especially by large discount retailers. The purpose behind using thispricing strategy is to not only have the customer buy the (loss leader) sale item, but otherproducts that are not discounted also.

* The loss leader method is used to – i) move non-moving or overstocked inventory, sothat the shelf space is freed, inventory is reduced and will increase the cash flow, ii) creatingbrand awareness, in case the retailer likes to be known for having low prices, iii) as marketingtool to gain new customers and increase return visits, by giving good bargains. Successcan be achieved by using loss leader pricing, but the retailer must be aware of someobstacles to the process. If done incorrectly, loss leaders can actually cause the businessto lose money.

* The competitive Markup Method for Pricing is used to price the products similar tothose of the competitors. In effect, the markup is controlled by the competitors and itfluctuates as a consequence of what the competitors are charging for their products andservices. This is a method which requires knowledge of actual costs as matching the pricesof a more efficient retailer may lead to losses on particular products. It also necessitates anunderstanding of the importance of the competitors’ pricing policies for a consumer’sperspective.

* Psychological pricing, which is sometimes referred as odd pricing, is a strategy whereprice is based on popular price points and what the consumer perceives to be fair. Themost common method is odd pricing using figures that end in 5, 7 and 9

* The everyday low price (EDLP) stresses the use of a pricing policy with the continuity ofprices at a level between the normal own store price and the price of the deep discountcompetitors. The term ‘low’ refers to a price position which is competitive and therefore,can remain stable. A number of retailer who use EDLP do not believe in markdownpolicies and sales, but attempt to generate all the year round demand by setting the pricesat the right level. There are many benefits perceived to be enjoyed by retailers followingthis method of pricing.

* Suggested retail price is a common strategy used by smaller retail shops to avoid pricewars and still maintain a stable level of profit. Some suppliers have minimum advertisedprices, but also suggest the retail pricing. One problem with using pre-set prices is that itdoesn’t give an advantage over the competition

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* Competitive pricing below competition simply means beating the competitor’s price.This strategy works well if the retailer follows an inventory plan, buys at the best prices anddesigns a marketing plan to concentrate on price specials.

* Competitive pricing above competition should only be considered when location,exclusivity or special service considerations can justify higher prices.

* Multiple pricing is a method which involves selling a number of units for one price, suchas three for Rs.10.00. Retailers find this an attractive pricing strategy for encouraginglarger commitments. It is also a desirable strategy for clearance sales.

* Discount pricing and price reductions are integral parts of retailing. Discounting caninclude coupons, rebates, buying clubs, markdowns or seasonal prices. The decision ofwhen and what type of discounting will vary greatly with the type of merchandise, theamount of competition and the stock on hand.

* As the best pricing model is being developed by the retailer for his business, he has tounderstand that the optimal pricing strategy will depend on more than his costs. It is difficultto say which component of pricing is more important than another. It should be kept inmind that the right product price is the price the consumer is willing to pay.

* In inventory or stock management, ABC analysis is a method of stock control. Its basicassumption is that not all stock is equally valuable, therefore doesn’t need the same kind ofattention. Hence, all the stock is categorized according to its cost and quantity - and agraph is created with cost shown on Y axis and quantity shown on X. From left to right,stock is placed from highest value to lowest. Typically, it can be seen that a small portion ofstock is the most valuable, and therefore needs maximum attention and resources - that’scalled ‘A’. The next most valuable section of stock is B, the next is C and so on. Basicallyit shows which stocks need more attention and which need less. It helps in utilizing resourcesfor stock management more effectively.

* In ABC analysis technique, the items of inventory are classified according to their valueof usage. The higher value items have lower safety stocks, because the cost of productionis very high in respect of higher value items. The lower value items carry higher safetystocks. ABC analysis divides the total inventory into three classes – A, B and C.

* Items in A class constitute the most important class of inventories so far as the proportionin the total value of the inventory. The ‘A’ items consist of approximately 15% of the totalitems and account for 80% of the total material usage. This class is made up of inventoryitems which are either very expensive or used in massive quantities. Under an ABC regimefor minimum stock value A should be managed by JIT since its value makes this closemanagement cost-effective.

* ‘A’ class items merit a tightly controlled inventory system with constant attention by thepurchase and stores management. A larger effort per item on only a few items will costonly moderately, but the effort can result in large savings. The inventory policy (re-order


NOTES


quantity and re-order point) should be carefully determined and the close control over theusage of materials is desirable.

* The ‘B’ items constitute an intermediate position, which constitute approximately 35%of the total items and account for approximately 15% of the total material consumption.This class is made up of inventory items which are not so few in number, but also they arenot too many either. Value wise also, they are neither very expensive, nor very cheap.Moreover, they are used in moderate quantities. Under an ABC regime for minimumstock value B should be managed by Kanban pulling- the micromanagement by JIT is notcost effective for this project but it should still be tracked methodically.

* ‘B’ class items merit a formalized inventory system and periodic attention by the purchaseand stores management. The economic order quantities and re-order level calculationscan be done and larger stocks can be maintained. The review of these items may be donequarterly or half-yearly.

* Items in ‘C’ class are quite negligible. It consists of the remaining 50% items and accountfor only 5% of the monetary value of total material usage. Class C items contain a relativelylarge number of items which are either inexpensive items or used in very small quantities sothat they do not constitute more than a negligible fraction of the total value of inventories.Under an ABC regime for minimum stock value C should be managed by 2 bins- wherebytwo huge bins of (eg screws) item are kept and one is used at a time- when one runs outanother is ordered and the next bin is used. The low value does not justify management-and any downtime because of running out would cost much more than the product itself.

* For ‘C’ class items still relaxed inventory procedures are used. For these items, generally,one year supply can be maintained. Periodic review once a year may be sufficient.

* ABC analysis helps a retailer to decide the items that should never be out of stock, itemsthat can go out of stock occasionally and the items that should be eliminated from thestock. This is done by ranking the merchandise on the basis of some performanceparameters. This not only provides information about relevance of merchandise to theretail store, but also helps in the placement of merchandise or shelf space, budgeting, andrevising the merchandise mix. It depends on the retailer or planner to select the unit ofmeasurement such as a department of SKU (stock keeping unit).

* ABC analysis uses Pareto Principle of 80-20 (principle of “Vital few and trivial many”based on the capital investment of the item.), where approximately 80% of the store’ssales of profits are derived from 20% of the products. A retailer has to decide on themeasurement criteria – which might vary from contribution margin, sales in terms of money,sales in units, gross margin and gross margin return on investment, before ranking eachSKU, category, or department.

* Procedure suggested for developing an ABC analysis is like – i) List each itemcarried in inventory by number or some other designation; ii) Determine the annual volume

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of usage and rupee value of each item; iii) Multiply each item’s annual volume of usage byits rupee value; iv) Compute each item’s percentage of the total inventory in terms ofannual usage in rupees; v) Select the top 10% of all items which have the highest rupeepercentages and classify them as ‘A’ items; vi) Select the next 20% of all items with thenext highest rupee percentages and designate them as ‘B’ items; vii) The next 70% of allitems with the lowest rupee percentages are ‘C’ items.

* VED analysis is another technique of inventory control, where the inventory is dividedinto three categories – V (vital), E (essential) and D (desirable), based on their importanceor demand or criticality. This analysis is highly useful to a retailer in planning his merchandiseand shelf spacing. The three categories of merchandise according to this technique can bedescribed as follows.

* ‘V’ stands for vital– SKUs or departments. The stock analysis of these SKUs requiresmore attention because out of stock situation in these SKUs might lead to customer attrition,customer shift and ultimately might result in loss of consumers. Thus, ‘V’ SKUs must bestored adequately to ensure smooth running of the business. ‘E’ stands for essential SKUsor departments. These SKUs are essential for running the business, but without theseSKUS, the business won’t incur huge losses. Care must be taken to see that these SKUsare adequately stocked. And ‘D’ stands for desirable SKUs or departments, which donot affect the goodwill of the retailer in the immediate future, but non availability of theseSKUs, might result in eroding the goodwill in the long run.

11. SHORT QUESTIONS

1. Define ‘merchandise management’.2. Explain the importance of inventory budget3. Explain the various life cycle stages of a product4. Into how many categories can you classify the retail outlets?5. Write a short note on retail supply chain management.6. What do you mean by reverse logistics?7. Write a short note on physical inventory count management in retail.8. Distinguish between FIFO and LIFO methods of pricing the issues9. How will you classify retail customers?10. Briefly explain the relationship between demand and total revenue.11. What is the influence of competition on retail pricing?12. Explain the terms – cost of goods sold, net sales, gross margin in retail business.13. Explain the terms – markups, margins and markdowns.14. Write a brief note on the utility of ABC analysis15. Explain VED analysis.


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12. LONG QUESTIONS

1. Explain in depth the various forecasting techniques.2. What is an inventory budget? Explain its process.3. Explain with examples the various challenges faced by retailers while preparing their

sales forecasts.4. Explain in depth the methods of retail sales forecasting – (i) in the case of an existing

firm and (ii) in the case of a newly started firm.5. Explain the various equations available to calculate retail sales and forecasts.6. Write a note on retail inventory management.7. Write a note on retail material issue management. What are the popular methods of

material issue in retail businesses?8. What do you mean by retail method? What are its advantages and disadvantages?9. What do you mean by pricing of inventory? What are the various objectives of retail

pricing policy?10. Write a note on pricing philosophies.11. Write a note on pricing strategies.12. What is the relationship between demand and retail pricing? What factors will influence

the price sensitivity of a product / service?13. What do you mean by ABC analysis? What are its advantages and disadvantages?

13. EXERCISES

1. The annual demand for an item is 3,200 units. The unit cost is Rs.6 and inventorycarrying charges are 25% pa. if the cost of one procurement is Rs.150, determineEOQ.

2. Following information relating to a type of raw material is available.Annual demand = 2,400 unitsUnit price = Rs.2.40Ordering cost per order = Rs.4Storage cost = 2% paInterest cost = 10% paLead time = half monthCalculate EOQ.

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UNIT III

MERCHANDISE PERFORMANCE1. INTRODUCTION

Product and merchandise management is a key activity in the management of retailbusiness. It drives the business strategy of the retailer and has immense cost and profitimplications. While product management deals with issues related to the kind of productssold by the retailer, merchandise management concerns itself with the selection of the rightquantity of the product and ensuring its availability at the right place and time. This involvesa careful planning of merchandise mix and its financial implications are reflected in themerchandise budget. The product and merchandise plan is drawn keeping in mind variousfactors that influence shopping behavior and the strategic and cost concerns of the retailer.

2 LEARNING OBJECTIVES


1. Understand what how to analyze merchandise performance2. Understand the methods of planning and calculating inventory levels and the related

various techniques such as - weeks supply method, stock to sales method, percentagevariation method, basic stock method of planning inventory etc.

3. Understand the other factors which influence the estimation of inventory requirements4. Understand the various skills that a merchandiser should possess to discharge his

duties effectively5. Understand various concepts such as – retail range planning, assortment of

merchandise, store grading etc6. Understand the preparation of sales budgets

3 ANALYZING MERCHANDISE PERFORMANCE

In order to be successful, retailers must make competent decisions over what is to bebought, in what quantities and at what time. The selection and presentation of merchandiseenables a key source of difference to exist which will allow one store to differentiate itselffrom another. This is in line with the saying – ‘goods well bought are half sold’. In otherwords, retailers must have the proper product assortments and sell them in a mannerconsistent with their overall strategy. Merchandising consists of the activities involved in

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acquiring particular goods and/or services and making them available at the places, times,and prices and in the quantity that enable a retailer to reach its goal. In the words of LateStanley Marcus, former chief executive of Neiman Marcus, “I believe that retailmerchandising is actually very simple; it consists of two factors, customers and products.If you take good care in the buying of the product, it doesn’t come back. If you take goodcare of your customers, they do come back. It’s just that simple and just that difficult. Thisis obviously an oversimplification of the problem of relating. It’s not quite that easy – butalmost”.

Yet, sometimes, it is found that customer loyalty had dropped. It is because, there isno reason for a customer to go across to a shop when it is a foregone conclusion that he/she will get the same merchandise in any other shop that he/she had found in that particularshop. This is because of merchandise sameness. This merchandise sameness arisesfrom the buyers who were taught to play safe by avoiding risky fashions, to play it cautiouslyby buying from a limited number of standard vendors who sell the same “packages” to allmajor customers, to play it for profit by advertising only the products supported bymanufacturers’ advertising allowances. Many retailers mistakenly believe that their onlygoal is to make profits and fail to realize that a profit is due to having products or servicesthat are so satisfactory that the customer is willing to pay a bonus, or a profit, over andabove the distributor’s cost.

Merchandise management focuses on the planning and controlling of the retailer’sinventories and balances the financial requirements of the company with a strategy formerchandise purchasing. Merchandise management may be defined as ‘planning andimplementation of the acquisition, handling and monitoring of merchandise categories foran identified retail organization’.

The complexity of modern retail operations often requires the grouping of the buyingprocess into an individual category. This is normally structured to ensure that the buyercan understand different market segments such as those defined by age (infants, children,youth etc) or by gender. In general, a category is an assortment of items that the customerwould perceive as being substitutes for each other. This approach enables a customer ledfocus on the assortment profile and the issues of the width and depth, quality and cost toprice implications. Category management, working with key brands is a feature of modernretailing. Cobb (1997) explains that at the point of purchase, the shop-in-shop concept,traditionally utilized to promote a single manufacturer or brand, has been developed toimprove category differentiation in the grocery multiples.

The various phases in developing a merchandise plan include – marketingconsiderations, merchandise strategy options, type of customer base, financial considerationsand merchandise assortment search.


NOTES


Merchandise plan considerations

(Source: David Gilbert, “Retail Marketing Management”, Financial Times, Prentice Halland an imprint of Pearson Education, 2000)

Some of the other important merchandise decisions relating to this plan include –availability, turnover etc.

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Availability is based upon the seller’s need to ensure that the level of stock requiredmeets the demand from his consumer. The higher the level of stockholding, the higher thelevel of costs (and working capital), but at the same time, improved stockholding mayincrease sales due to the rapid flow of merchandise. The concept of availability implies theefficient maintenance of the reorder / replenishment cycles. In other words, the availabilityperformance is linked to inventory turnover, which can also be described as merchandisestock run.

This inventory turnover concept enables the working out how long inventory onhand is prior to its being sold. Goods with high inventory turnover will need to be planneddifferently from those with low turnover. Retailers can use different methods of measuringthis, such as the following.

Net sales / Cost of merchandise sold / Units soldAvg inventory at retail store / Avg inventory at cost / Avg. units in inventory

This inventory turnover concept enables a store to operate at a more optimal level.

3.1 METHODS OF PLANNING AND CALCULATING INVENTORY LEVELS

3.3.1 Basic stock method of planning inventory (BSM)

When the firm has a requirement to maintain a particular level of inventory all the time,it may have to follow the BSM method of planning for inventory. Inventory under BSMmethod meets sales expectations and at the same time allow for a margin of error, as it triesto avoid customer dissatisfaction due to stock outs. It takes more priority if sales arehigher than expected or if there could be any problem with the shipment and delivery ofstocks. This method is better suited to a firm with lower turnover or a firm with erraticsales. The main advantage of this method is that stock can be added to over time ratherthan purchasing the entire lot in advance. The main disadvantage of this method is that itdoes not take into consideration the holding costs of stocks.

The level of beginning of month stock (BOM) for a retailer can be calculated byconsidering the data for a season and working out the BOM as the planned monthly salesplus the basic stock.

Beginning month stock (BOM) = Planned monthly sales + Basic stock, where

(a) Average stock for season = Total planned sales for season , andEstimated inventory turnover

(b) Average monthly sales = Total planned sales for season , and Number of months


NOTES


Basic stock = (a) – (b)

Example: If the inventory turnover of a firm is 2 and total sales for the season (6 months)are Rs.6,00,000, then,

(a) Average stock for season = Rs.6,00,000/2 = Rs.3,00,000, and(b) Average monthly sales = Rs.6,00,000/6 = Rs.1,00,000, andBasic stock = Rs.3,00,000 – Rs.1,00,000 = Rs.2,00,000, andThe final average basic stock requirement for the season = Planned monthly sales + Basicstock = Rs.1,00,000 + Rs.2,00,000 = Rs.3,00,000

Like this, the retailer’s required inventory may be as follows:

3.1.2 Percentage variation method (PVM)

When stock turnover is higher than 6 or more annually, another method, percentagevariation method (PVM) may be used to determine the planned stock levels of a retailer.This method is suitable when stock is quite stable and it results in planned monthly inventoriesthat are closer to the monthly average compared to other techniques. If the retailer hasfluctuating sales, but do not want to maintain a given level of inventory at all times, thismethod is highly suitable. This technique assumes that the monthly percentage fluctuationsfrom average stock should be half as great as the percentage fluctuations in monthly salesfrom average sales. It can be calculated as follows.

Beginning of month planned inventory level =Planned avg monthly stock for season * 1/2 [1+ (Estimate monthly sales)]

(Estimated avg monthly sales)

Example: Since the PVM utilizes the same basic components, the previous exampledata might be used to calculate the planned stock as follows.

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PVM is a better choice when the annual turnover rate is greater than 6 as the resultswill fluctuate less. If the annual turnover rate is less than 6, BSM method of calculationwould be preferred.

3.1.3 Weeks’ supply method (WSM)

The weeks’ supply method (WSM) involves forecasting average sales on a weeklyrather than monthly basis. The basic assumption of this method is that the inventory is indirect proportion to sales. This method suits shops/ supermarkets where sales do notfluctuate in significant amounts and where weekly planning of inventory is possible. Underthis method, calculation of inventory value is based on a predetermined number of weeks’supply which is linked to the desired stock turnover rate. Thus, in WSM, there is aproportional link between the value of the stock and the forecasted sales. If the forecastedsales double, then inventory value will triple.

BOM stock = Avg weekly sales * Number of weeks to be stocked, where,

Avg weekly sales = Estimated total sales for the period , and Stock turnover rate for the period

Number of weeks to be stocked = Number of weeks in the period Stock turnover rate for period

Taking the previous example figures,

Number of weeks to be stocked = 26/2 = 13 weeksAvg. weekly sales = Rs.6,00,000/26 = Rs.23,076.9BOM Stock = Rs.23,076.9*13 = Rs.3,00,000

When the number of weeks supply to be stocked at 13 weeks based upon the averageweekly sales of Rs.23,077, stocks may have to be checked on a regular basis to ensurethat the twin dangers of stock outs or stock buildups are not there, which will increase the


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holding costs of the inventory. Thus, the pre-requirements of this method are – stable salesand turnover.

3.1.4 Stock to sales method

Another alternate method to use when a retailer wants to maintain a specified ratio ofgoods on hand to sales is stock-to-sales method. For this, the retailer has to use beginningof the month sales-to-stock ratio, which informs the retailer as to the amount of inventoryrequired for sustaining that month’s estimated sales. A ratio of 2 signals to the retailer thathe should maintain twice that month’s expected sales available in inventory at the beginningof the month. This method is easy to calculate and can be calculated from a retailer’s ownhistorical results or from external sources which are reliable.

3.2 OTHER FACTORS WHICH INFLUENCE THE ESTIMATION OFINVENTORY REQUIREMENTS

Level of shrinkage, markdowns and employee discounts which will influence both thefinancial and availability aspects of the business. These reductions make the retail value ofthe inventory lower than its beginning balance, and therefore, the estimates should beincluded in the merchandise budget.

Shrinkage is the difference between the amount of merchandise which is reportedon the inventory stock system and what is available for sale or on the shelves. This shrinkagemay be due to – shoplifting, employee theft, vendor over billing, distributor theft, paperwork errors, and breakage and spoilage. Shrinkage results in the reduction of the totalretail value of the merchandise. Calculation of the effect of shrinkage requires some detailedunderstanding of the business as it differs across merchandise types and department types.

Markdowns imply price reductions of the merchandise which act as a sort ofpromotion; for special sales periods or for moving sluggish lines, because of damage orsoiling of merchandise, due to end of range offers, or because of greater price competitionfrom competitors or part of planned reductions and offer value to the employee in workingat store. In such cases, all sales are recorded and the discounts arising therein also areaccounted for.

Employee discounts are part of planned reductions and offer value to the employeein working at the store, which should also be recorded so that they become accountable.

4. MERCHANDISER SKILLS

The Merchandiser is responsible for all the activities (including operational) to betaken to realize the strategic objectives of the retail outlet.

It is critical for the success of a business to constantly work towards improving notonly the efficiency of its employees, but the productivity of the store’s selling space and

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inventory as well. This can be achieved by using various retail math formulas and calculationsbased on sales.

The role of merchandiser is crucial between the pursuit of the strategic objectives ofthe retailer and operational activity of the shop. The merchandiser’s role in the retail firmincludes planning and controlling the stock ranges and replenishment. For this, he needs toliaise closely with the retail buyer. He also should have a holistic view of the supply chainof the firm and should have regular interactions with central functions ranging frommanagement accounting to distribution, and also from the top level executive through thoseoperating at store level. Then only he will be in a position to forecast the potential /expected merchandise at the right time, in right quantity, of right quality through right people.

To be effective, the merchandiser, thus, need to be an effective communicator withthe required interpersonal skills. Apart from people skills, the merchandiser also needssome technical skills, which include - advanced numerical capability supported by PCliteracy, notably in the use of spread sheets and databases. Also, apart from people skillsand technical skills, he would require administrative competence, because of the complexityof merchandise management. There are many key areas to be controlled which relate tothe need for attention to detail in order to ensure that the plan is always aligned to operationalobjectives.

4.1 DEVELOPING THE FIRST STAGE OF THE MERCHANDISE PLAN

• Understanding the target market groups;• Agreeing regional and branch sales forecasts;• Collecting information on competitors and any new branch plans;• Taking in to consideration branding and corporate policy;• Agreeing merchandise budget;• Liaison and initial discussion with buyer(s).

The qualifications and competencies required for a merchandiser varies from businessto business, shop to shop and also between retailer and another retailer. But, there is onecommon and the most important quality a merchandiser should possess, which is – to playthe support role to the buyer. An effective working relationship with the buyer is veryimportant for the trading objectives to be realized and beyond this, the extent of reactivenumber-crunching or proactivism required in a merchandiser, vary.

Budgeting process is another factor which decides the role of the merchandiser. Duringthe process of Budgeting, the retailer is expected to quantify in financial terms, his objectivesfor the required time period. Once this financial plan or master budget has been devised,it can then be used to monitor the performance of the retail business. Retailers have to buymerchandise that has to be priced at an acceptable market price and also provides aplanned gross margin. There are two values a retailer comes across as part of this process- the retail value of sales and the cost value based on the purchase price of the merchandise.


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The merchandiser has an important role to play in both planning and controlling the retailactivity. In the early stages, it might be necessary to analyse market information and salestrends in order to produce agreed forecasts which may be incorporated in to the masterbudget.

The merchandise budget thus, is a tool for the financial planning and control of theinvestment the retailer had to make on the inventory he has acquired. The master merchandisebudget will be required to offer various types of information such as - gross sales projection,stock level requirements, retail reduction estimates and expected profit margins etc.Following the budget preparation, a merchandiser has to make plans for meeting theprojected sales. The resultant process has three dimensions - the merchandise range itself,the profile of stores in the group, and the variations in sales demand over time.

4.2 VARIATIONS IN DEMAND

The merchandiser, as part of his duties, needs to plan for the extent to which demandfor various product lines fluctuate. In such cases, he should ensure that the retailer’scapacity to meet the demand and the actual turnover will meet customer expectations withthe minimum of wastage. However, many merchandise categories may exhibit a degree ofseasonality.

For forecasting the future demand, the merchandiser has to have intimate knowledgeof customers and the type of demand for the product being sold. The variations in thecategory lifestyle wherein, the fact that some products sustain demand for longer periods isan important aspect in deciding up on the merchandise plan.

Merchandise category life-cycle analysis

(Source: David Gilbert, “Retail Marketing Management”, Financial Times, Prentice Halland an imprint of Pearson Education, 2000)

A fad product will generate a high level of sales due to a large segment of the populationrequesting the sales team for higher supply of the item. However, the demand for the itemwill last only for a short time and perhaps not even for the whole season. Given that a highnumber of fad items can be sold in a short time, they can be sold at substantial mark- upsdue to their price insensitive nature and supplier’s price increases based on their decisionsto ‘cash in’ while the fad lasts. Fads are difficult to predict and forecast and quite often,

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demand exerts a great deal of pressure on distribution chains as demand will always outstripsupply for fad items. The only way to deal with a fad is to recognize the signs of its importanceas early as possible.

In the case of fashion products, its demand cycle usually lasts for several seasonsalthough sales may vary from season to season. This demand depends on the type ofcustomer and the product categories. For instance, Men’s suits will have a different demandcurve to that of teenage clothing (boys).

The staple merchandise will provide continuous demand over an extended life span,of the product. Most of the food products and household cleaning items come under thisproduct category.

Seasonal merchandise is characterized by fluctuations in demand according to thetime /season of year. In addition, both the fashion and staple merchandise categories willnormally have seasonal variations of demand based upon the season and the weather ofthe respective geographic region of the target customer(s). As the staple merchandiseoffers a reliably repeatable sales history on which to base predictions of planned stock, themerchandise manager finds the staple category to be the easiest to manage. The inventorysystem for fads and fashion merchandise requires much more careful appraisal by themerchandise manager.

4.3 RETAIL RANGE PLANNING

A retailer’s stock range can be described in terms of its width and depth, with theextent of each determined by the respective company policy. This is sometimes termed asthe assortment.

The width of the stock assortment relates to the number of categories that are foundin the merchandise line and the various generic classes of the product or merchandisewhich it carries. A wide and narrow stock assortment is normally where there is littlechoice in brands, styles, etc. within an individual range. Stock turn could be higher for abroad merchandise assortment, but margins will be very slim in order to encourage thecustomers.

The depth of the stock assortment relates to the sizes, styles, colors, and priceswithin a particular generic class of product. There are specialist shops, the niche boutiques,etc, which offer a lot of depth but with a narrow product range.

The retail offers of each business are substantially different, with the respective stockranges of each being an integral part of their business strategy. The superstore is seekingto charge a premium price for added value as perceived by the target customer. Thispremium should not be visible and the leading operators must be skilled at promoting alimited part of their ranges on a price basis to create this effect. The profitability comesfrom offering a very extensive range of product lines, some with comparatively slow rates


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of stock turn, with healthy profit margins. The number of different lines a retailer stocks inhis store is often referred to as the variety of the merchandise mix.

The extent of the range plays an important role in framing the customer’s perceptionof added value. In the case of a hard discounter, the offer is extremely competitively priced- the key concern of the target customer. Profitability stems from achieving a very high rateof stock turn, and by keeping costs to a minimum. Product line proliferation would be theundoing of this discount strategy, as it is not what target customers expect and wouldimpact on stock turn and costs.

In extreme cases, for instance in the case of products such as toys and lingerie, mostof the annual turnover is takes place in a very few weeks of the year. This represents asignificant challenge to the merchandiser when he is preparing his range planning. Balancingbetween meeting customer expectations and avoiding wasting resources is not easy. Stockof merchandise needs to be built against an anticipated rise in demand. This will affect thesupply chain management of the retailer. Distribution networks have their own limitations interms of capacity. Peak trading will place massive physical demands on the warehousingand transport systems and also on store staff who are handling the merchandise.

There are many other examples of the focal role that range planning plays in retailstrategy. Of particular interest is the attempt made by some multiple chains to become‘category killers’; that is to meet all customer needs within a particular category ofmerchandise. The ‘category killer’ is normally a large store that concentrates on onecategory,- thus making it possible for it to carry both a broad assortment and deep selectionof merchandise, coupled with low price and moderate service.

4.4 DEVELOPING THE RANGE PLANNING AND MERCHANDISEALLOCATION PLAN

- Development of range planning and merchandise allocation plan requires the following:• Understanding the product or service selection process of target consumers;• Deciding the core and seasonal merchandise;• Agreeing the range - e.g. style, size and color mix - depth and width of assortment

of merchandise.• Taking into consideration the sales to stock level targets and calculating the optimum

level of stock by utilizing one of the stock inventory planning methods;• Relating the range assortment plans to individual stores and possible promotional

plans;• Briefing the buyer(s) on agreed source,

The range planning has to take into consideration the space constraints imposedupon by the merchandise manager. If breadth and depth of assortments are important thenthis requires both stock space as well as display space to separate the merchandise. Thereis also a need to ensure that any move at providing more depth does not affect the sales.

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To provide for more depth to the assortment, the retailer has to stock more variations ofthe product for smaller retail segments; which implies that turnover could deteriorate andstock levels would be difficult to control.

Any decision over the range of assortment and the amount of inventory to stock hasto be followed up by the determination of the source of merchandise. While selecting thesource of the supply, there should be some considerations to be made, such as – theprevious sales performance, acceptability of the design or brand name, manufacturing andproduct quality, reliability of delivery and service, assurance of ability to provide furtherstock if required, and the cost of items. In case of some high fashion lines, the buyer maywant to know who else is being supplied and may even specify that the contract will orshould deny their competitors the purchase of a similar range of merchandise.

Range planning needs to be customer driven and should incorporate the requirementsof the target customers. The merchandiser has to identify which product attributes aremost important to the customer and plan accordingly. In the case of underperformingretailers, problems are often most apparent in their ranges as a direct consequence oflosing touch with their target customer(s).

The depth and width assortment profiles are - narrow and deep, square, and broadand shallow. Some of the factors which needs attention when planning the width anddepth of assortment are - estimated sales and profit performance.

Many merchandise lines will become more successful if adequate promotional supportis given. Merchandisers will try to evaluate the significance of offering different types ofassistance with the promotion of various items, which may assume many different formssuch as - advertising allowances, co-operative advertising, free display materials, in-storedemonstrations or videos, consumer sales inducements - such as special offers, couponredemptions, free samples, and contests etc. Apart from the above mentioned promotionalassistance, if any major advertising is carried out by the manufacturer to support the brand,or the product, it will be an important consideration.


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4.5 ASSORTMENT PROFILES FOR DIFFERING MERCHANDISESTRATEGIES

(source: Cook and Walters, 1991; David Gilbert, “Retail Marketing Management”,Financial Times, Prentice Hall and an imprint of Pearson Education, 2000)

4.6 STORE GRADING

To explain in simple words, store grading can be related to the gross sales forecast.The gross sales projection for the company requires disaggregating across the portfolio ofthe stores. Hence, each store will have its own budgeted gross sales figure. Part of themerchandiser’s job is, to see that the merchandise plan for the store will meet the projectedtarget sales figure. Rather than produce a customized plan for each store, majority of theretailers follow the common practice of grading the stores. The shelf or display space is thekey yet limited selling medium. That is why, usually, store grading is conducted on thebasis of floor sales area. However, it should be understood that this is inevitably a crudedevice, as depending on the location, there might be smaller stores capable of achievingmuch higher than average sales densities and larger units with the reverse characteristic.

Store grading can become a major source of controversy between store operationsmanagement and the central merchandise functions. From the perspective of storemanagement, crude grading may be understood as yet another example of how HeadOffice is out of touch with what is happening at the ‘sharp end’. This showcases the needfor effective liaison between the stores and the central buying function. This connectionbetween the stores and the buying function is an important part of the merchandiser’sremit. It involves making sure that all relevant local characteristics are accommodated inthe merchandise planning, and at the same time, realizing the efficiency benefits that accruefrom store grading.

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4.7 DEVELOPMENT OF CONTROL MECHANISMS OF THEMERCHANDISE PLAN

Development of control mechanisms of the merchandise plan requires:• An understanding of the comparative frequency of store visits of the target

market groups, based upon their browsing, or items purchased by them.• Forecasting of sales of range items and their profitability.• Monitoring the stock levels and the availability of new stocks and their

replenishment levels.• Assessing the value of merchandise through shrinkage, markdowns and

employee reductions• Liaising with the buyer(s) to discuss the merchandise performance figures.• Expanding or reducing merchandise categories, based upon the respective

sales performances.

4.8 MERCHANDISE ASSORTMENT AND SUPPORT

The next step in merchandise management is – to monitor the sales performance,which is to be done by the merchandiser, after devising the range plan to provide for

the nature of the merchandise, deciding the spread of stores in the company portfolioand accounting for the variations in demand over time. Then, the actual sales performancewill be compared against the budgeted performance. During this phase of sales management,the merchandiser needs to be proactive in seeking out opportunities to maintain and improvethe rate of the stock turn. This necessitates an understanding of and a competency to dosophisticated analysis of merchandise category performance. If demand is more than theprojected figures, there is the prospect of missed opportunities and disappointed customers,which is popularly termed as – stock out condition. If the retail shop is able to read theearly warning of this situation, it might allow some degree of remedial action but, dependingon the category, this may be limited. At the very least, the higher than anticipated salesvolume will give the buyer, a greater freedom to increase supply, and, if necessary, fromdifferent sources.

If a category is underperforming sales wise or its sales figure is lower than the anticipatedfigure, the retailer has to entertain the prospect of markdowns (reduction in the normalselling price of a retailer). In this markdown decision-making process, the merchandiserplays a very important role.

Retail profitability stems from both the gross margins realized on each product lineand from the frequency with which the business is able to turn the product line over, that is,the rate of stock turn. Therefore, by marking-down a product line in such a way that it’sselling price is reduced, the retailer is accepting a lower gross margin in return for ananticipated increase in the rate of stock turn or sales. The focal point in this decision is torecognize that gross margin is realized only when the stock is turned over or sold.


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Some time or the other, almost all the retailers or merchandisers would have had toexecute markdowns. In this process, the merchandiser’s skill and expertise is to knowwhen and by how much to markdown a product or a product line in order to achieve thedesired effect. Again, this requires careful monitoring of performance and a proactive ratherthan reactive approach on the part of the merchandiser. Given the direct financialimplications, strict controls are very important. The markdown policy of the retailer will tryto support his positioning strategy. Customer perceptions of reduced merchandise are avery important considerations and the public profile of the ‘bargain-bin’ cannot be allowedto compromise the image of the shop or outlet. So the merchandiser has to strike a balancebetween stimulating the sales or stock turn with price reductions, and not undermining theperception of added value that the retailer has to preserve in order to command its ‘full’price on the remainder of the stock range.

4.9 NEGOTIATING THE TERMS OF PURCHASE

The retailer has to negotiate the purchase of his merchandise and its terms, when allthe different aspects of the merchandise have been assessed and the source, throughevaluation, has been evaluated and carefully chosen. This can be carried out throughcentralized buying (where there exists a single deciding authority for the entire purchaseneeds of the company) where coordination takes place, so as to achieve scale of purchasediscounts based upon full-time buying specialist inputs. However, centralized buying usuallylacks the flexibility of responding to local market needs or taking advantage of some timelydiscounts given by the various suppliers such as quantity discounts, annual discounts, anyspecial occasion related sales events etc, or ensuring that good communication takes placebetween the buyers and the store units. Decentralized buying may take place at the locallevel based upon the geographic needs of the target market. A balance between theinconsistency of the store offer and the loss of economies of scale for purchase is requiredand must be ensured. In practice, some retailers structure the buying function with specialistbuyers in one or a few merchandise lines and also generalist buyers who can buy across anumber of lines, which needs less specialist knowledge. The specialists can become expertsin the merchandise areas related to their field and as such can identify the best suppliers assources for the company’s product offer, and can ensure that the control of quality, costand delivery are met.

A new or different type of order necessitates a negotiated contract specifying allaspects of the purchase. Alternatively, where regular orders are already agreed and reorderneeds to take place, there will be a uniform contract with the standard pre-agreed conditionsforming the basis of their agreement. However, the purchase terms should be stipulated inthe contract, whatever is the type of contract. These should involve clear documentation ofaspects such as- delivery date; quantity to be purchased; method of delivery or storage,and who should bear the related charges; price and payment terms including any discount

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for level of order or returns allowed by the retailer; advertising or merchandising supportfrom the supplier; the stage in the process as to the title and ownership responsibility etc.

5. PREPARATION OF SALES BUDGETS

It is critical for the success of a business to constantly work towards improving notonly the efficiency of its employees, but the productivity of the store’s selling space andinventory as well. This can be achieved by using various retail math formulas and calculationsbased on sales.

A retailer’s shop has customers steadily coming through the doors, his employees arebusy and there is the frequent ‘cha-ching’ of the cash register, but how well is his businessreally doing?

One simple way to know if any business is good is to compare current year’s same-store sales data to last year’s sales revenue.

Apart from these steps, sales budget may be prepared by the retailer for forecastinghis sales. Generally sales factor becomes a key factor in majority of cases. Sales budgetis the most important of the budgets, as it is usually the most difficult to forecast. It isusually prepared by a sales manager. The points to be considered while preparing thissales budget are as follows.

• Analysis of the previous year’s sales• Salesman’s assessment• General trade conditions• Availability of funds• Plant capacity• Seasonal fluctuations• Restrictions imposed by the government• Competition and consumer’s preference• Efficiency of advertising

Sales budget must show in terms of finished products, quantities and price ; and it isprepared according to products, territories, periods, types of customer or salesman etc.

Illustration :

A company produces and sells three items : (a) Snow Cream, (b) Talcum Powderand (c) Cold Cream. The Company has divided its market into two Zones : Zone A andZone B. The actual figures for the previous year sales were as under :


NOTES


Zone A Zone BUnit Unit Price Units Unit Price

Rs. Rs.(a) Snow Cream 4,00,000 12.00 2,50,000 12.00(b) Talcum Powder 2,50,000 15.00 3,50,000 15.00(c) Cold Cream 3,00,000 16.00 3,00,000 16.00

For the current year i.e. 2008, it is estimated the sale of Snow cream will go up by10% in Zone B and of Cold cream by 25,000 units in Zone A. The company plans tointroduce a publicity film for Talcum powder in the T.V, network. The budgeted figures forTalcum powder are to be increased by 20% in both the Zones.

The prices of the two creams are to be maintained but for talcum powder, a bonuscut of Re.1 will be announced.

You are required to prepare quantitative-cum-financial budget for sales in the currentyear i.e. 2008.

Solution:

SALES BUDGET (2008)

6. SUMMARY

* Product and merchandise management is a key activity in the management of retailbusiness. It drives the business strategy of the retailer and has immense cost and profitimplications. While product management deals with issues related to the kind of productssold by the retailer, merchandise management concerns itself with the selection of the rightquantity of the product and ensuring its availability at the right place and time. This involvesa careful planning of merchandise mix and its financial implications are reflected in themerchandise budget. The product and merchandise plan is drawn keeping in mind variousfactors that influence shopping behavior and the strategic and cost concerns of the retailer.

* In order to be successful, retailers must make competent decisions over what is to bebought, in what quantities and at what time. The selection and presentation of merchandiseenables a key source of difference to exist which will allow one store to differentiate itselffrom another.

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* Merchandising consists of the activities involved in acquiring particular goods and/orservices and making them available at the places, times, and prices and in the quantity thatenable a retailer to reach its goal.

* Sometimes, it is found that customer loyalty had dropped. It is because, there is noreason for a customer to go across to a shop when it is a foregone conclusion that he/shewill get the same merchandise in any other shop that he/she had found in that particularshop. This is because of merchandise sameness. This merchandise sameness arisesfrom the buyers who were taught to play safe by avoiding risky fashions, to play it cautiouslyby buying from a limited number of standard vendors who sell the same “packages” to allmajor customers, to play it for profit by advertising only the products supported bymanufacturers’ advertising allowances.

* Merchandise management focuses on the planning and controlling of the retailer’sinventories and balances the financial requirements of the company with a strategy formerchandise purchasing. Merchandise management may be defined as ‘planning andimplementation of the acquisition, handling and monitoring of merchandise categories foran identified retail organization’.

* The complexity of modern retail operations often requires the grouping of the buyingprocess into an individual category. In general, a category is an assortment of items thatthe customer would perceive as being substitutes for each other. Category management,working with key brands is a feature of modern retailing. Cobb (1997) explains that at thepoint of purchase, the shop-in-shop concept, traditionally utilized to promote a singlemanufacturer or brand, has been developed to improve category differentiation in thegrocery multiples.

* The various phases in developing a merchandise plan include – marketing considerations,merchandise strategy options, type of customer base, financial considerations andmerchandise assortment search.

* Some of the other important merchandise decisions relating to this plan include – availability,turnover etc. Availability is based upon the seller’s need to ensure that the level of stockrequired meets the demand from his consumer. The higher the level of stockholding, thehigher the level of costs (and working capital), but at the same time, improved stockholdingmay increase sales due to the rapid flow of merchandise.

Inventory turnover concept enables the working out of how long inventory onhand is prior to its being sold. Goods with high inventory turnover will need to be planneddifferently from those with low turnover. This inventory turnover concept enables a storeto operate at a more optimal level.

* Basic stock method of planning inventory (BSM): When the firm has a requirementto maintain a particular level of inventory all the time, it may have to follow the BSM


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method of planning for inventory. Inventory under BSM method meets sales expectationsand at the same time allow for a margin of error, as it tries to avoid customer dissatisfactiondue to stock outs. This method is better suited to a firm with lower turnover or a firm witherratic sales. The main advantage of this method is that stock can be added to over timerather than purchasing the entire lot in advance. The main disadvantage of this method isthat it does not take into consideration the holding costs of stocks.

* The level of beginning of month stock (BOM) for a retailer can be calculated by consideringthe data for a season and working out the BOM as the planned monthly sales plus thebasic stock.

* Percentage variation method (PVM): When stock turnover is higher than 6 or moreannually, another method, percentage variation method (PVM) may be used to determinethe planned stock levels of a retailer. This method is suitable when stock is quite stable andit results in planned monthly inventories that are closer to the monthly average compared toother techniques. If the retailer has fluctuating sales, but do not want to maintain a givenlevel of inventory at all times, this method is highly suitable. This technique assumes thatthe monthly percentage fluctuations from average stock should be half as great as thepercentage fluctuations in monthly sales from average sales. It can be calculated as follows.

* PVM is a better choice when the annual turnover rate is greater than 6 as the results willfluctuate less. If the annual turnover rate is less than 6, BSM method of calculation wouldbe preferred.

* Weeks’ supply method (WSM): The weeks’ supply method (WSM) involves forecastingaverage sales on a weekly rather than monthly basis. The basic assumption of this methodis that the inventory is in direct proportion to sales. This method suits shops/ supermarketswhere sales do not fluctuate in significant amounts and where weekly planning of inventoryis possible. Under this method, calculation of inventory value is based on a predeterminednumber of weeks’ supply which is linked to the desired stock turnover rate.

* Stock to sales method: Another alternate method to use when a retailer wants tomaintain a specified ratio of goods on hand to sales is stock-to-sales method. For this, theretailer has to use beginning of the month sales-to-stock ratio, which informs the retailer asto the amount of inventory required for sustaining that month’s estimated sales. This methodis easy to calculate and can be calculated from a retailer’s own historical results or fromexternal sources which are reliable.

* Other factors which influence the estimation of inventory requirements include the levelof shrinkage, markdowns and employee discounts. These factors will influence both thefinancial and availability aspects of the business. These reductions make the retail value ofthe inventory lower than its beginning balance, and therefore, the estimates should beincluded in the merchandise budget.

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* Shrinkage is the difference between the amount of merchandise which is reported onthe inventory stock system and what is available for sale or on the shelves. This shrinkagemay be due to – shoplifting, employee theft, vendor over billing, distributor theft, paperwork errors, and breakage and spoilage.

* Markdowns imply price reductions of the merchandise which act as a sort of promotion;for special sales periods or for moving sluggish lines, because of damage or soiling ofmerchandise, due to end of range offers, or because of greater price competition fromcompetitors or part of planned reductions and offer value to the employee in working atstore.

* Employee discounts are part of planned reductions and offer value to the employee inworking at the store, which should also be recorded so that they become accountable.

* The Merchandiser is responsible for all the activities (including operational) to be takento realize the strategic objectives of the retail outlet. It is critical for the success of abusiness to constantly work towards improving not only the efficiency of its employees,but the productivity of the store’s selling space and inventory as well.

* The merchandiser’s role in the retail firm includes planning and controlling the stockranges and replenishment. For this, he needs to liaise closely with the retail buyer. He alsoshould have a holistic view of the supply chain of the firm and should have regular interactionswith central functions ranging from management accounting to distribution, and also fromthe top level executive through those operating at store level.

* To be effective, apart from people skills, the merchandiser also needs some technicalskills, such as - advanced numerical capability supported by PC literacy, notably in the useof spread sheets and databases and administrative competence. There are many keyareas to be controlled which relate to the need for attention to detail in order to ensure thatthe plan is always aligned to operational objectives.

* Developing the first stage of the merchandise plan include activities like – i) understandingthe target market groups ii) agreeing regional and branch sales forecasts iii) collectinginformation on competitors and any new branch plans iv) taking into consideration brandingand corporate policy v) agreeing merchandise budget vi) liaison and initial discussion withbuyers etc.

* The qualifications and competencies required for a merchandiser varies from business tobusiness, shop to shop and also between retailer and another retailer. But, there is onecommon and the most important quality a merchandiser should possess, which is – to playthe support role to the buyer.

* Budgeting process is another factor which decides the role of the merchandiser. Duringthe process of Budgeting, the retailer is expected to quantify in financial terms, his objectivesfor the required time period. Once this financial plan or master budget has been devised,it can then be used to monitor the performance of the retail business.


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* Retailers have to buy merchandise that has to be priced at an acceptable market priceand also provides a planned gross margin. There are two values a retailer comes across aspart of this process - the retail value of sales and the cost value based on the purchaseprice of the merchandise. In the early stages, it might be necessary to analyse marketinformation and sales trends in order to produce agreed forecasts which may be incorporatedin to the master budget.

* The merchandise budget is a tool for the financial planning and control of the investmentthe retailer had to make on the inventory he has acquired. The master merchandise budgetwill be required to offer various types of information such as - gross sales projection, stocklevel requirements, retail reduction estimates and expected profit margins etc.

* The merchandiser, as part of his duties, needs to plan for the extent to which demand forvarious product lines fluctuate. He should ensure that the retailer’s capacity to meet thedemand and the actual turnover will meet customer expectations with the minimum ofwastage.

* For forecasting the future demand, the merchandiser has to have intimate knowledge ofcustomers and the type of demand for the product being sold. The variations in the categorylifestyle wherein, the fact that some products sustain demand for longer periods is animportant aspect in deciding up on the merchandise plan.

* A fad product will generate a high level of sales due to a large segment of the populationrequesting the sales team for higher supply of the item. The demand for fad items will lastonly for a short time and perhaps not even for the whole season. Fads are difficult topredict and forecast and quite often, demand exerts a great deal of pressure on distributionchains as demand will always outstrip supply for fad items.

* The demand cycle of fashion products usually lasts for several seasons although salesmay vary from season to season. This demand depends on the type of customer and theproduct categories.

* The staple merchandise will provide continuous demand over an extended life span, ofthe product. Most of the food products and household cleaning items come under thisproduct category.

* Seasonal merchandise is characterized by fluctuations in demand according to the time/season of year. As the staple merchandise offers a reliably repeatable sales history onwhich to base predictions of planned stock, the merchandise manager finds the staplecategory to be the easiest to manage. The inventory system for fads and fashion merchandiserequires much more careful appraisal by the merchandise manager.

* A retailer’s stock range can be described in terms of its width and depth, with the extentof each determined by the respective company policy. This is sometimes termed as theassortment.

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* The width of the stock assortment relates to the number of categories that are found inthe merchandise line and the various generic classes of the product or merchandise whichit carries. A wide and narrow stock assortment is normally where there is little choice inbrands, styles, etc. within an individual range.

* The depth of the stock assortment relates to the sizes, styles, colors, and prices within aparticular generic class of product. There are specialist shops, the niche boutiques, etc,which offer a lot of depth but with a narrow product range.

* The retail offers of each business are substantially different, with the respective stockranges of each being an integral part of their business strategy. The superstore is seekingto charge a premium price for added value as perceived by the target customer. Thispremium should not be visible and the leading operators must be skilled at promoting alimited part of their ranges on a price basis to create this effect. The profitability comesfrom offering a very extensive range of product lines, some with comparatively slow ratesof stock turn, with healthy profit margins. The number of different lines a retailer stocks inhis store is often referred to as the variety of the merchandise mix.

* The extent of the range plays an important role in framing the customer’s perception ofadded value. In the case of a hard discounter, the offer is extremely competitively priced -the key concern of the target customer.

* The merchandiser faces great challenges when he is preparing his range planning. He hasto balance between meeting customer expectations and avoiding wasting resources, whichis not easy.

* The ‘category killer’ is normally a large store that concentrates on one category,- thusmaking it possible for it to carry both a broad assortment and deep selection of merchandise,coupled with low price and moderate service.

* Developing the range planning and merchandise allocation plan requires – i) - Developmentof range planning and merchandise allocation plan requires the following ii) Understandingthe product or service selection process of target consumers iii) Deciding the core andseasonal merchandise iv) Agreeing the range - e.g. style, size and color mix - depth andwidth of assortment of merchandise v) Taking into consideration the sales to stock leveltargets and calculating the optimum level of stock by utilizing one of the stock inventoryplanning methods vi) Relating the range assortment plans to individual stores and possiblepromotional plans vii) Briefing the buyer(s) on agreed source etc.

* The range planning has to take into consideration the space constraints imposed upon bythe merchandise manager. If breadth and depth of assortments are important then thisrequires both stock space as well as display space to separate the merchandise.

* While selecting the source of the supply, there should be some considerations to bemade, such as – the previous sales performance, acceptability of the design or brand


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name, manufacturing and product quality, reliability of delivery and service, assurance ofability to provide further stock if required, and the cost of items.

* Range planning needs to be customer driven and should incorporate the requirements ofthe target customers. The merchandiser has to identify which product attributes are mostimportant to the customer and plan accordingly.

* The depth and width assortment profiles are - narrow and deep, square, and broad andshallow. Some of the factors which needs attention when planning the width and depth ofassortment are - estimated sales and profit performance.

* Many merchandise lines will become more successful if adequate promotional support isgiven. Merchandisers will try to evaluate the significance of offering different types ofassistance with the promotion of various items, which may assume many different formssuch as - advertising allowances, co-operative advertising, free display materials, in-storedemonstrations or videos, consumer sales inducements - such as special offers, couponredemptions, free samples, and contests etc. Apart from the above mentioned promotionalassistance, if any major advertising is carried out by the manufacturer to support the brand,or the product, it will be an important consideration.

* Store grading can be related to the gross sales forecast. The gross sales projection forthe company requires disaggregating across the portfolio of the stores. Hence, each storewill have its own budgeted gross sales figure. Part of the merchandiser’s job is, to see thatthe merchandise plan for the store will meet the projected target sales figure. The shelf ordisplay space is the key yet limited selling medium. That is why, usually, store grading isconducted on the basis of floor sales area.

* Store grading can become a major source of controversy between store operationsmanagement and the central merchandise functions. The connection between the storesand the buying function is an important part of the merchandiser’s remit. It involves makingsure that all relevant local characteristics are accommodated in the merchandise planning,and at the same time, realizing the efficiency benefits that accrue from store grading.

* Development of control mechanisms of the merchandise plan requires – i) An understandingof the comparative frequency of store visits of the target market groups, based upon theirbrowsing, or items purchased by them ii) Forecasting of sales of range items and theirprofitability iii) Monitoring the stock levels and the availability of new stocks and theirreplenishment levels iv) Assessing the value of merchandise through shrinkage, markdownsand employee reductions v) Liaising with the buyer(s) to discuss the merchandiseperformance figures vi) Expanding or reducing merchandise categories, based upon therespective sales performances.

* The next step in merchandise management is – to monitor the sales performance, whichis to be done by the merchandiser, after devising the range plan to provide for the nature of

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the merchandise, deciding the spread of stores in the company portfolio and accountingfor the variations in demand over time. Then, the actual sales performance will be comparedagainst the budgeted performance.

* If a category is underperforming sales wise or its sales figure is lower than the anticipatedfigure, the retailer has to entertain the prospect of markdowns (reduction in the normalselling price of a retailer). In this markdown decision-making process, the merchandiserplays a very important role.

* Retail profitability stems from both the gross margins realized on each product line andfrom the frequency with which the business is able to turn the product line over, that is, therate of stock turn. Therefore, by marking-down a product line in such a way that it’s sellingprice is reduced, the retailer is accepting a lower gross margin in return for an anticipatedincrease in the rate of stock turn or sales.

* While deciding on markdowns, the merchandiser’s skill and expertise is to know whenand by how much to markdown a product or a product line in order to achieve the desiredeffect. The markdown policy of the retailer will try to support his positioning strategy. Sothe merchandiser has to strike a balance between stimulating the sales or stock turn withprice reductions, and not undermining the perception of added value that the retailer has topreserve in order to command its ‘full’ price on the remainder of the stock range.

* The retailer has to negotiate the purchase of his merchandise and its terms, when all thedifferent aspects of the merchandise have been assessed and the source, through evaluation,has been evaluated and carefully chosen. This can be carried out through centralizedbuying (where there exists a single deciding authority for the entire purchase needs of thecompany) where coordination takes place, so as to achieve scale of purchase discountsbased upon full-time buying specialist inputs. Decentralized buying may take place at thelocal level based upon the geographic needs of the target market.

* A new or different type of order necessitates a negotiated contract specifying all aspectsof the purchase. Alternatively, where regular orders are already agreed and reorder needsto take place, there will be a uniform contract with the standard pre-agreed conditionsforming the basis of their agreement. However, the purchase terms should be stipulated inthe contract such as- delivery date; quantity to be purchased; method of delivery or storage,and who should bear the related charges; price and payment terms including any discountfor level of order or returns allowed by the retailer; advertising or merchandising supportfrom the supplier; the stage in the process as to the title and ownership responsibility etc.

* It is critical for the success of a business to constantly work towards improving not onlythe efficiency of its employees, but the productivity of the store’s selling space and inventoryas well. This can be achieved by using various retail math formulas and calculations basedon sales.


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* One simple way to know if any business is good is to compare current year’s same-storesales data to last year’s sales revenue. Apart from these steps, sales budget may be preparedby the retailer for forecasting his sales.

* Sales budget is the most important of the budgets, as it is usually the most difficult toforecast. It is usually prepared by a sales manager. The points to be considered whilepreparing this sales budget are – i) Analysis of the previous year’s sales ii) Salesman’sassessment iii) General trade conditions iv) Availability of funds v) Plant capacity vi) Seasonalfluctuations vii) Restrictions imposed by the government viii) Competition and consumer’spreference and ix) Efficiency of advertising.

7. SHORT QUESTIONS

1. What do you mean by analysing the merchandise performance?2. Explain the process of basic stock method of planning inventory.3. Explain the process of percentage method of planning inventory.4. Explain the process of weeks supply method of inventory planning.5. Explain the process of stock to sales method6. What do you mean by range planning in retail management?7. What do you mean by assortment of merchandise?8. What do you mean by store grading?9. What is a sales budget?

8. LONG QUESTIONS

1. Explain in depth how merchandise performance is analysed? What methods areavailable to do so?

2. Explain the various factors which influence the estimation of inventory requirements ina retail shop.

3. Explain in detail the – weeks supply method and percentage variation methods ofplanning and controlling inventory levels.

4. What is a sales budget? How is it prepared? What points are to be considered whilepreparing a sales budget?

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UNIT IV

PROFIT MEASUREMENTS1. INTRODUCTION

Retailers usually come across situations where they have to revise (drop or add)various stock keeping units (SKUs), vendors, or departments during merchandisemanagement. These decisions impact the profitability of retail outlets to a great extent.

In the words of Paul T. McGurr,(Ashland University), in his article ‘Retail grossprofit: A stage by stage analysis’, concluded that the determination of a store’s final achievedgross profit is the responsibility of not only corporate management which sets overall profitguidelines but also of the activities of purchasing, merchandising and store operationsfunctions, each of which has a specific impact on the final achieved gross profit.

To determine the accurate value of the gross profit of a retail store, its physicalinventories must be taken into account. However, because of the costs of physical inventoriesand the difficulties in converting the physical retail inventory to accurate historic cost,estimations are almost always used in the gross profit determination and the financialstatement recording of a retail organization’s gross profit. Different methods are used byretail organizations to develop estimations. These differences make it difficult to comparegross profit percentages of retail organizations. Gross profit percentage comparison isfurther complicated because different retail organizations include different cost centers andcost components in their accounting for gross profit. For these reasons, analysts must takecare when attempting to compare gross profit percentages based on financial statementpresentation alone.

2. LEARNING OBJECTIVES


1. Understand the meaning of financial performance measure in a retail organization2. Understand the various measures which calculate or measure the profitability of a

retail outlet such as – sales per square meter, sales per employee etc.3. Understand the various elements of retail cost and profitability4. Understand the various components of retail cost5. Understand the meaning of margins and markups in retail business6. Understand the meaning of customer service cost and benefits

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3. RETAIL PERFORMANCE MEASURES (Financial)

High inventory levels, long hours, expensive fixtures, extensive customer services andwidespread advertising may lead to higher revenues. But at what cost? If a store paysnight shift workers a 25 percent premium, is being open 24 hours per day worthwhile (dohigher sales justify the costs and add to overall profit)?

3.1 PROFIT PLANNING:

A profit and loss (income) statement is a summary of a retailer’s revenues and expensesover a given period of time, usually a month, quarter, or year. By having frequent statements,a firm can monitor progress toward goals, update performance estimates, and revisestrategies and tactics.

In comparing profit and loss performance over time, it is crucial that the same timeperiods be used (such as the third quarter of 2006 with the third quarter of 2005) due toseasonality. Some fiscal years may have an unequal number of weeks (53 weeks one yearversus 51 weeks another). Retailers that open new stores or expand existing stores betweenaccounting periods should also take into account the larger facilities. Yearly results shouldreflect total revenue growth and the rise in same-store sales.

A profit and loss statement consists of these major components:-

* Net sales – The revenues received by a retailer during a given period after deductingcustomer returns, markdowns, and employee discounts.

* Cost of goods sold – The amount of retailer pays to acquire the merchandise soldduring a given time peri9od. It is based on purchase prices and freight charges, lessall discounts (such as quantity, cash and promotion).

* Gross profit (margin) – The difference between net sales and the cost of goodssold. It consists of operating expenses plus net profit.

* Operating expenses - The cost of running a retail business.* Taxes – The portion of revenues turned over to the federal, state, and or local

government.* Net profit after taxes – The profit earned after all costs and taxes have been

deducted.

3.2 ASSET MANAGEMENT

Each retailer has assets to manage and liabilities to control. A balance sheet itemizesa retailer’s assets, liabilities and net worth at a specific time – based on the principle thatassets = liabilities + net worth.

Assets are any items a retailer owns with a monetary value. Current assets are cashon hand (or in the bank) and items readily converted to cash, such as inventory on handand accounts receivable (amounts owned to the firm). Fixed assets are property, buildings(a store, warehouse, and so on), fixtures, and equipment such as cash registers and trucks;


NOTES


these are used for a long period. The major fixed asset for any retailers is real-estate.Unlike current assets, which are recorded at cost, fixed assets are recorded at cost lessaccumulated depreciation. Thus, records may not reflect the true value of these assets.Many retailing analysts use the term hidden assets to describe depreciated assets, suchas buildings and warehouses that are noted on a retail balance sheet at low values relativeto their actual worth.

Liabilities are financial obligations a retailer incurs in operating a business. Current liabilitiesare payroll expenses payable, taxes payable, accounts payable (amounts owned tosuppliers), and short-term loans; these are generally repaid over several years.

A retailer’s net worth is computed as assets minus liabilities. It is also called owner’sequity and represents the value of a business after deducting all financial obligations.

In operations management, the retailer’s goal is to use its assets in the manner providingthe best results possible. There are three basic ways to measure those results: net profitmargin, asset turnover, and financial leverage.Net profit margin is a performance measure based on a retailer’s net profit and net sales:

Net profit margin = Net profit after taxes Net sales

To enhance its net profit margin, a retailer must either raise gross profit as a percentageof sales or reduce expenses as a percentage of sales. It could lift gross profit by purchasingopportunistically, selling exclusive products, avoiding price competition through excellentservice, and adding items with higher margins. It could reduce operating costs by stressingself-service, lowering labor costs, refinancing the mortgage, cutting energy costs, and soon. The firm must be careful not to lessen customer service to the extent that sales andprofit would decline.

Asset turnover is a performance measure based on a retailer’s net sales and total assets

Asset turnover = Net sales Total assets

To improve the asset turnover ratio, a firm must generate increased sales from thesame level of assets or keep the same sales with fewer assets. A firm might increase salesby having longer hours, accepting web orders, training employees to sell additional products,or stocking better-known brands. None of these tactics requires expanding the assetbase. Or a firm might maintain its sales on a lower asset base by moving to a smaller store,simplifying fixtures (or having suppliers install fixtures), keeping a smaller inventory andnegotiating for the property owner to pay part of the costs of a renovation.

By looking at the relationship between net profit margin and asset turnover, return onassets (ROA) can be computed:

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Return on Assets = Net Profit margin x Asset turnover

Return on Assets = Net Profit after taxes x Net sales Net sales Total assets

= Net Profit after taxes Total assets

Financial Leverage is a performance measure based on the relationship between aretailer’s total assets and net worth;

Financial Leverage = Total Assets Net worth

A retailer with a high financial leverage ratio has substantial debt, while a ratio of 1means it has no debt – assets equal net worth. If the ratio is too high, there may be anexcessive focus on cost-cutting and short-run sales so as to make interest payments, netprofit margins may suffer, and a firm may be forced into bankruptcy if debts cannot bepaid. When financial leverage is low, a retailer may be overly conservative – limiting itsability to renovate and expand existing stores and to enter new markets. Leverage is toolow if owner’s equity is relatively high; equity could be partly replaced by increasing shortand long term loans and / or accounts payable. Some equity funds could be taken out ofa business by the owner (stock holders if a public firm)

3.3 THE STRATEGIC PROFIT MODEL

The relationship among net profit margin, asset turnover and financial leverage isexpressed by the strategic profit model, which reflects a performance measure known asreturn on net worth (RONW). The strategic profit model can be used in planning orcontrolling assets. Thus, a retailer could learn that the major cause of its poor return on networth is weak asset turnover or financial leverage that is too low. A firm can raise its returnon net worth by lifting the net profit margin, asset turnover or financial leverage. Becausethese measures are multiplied to determine return on net worth, doubling any of themwould double the return on net worth.

Return on net worth = Net profit after taxes x Net sales x Total assets Net Sales Total Assets Net worth

(or) Return on net worth = Net profit margin x Asset turnover x Financial leverage.

Because financial performance differs from year to year, caution is advised in studyingthese data. Furthermore, the individual components of the strategic profit model must beanalyzed, not just the return on net worth.


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3.4 OTHER KEY BUSINESS RATIOS

Other ratios also measure the success or failure of a retailer in achieving his performancegoals. These ratios deal mainly with the overall financial performance of a retail business.They include some of the most common standards for measuring profitability, growth,liquidity and costs.

3.4.1 Measures of Profit and Growth

Key Measures

a. Percent Profitability

Net Profit This Period x 100 Net Sales this Period

This ratio can be used for setting profitability targets, forecasting the desirable targetsbased on the past data or comparing data belonging to different operating periods. Ahigher percentage implies higher profitability and vice versa. As far as net profit is concerned,it may be expressed as either before or after interest and taxes, as long as there is consistencyin the method chosen. To allow for comparison over different time periods, any extraordinarygains such as sale of a major asset etc, or losses, or any non-operational income andexpenses should be removed.

b. Percent Profit Growth

Net Profit This Period x 100 Net Profit Last Period

This ratio helps a retailer to track the growth of his company’s profit over a timeperiod. It can be used to compare annual results or to check monthly performance againstan earlier month. Net profit can be defined as before or after interest and taxes figure andbefore or after extraordinary items.

c. Percent Sales Growth

Net Sales This Period x 100 Net Sales Last Period

This ratio may be used to track the growth of sales of a company /division / departmentover a time period. This can be calculated in either current or constant rupee value. Constantrupee value includes an adjustment to correct for the impact of inflation on costs andprices. Some retailers use the Consumer Price Index (CPI) or specific retail sector indiceswith which they have become familiar.

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d. Percent Return on Investment

Net Profit after Tax x 100 Average Shareholders’ Equity

Return on Investment (ROI) is one of the most common performance measures usedin retailing. It gives the percentage return on capital invested in the business. It also providesa standard for comparing such an investment with the cost of investment capital and withthe rate of return offered by competing investment opportunities. For small businesses, theowners’ intake (salary and bonus if applicable), may greatly affect this ratio.

e. Percent Return on Sales

Gross Margin x 100 Net Sales

This percentage indicates how much return is being generated through sales beforetaking into account the operating expenses not directly related to the merchandise. A dropin this percentage could mean problems with pricing, inventory management or markdowns.

3.4.2 Measures of Cash Flow and Liquidity

1. Key Measures

a. Working Capital

= Current Assets - Current Liabilities

This measure gives the rupee value of working capital available. For many retailers,this measure is a useful means of approximating their cash flow. Many retailers also find ituseful to monitor their cash positions relative to average day’s cash needs.

b. Short-Term Liquidity

Current Assets Current Liabilities

Expressed as number of times, this measure reflects a company’s immediate debtpaying ability / liquidity. It indicates the retailer’s ability to pay short-term debts with assetsthat can be converted to cash during the period in which the claims become due. Alsoknown as the “current ratio”, the total increases as short-term liquidity improves. Thegeneral norm is, a ratio of 2 to 1 or more is good.


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2. Additional Measures

a. Quick or Acid Test Ratio

Current Assets – Inventory Current Liabilities

Expressed also as number of times, this measure indicates the short-term liquidityposition of a business, adjusted for the value of inventory at cost. The number increases asshort-term liquidity improves. Retailers use it when circumstances prevent selling inventoryquickly in return for cash or short-term receivables. Usually a ratio of 1 to 1 is taken toimply that the firm is liquid and can cover short term debt.

b. Days Outstanding In Receivables

Average Accounts Receivable x 365 Days Total Credit Sales

This measure provides the number of days of credit sales are tied up at any one pointof time in accounts receivable or the number of days it will take to collect the credit sales.It gives an indication of credit policies and the effectiveness of collection procedures. Anunusual increase in this measure suggests that receivables should be examined carefully,either individually or by age. If most sales are on credit, a collection period of one-third ormore over normal terms implies slow moving / turning receivables.

c. Days Outstanding In Payables

Average Accounts Payable x 365 Days Total Credit Purchases

This measure gives the number of days of credit purchases represented by the averageaccounts payable level, or the number of days it takes to pay for goods purchased oncredit. An increase in this ratio may indicate deterioration in payment on time of currentobligations and signals the possibility of problems in payable procedures. This compareshow a retailer pays suppliers relative to volume transacted. A figure above the industryaverage indicates that a firm relies on suppliers to finance operations.

3.4.3 Measures of Costs

1. Key Measures

a. Operating Costs as Percent of Net Sales

Operating Costs x 100 Net Sales

This percentage is used to track operating costs over a period of time. Retailersusually use it to compare cost performances on an annual or monthly basis. Unexpected

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increases in this measure could mean that operating costs are getting out of hand and thatproblems may exist in the components of the operating cost category.


a. Administrative Costs as Percent of Net Sales

Total Administration Costs x 100 Net Sales

This measure is expressed as a percentage, and retailers use it to determine ifadministrative costs are in proportion to net sales. Like the preceding ratio, it can becalculated for different time periods. Although time spent on administrative tasks, such aspayroll management, depends on the size and type of operation, a significant increase inthis ratio might mean that administrative procedures need reassessment.

b. Occupancy Cost as Percent of Net Sales

Occupancy Cost x 100 Net Sales

This percentage gives the cost of the current premises as a percentage of sales. Withthe exception of percentage clauses in leases, this cost is usually fixed relative to changes inthe sales volume. Any increases in this ratio may indicate that space costs have risen to alevel where renegotiation or relocation should be considered.

3.5 SALES AND PROFITABILITY

Sales and profitability are considered as the standard measures for measuring thesuccess of a retail outlet. The same can also be used to measure the successful spacemanagement of the retail outlet. The measures of retail space performance indicate theproductivity of retail space. The three commonly used retail space performance measuresare – (i) sales per square meter or profit per square meter (ii) sales per linear meter orprofit per linear meter and, (iii) sales per cubic meter or profit per cubic meter.

3.5.1. Sales per square meter or profit per square meter or sales per square foot

This method measures the retail space performance on the basis of sales / profitsaccording to the area of floor space covered. This measure is convenient to use when onlya single layer of merchandise is displayed and various types of fixtures are placed. This isa common measure for fashion retailing.

The sales per square foot data is most commonly used for planning inventory purchases.It can also roughly calculate return on investment (ROI) and it is used to determine rent ona retail location. When measuring sales per square foot, it should be kept in mind thatselling space does not include the stock room or any area where products are not displayed.


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Total Net Sales ÷ Square Feet of Selling Space = Sales per Square Foot of SellingSpace

Sales per Square Foot = Sales (typically annual results) # of square feet (store or department)

3.5.2 Sales per linear meter or profit per linear meter or Sales per Linear Footof Shelf Space

This method measures the productivity of the retail space on the basis of incomegenerated by footage of shelf space allocated. This measure is more suitable for the storesusing multi-shelved fixtures such as a gondola or racks. It takes into consideration thelinear meter value of a shelf rather than the area of space exposed in terms of the heightvalue of a shelf. A retail store with wall units and other shelf space may want to use salesper linear foot of shelf space to determine a product or product category’s allotment ofspace.

Total Net Sales ÷ Linear Feet of Shelving = Sales per Linear Foot

3.5.3 Sales per cubic meter or profit per cubic meter.

This method measures retail space performance on the basis of length, width, anddepth of the fixtures placed in the store. This measure is necessarily used by retailers in thefrozen food business or those who place dump bins on the retail floor.

Space-to-sales ratio, turn rate, and gross margin ROI analyses can help create themost profitable planogram for the retailer. In effect, the performance of retail space dependson the levels of sales, the profitability of the merchandise place within the space, and thevalue of the retail space.

3.5.4 Sales by Department or Product Category

Retailers selling various categories of products will find the sales by department tooluseful in comparing product categories within a store. For example, a woman’s clothingstore can see how the sales of the lingerie department compared with the rest of the store’ssales.

Category’s Total Net Sales ÷ Store’s Total Net Sales = Category’s % of Total StoreSales

3.6 MEASURING PRODUCTIVITY OF STAFF

The performance measures of staff or employee standards deal with a retailer’semployee efficiency. They include methods of developing performance targets and waysof evaluating the -volume of work employees are handling. Labor cost typically represents15 to 25 per cent of net sales and 40 to 70 per cent of total operating costs. Thus

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improvements in the productivity of employees, and of each rupee spent on labor, canhave a significant impact on retail profitability.

3.6.1 Sales per Transaction

Also known as sales per customer, the sales per transaction number tells a retailerwhat is the average transaction in rupee value. A store dependant on its sales clerks tomake a sale will use this formula in measuring the productivity of staff.

Gross Sales ÷ Number of Transactions = Sales per Transaction

3.6.2 Sales per Employee

When factoring sales per employee, a retailer need to consider whether the store hasfull time or part time workers. Then, he has to convert the hours worked by part-timeemployees during the period to an equivalent number of full-time workers. This form ofmeasuring productivity is an excellent tool in determining the amount of sales a businessneeds to bring in when increasing staffing levels.

Net Sales ÷ Number of Employees = Sales per Employee

(or)

Net Sales per FTE (Sales) Employee = Net Sales Total FTE (Sales) Employees

Expressed in rupee value, this measure represents the average sales generated byeach “Full-Time Equivalent” (FTE) sales employee.

These are just a few of the ways to measure a retail store’s performance. As retailerstrack these numbers month after month and year after year, it becomes easier to understandwhere the sales are generated, by which employees and how the store’s merchandisingcan maximize sales growth. Some of the other popular retail performance measures includethe following.

3.6.3 Labor Productivity

Labor Productivity = Total Labor Costs x 100 Net Sales

This percentage measures labor productivity by tracking the labor costs incurred toachieve a given sales volume. This measure can also be applied solely to sales employees.

3.6.4 Gross Margin Per FTE (Sales) Employee

Gross Margin per FTE (Sales) Employee = Gross Margin Total FTE (Sales) Employees


NOTES


Expressed in rupee value, this ratio indicates the gross profit generated per employee,and establishes a measure against which to compare a sales employee’s performance. Thisshould not be the only measure of an employee’s performance, but it does provide astarting point for closer examination. This measure can be adapted to apply to all employeesor solely to buyers.

3.6.5 Suppliers per Buyer

Suppliers per Buyer = Total Suppliers Total FTE Buyers

This measure gives an average of the number of suppliers each full-time buyer in acompany is dealing with. There is no ideal number, but by comparing the workload ofindividual buyers to this measure, management can see how well the buying load is beingdistributed among purchasing staff. Research has shown that an average buyer’s ability tomake appropriate decisions about buying declines as the number of suppliers increases.This measure should be looked at in conjunction with the number of stock-keeping units(SKU’s) the average buyer handles, as well as with the replenishment cycles involved.

3.7 CALCULATING RETAIL SELLING SPACE

What size building or store does a retailer need? When planning his retail store, theamount of selling space will be one of the most important factors in selecting a location. Itis can also be one of the most difficult to determine.

As with any new business, most of the assumptions will be based on industry researchand comparing similar stores operating in similar locations. To get an estimate on howmuch selling space a retail store must have, the planned sales volume must be divided bythe industry’s sales per square foot.

Sales Volume ÷ Sales per Square Foot = Selling Space

Besides selling space, a retailer must remember to factor in extra square feet for anoffice area, stockroom, storage, and/or bathrooms. Although a retailer may want roomto grow, he should keep the size of the building close to his store’s needs. A big storetakes more

4. OVERALL FINANCIAL AND ADMINISTRATIVE STANDARDS

4.1 Marketing and Merchandising Standards

Some of the performance measures are designed to help the retailer to monitor theeffectiveness of his marketing and merchandising practices. Many of these measures canbe applied to an entire store or a single department on an hourly, daily, weekly or seasonalbasis. They include methods for determining a retailer’s ability to convert potential customersinto buyers as well as measures for assessing customer satisfaction and traffic flow.

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4.2 MEASURES OF MARKETING PERFORMANCE

1. Key Measures

a. Transactions per Customer

Number of Transactions x 100 Customer Traffic In

This measure is also known as the “percentage yield rate” or the “walk to buy ratio”.A low percentage for this measure could mean that promotional activities are not beingrealized in sales, or that overall sales effort needs assessment. This percentage reflects theretailer’s ability to turn a potential customer into a buyer. Unless automatic countingmechanisms are recording customer traffic, periodic surveys of customer traffic are requiredto arrive at a representative figure for this measure. Information on transactions can begathered from cash register tapes which keep track of the time of the sale, or by havingstaff record the number of transactions for selected periods of time.

b. Returns to Net Sales

Total Returns and Allowances x 100 Net Sales

= Total Returns and Allowances x 100 Net Sales

This measure gives the relationship between the value of returned goods and allowancesas a percentage of net sales. This percentage is an indication of customer satisfactionexpressed in the form of a percentage. An increase in this percentage provides an earlywarning that the quality of the merchandise may need to be re-examined or that customers’expectations are not being met.


a. Transactions per Hour

Number of Transactions Number of Hours

The number expressed by this measure helps the retailer in keeping track of thenumber of transactions he is carrying out per hour, day, week or season. Hourly variationsin sales activity can be an important factor in setting/fixing the store hours and staff schedules,particularly for cashiers. The information can be collected with the help of cash registerswhich keep track of the time of the sale or by having staff periodically record the numberof transactions for selected periods of time.


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b. Sales per Transaction

Net Sales Number of Transactions

This measure gives the rupee value of the average sales, net of returns and allowances.This number can be used to study the sales trends over time, or in combination with othermeasures, to decide whether a high volume of sales is more important than a high rupeevalue on each sale.

c. Hourly Customer Traffic

Customer Traffic In Number of Hours

Many retailers use this measure to track total customer traffic per hour, day, week orseason. This measure can be applied to the entire store or a single department in the store,to schedule hours and establish staff levels. Unless automatic counting mechanisms arerecording customer traffic, periodic surveys of customer traffic are required to arrive at arepresentative figure.

4.3 MEASURES OF MERCHANDISING PERFORMANCE

1. Key Measures

a. Markdown Goods Percentage

Net Sales at Markdown x 100 Total Net Sales

This measure gives the percentage of sales generated by marked-down merchandise.If the ratio increases, it suggests a closer look at merchandising practices, particularlypricing. Markdowns may be symptoms of other problems, such as poor buying, advertisingor store layout.

b. Percent Devoted To Merchandising Costs

Total Merchandising Costs x 100 Gross Margin

This measure gives the percentage of margin on sales, accounted for by merchandisingactivities, such as buying and advertising. It helps the retailer in monitoring the total cost ofmerchandising.

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a. Percent Utilization of Discounts

Value of Discounts Taken x 100 Total Purchases

This measure is gives the relationship between the value of discounts and the value ofthe total purchases made expressed as a percentage. Retailers usually use this measure todetermine the extent to which their operations, or any individual buyer, has been takingadvantage of supplier discounts on merchandise purchased. Similar measures can beconstructed to assess the use made of other discounts or allowances.

5. INVENTORY STANDARDS

Investment in inventory typically represents 40 to 60 per cent of a retailer’s totalassets. Hence, any improvements in inventory management can have a significant impacton retail profitability. The performance measures related to this aspect, which will help aretailer in monitoring his efficiency at managing inventory, are given below.

5.1 MEASURES OF INVENTORY

1. Key Measures

a. Inventory Turnover Rate

Net Sales Average Retail Value of Inventory

Expressed as number of times, this ratio indicates how often the inventory of adepartment, store or a firm, is sold and replaced in a given period of time. Some retailersalso use the ratio “Cost of Goods Sold” divided by “Average Value of Inventory at Cost”.Both can be calculated for any time period. When either of these ratios declines, thepossibility exists that inventory is excessive.

b. Percent Inventory Carrying Costs

Inventory Carrying Costs x 100 Net Sales

This is a very important measure which has been gaining lot of popularity in the recentyears, with the rise in inventory carrying costs, particularly interest rates. Retailers use thismeasure to track the percentage of their net sales represented by the fixed costs ofmaintaining their inventory.


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c. Gross Margin Return on Inventory

Gross Margin Average Value of Inventory

Expressed in rupee value, the “Gross Margin Return on Inventory” (GMROI)compares the margin on sales with the original cost value of the merchandise to yield areturn on merchandise investment. Inventory can be valued at retail or at cost, but formany retailers, inventory valued at retail is more accessible than inventory valued at cost;however, using inventory valued at retail will not necessarily give an accurate indication ofinvestment cost.

GMROI can be dramatically altered by changes in inventory turnover and gross margin.


a. Shrinkage to Net Sales

Actual Inventory - Book Inventory x 100 Net Sales

Retailers use this control ratio to determine the percentage of net sales they are losingdue to shrinkage. It does not indicate the cause of the shrinkage, but it does express theseriousness of the problem.

6. FACILITIES STANDARDS

These performance measures are designed to help retailers track the value they aregetting from their expenditure on space. These ratios can be calculated with either Imperialor metric measures.

6.1 MEASURES OF SPACE PERFORMANCE

1. Key Measures

a. Occupancy Cost per Square Meter Selling Space

Occupancy CostSquare Meters of Selling Space

Expressed in rupee value, this measure translates occupancy cost into rupee valueper unit of selling space. It gives an estimate of the amount of gross margin rupees each unitof selling space must generate just to cover occupancy costs, before consideration oflabor, inventory, marketing and other costs. For a multi-unit retailer it is a helpful measureto use when comparing the performance of several locations. It can be calculated for anytime period, such as a year or a month.

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b. Sales per Square Meter

Net Sales Square Meters of Selling Space

Expressed in rupee value, this measure can be used to compare alternate uses ofspace involving different product lines, or to compare the performance of differentdepartments or stores using a common standard. This ratio will vary by type of merchandiseand merchandising methods.


a. Percent Selling Space

Square Meters Selling Space x 100 Square Meters Total Space

Retailers use this measure to calculate the percentage of total space used for sales.This ratio will vary by type of merchandise and merchandising methods; for example,catalogue showrooms have little selling space, whereas shoe stores have little non-sellingspace. Changes over time, or in relation to competitors, can help track the efficiency withwhich space is being used.

7. ESTABLISHING A PERFORMANCE MEASUREMENT PROGRAM

As a business man, the retailer has to design and establish an efficient performancemeasurement program to ensure that his performance goals are achieved. There are varioussteps that he can take to establish a performance measurement program. The varioussteps are as follows.

Step I: The Most Important Measures for the Firm must be selected

The retailer is in the best position to decide which performance measures will providethe information most relevant to his business. He should select the most important measuresfirst and can add the others later on. The objective is to achieve an overall assessment ofhis business.

Step II: Information must be gathered

Calculation of each performance measure requires specific information. First, theretaile must establish what information is required and then, using his own records, heshould assemble what information is readily available in a form that allows performancemeasurement. If the information is not available, a decision has to be made on whether thefigures can be retrieved at a cost that does not exceed the value of the information to him.For example, it may be productive to change his point-of-sale procedures to gatherinformation on transactions for later analysis.


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Step III: Performance Indicators must be calculated

Once the retailer has assembled his information, he has to calculate those performancemeasures already selected as the most suitable to his needs and circumstances. Becauseperformance measures can be individually defined, it is important to maintain consistencyin the way he performs the calculations. This will provide meaningful comparisons overtime.

Where averages are referred to, the objective is to arrive at a representative figurefor the period being considered. For example, sometimes the averaging of opening andclosing figures will not achieve this; it may be necessary to take the average of monthlyfigures.

Step IV: The Results must be Interpreted

Performance measures are not absolute numbers; they acquire meaning in the contextof comparison and analysis. Comparison with other measurement figures puts a retailer’sown performance into perspective; analysis leads to an understanding of the reasons for agiven level of performance.

He should compare the results of his measures with other measures, which are selectedeither from within his own business or from related industry figures. When a comparison isbeing made with industry figures, he should choose points of comparison that are analogousto his own, and has to ensure that the definitions he had used in calculating the performancemeasures are consistent with his own.

With a comparison set of reference points available, the retailer can begin to analyzehis own performance. His analysis should follow like - What does it mean if sales persquare meter have declined? Is it necessarily a bad sign? Perhaps his gross margin persquare meter has increased because of changes in merchandise assortment or pricingprocedures. Perhaps sales have not declined as much as they might have if, for example,he had not increased promotional activities earlier in the year. If his own analysis of aproblem fails to give him a clear understanding of his own situation, he should consider thevalue of doing additional calculations using the ADDITIONAL MEASURES. These aredesigned to focus on specific areas of operation. He must not, however, sacrifice his overallperformance assessment for the sake of a detailed analysis of minor procedures. Thepurpose is to arrive at an understanding of the broad performance and trends in his ownbusiness.Step V: The retailer has to set performance goals

Setting performance goals for the future provides a basis upon which to developstrategy of action. In selecting a set of goals, the retailer has to follow certain steps. He hasto deal with critical problems first and should set up a measurement function as part ofregular management to give him a consistent feedback. Over time, he has to broaden the

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scope of his data collection and analysis to make his performance assessment increasinglycomprehensive. Performance goals reflect the conditions of the present and should be setwithin a range of possibility that allows room for change. A creative and flexible approachto setting goals based on careful assessment is the objective.

8. SALES MANAGEMENT

8.1 TRACKING OF KEY INDICATORS

Retail is about information ... the right information at the right time. Here are some ofthe key performance measures that a retailer must understand and use to successfullymanage his business.

(i) Sales per Hour

Sales per Hour = Total Sales (Store or Individual) / Total Hours Worked

This is the most important performance statistic that the retailer can track. It is ameasure of his productivity and provides him with a comparative sales volume both for hisstore and his staff. In addition, it also gives him a clear indication of his wage cost. Thehigher his SPH, the better is the sales picture.

For example, if total sales are Rs.5,000 this week and there are 80 total hoursscheduled for the store, the Sales Per Hour for the store is Rs.62.50 this week (Rs5,000/80 hours). The impact of selling an additional Rs.5 per scheduled hour shall result in asales volume of Rs.5,400 (Rs.5000 + Rs5 * 80 hours), which represents an 8% increase.Some retailers might ask themselves what it would take to produce that extra Rs.5 in eachscheduled hour. But, for most of the retailers, tracking the SPH itself results in better salesperformance.

The retailer next can try to determine his daily and weekly average SPH, not only forthe store, but also for each individual. He should always strive to move the average upwards,because, it must be remembered that the higher the SPH, the better. (Although, there doescome a point where customer service will suffer if SPH becomes too high for the store.)

There are only two ways to increase the Sales per Hour:

1. Increase sales.2. Decrease scheduled hours.

Proper Sales Management allows a retailer to increase his staff sales and, in theprocess, improve his Sales per Hour.


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(ii) Average Sale

Average Sale = Total Sales in rupees / Total Transactions

This statistic indicates how much each customer buys from the retailer, on an average.It is so critical that it will allow him to see the moving price points and will also give himinformation about his ability to sell multiple items.

For example, if weekly sales are Rs. 5,000 and there were a total of 100 transactions,the average sale is Rs.50 (Rs.5, 000/100). Then, the retailer tries to calculate the impacton his overall sales if he could get an extra Rs.3.00 from each customer. Then he finds thatthe increase in average sales from Rs.50 to Rs.53 brings the total sales figure up to Rs.5,300.The question then facing the retailer will be, how would he go about getting that extra Rs.3from each customer?

In certain such occasions, the retailer has got a few options like the following.

1. He can increase his prices (Not advisable, but sometimes it can be done withoutlosing business.)

2. He can sell more items to each customer.3. He can sell more expensive items to the customer.

(iii) Items per Sale

Items per Sale = Total Items Sold / Total Transactions

This ratio tells the retailer, the average number of items each customer buys from him.It is an indication of the retailer’s ability to sell multiple items to a customer. This is importantto every retailer and should be included in his sales goals.

When a retailer begins to track and move his items per sale upwards, the impact onhis bottom line is tremendous. For example, if he has sold 150 items this week to 100customers, his IPS would be 1.5 (150 items sold/100 transactions). By increasing hisitems Per Sale to 1.8 from the current 1.5, he would have achieved a sales increase of20% (assuming the average price of the additional items remained the same).

There are a few methods to increase a retailer’s sale per Item per Sale:

1. The retailer can train his staff to add-on more items.2. The retailer can merchandise his store so that accessory and complementary items

are displayed next to each other.3. The retailer can make better use of the cash counter as a selling area.4. The retailer can use multiple-item pricing (e.g. 3 for Rs.11.97, instead of Rs.3.99

each).5. The retailer can track each individual’s IPS and compare it to the store average

IPS.

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(iv) Conversion Rate

Conversion Rate = Total Transactions / No. of People Entering Store

This will tell a retailer how effective he is at turning prospects into customers. If he cankeep an accurate count of the number of people entering his store every day, then heshould track conversion rate. His ability to sell to more of the existing traffic is critical intoday’s marketplace.

For example, if he is selling to 5 out of every 10 people who enters his store (50%)and he moves that up by one person to 60% (6 out of 10), that represents a full 20%increase in sales.

Here are some typical conversion rates one might expect to find:Ladies wear regional shopping center 5 to 10%Pharmacy 75 to 85%Furniture store 5%Jewellery store, regional shopping center 3 to 8%Big box clothing store 30 to 40%

A retailer may not be able to track his conversion rate without the installation of abasic traffic counting system. If the purchase of such a system is not in his immediatefuture, he should try doing spot checks throughout the month to get a better feel for hisperformance in the area. Conversion rate will tell him more about how effective he is as aretailer than any other statistic. If customers are buying when they come in, he must bedoing something right. One simply need to understand exactly why they are buying fromthe retailer, and use that information to convince one or two more people (out of every tenwho enters his store) to do the same thing.

Improving his conversion rate involves every major aspect of a retailer’s business.For this, he must examine:

Staff performance and salesmanshipPricing practicesInventory selectionMarketing messageStore layoutService qualityStore presentationSignage

This list is not exhaustive, and can probably be expanded for his specific store. Thepoint is that if he knew what his conversion rate was (and it’s probably a lot lower than hethought), he could begin to find ways to improve it.


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9. PERFORMANCE EVALUATION

Multiple methods of measuring retail performance that is essential to understandingand growing his business.Measuring the productivity of his store and various departments.A method for projecting and controlling his cash flow.

All retailers know that Sales are the lifeblood of their business. Unfortunately, thereality is that measuring Sales alone is not nearly enough. Retail has become a slick andsophisticated business. There are retailers who play the game merely for the cash flow,using it to leverage other investment opportunities. Profitability for them is secondary.

To compete, even the smallest retailers need to create and manage a series of reports,statistics and measurements for their stores. There are a myriad of Key PerformanceIndicators(KPIs) that he need to understand, track and manage if he is going to succeed atgrowing his own business.

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10. REFERENCE GUIDE FOR RETAIL PERFORMANCE INDICATORS

10.1. SALES STATISTICS


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10.2 INVENTORY STATISTICS

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10.3 PAYROLL STATISTICS

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10.4 FINANCIAL STATISTICS


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10.5 CUSTOMER SERVICE TERMINOLOGY

11. MEASURING THE RETAIL SHOP’S PRODUCTIVITY

Measuring the productivity of the retail store and its various departments is based ontwo key statistics:

11.1 PROFIT PER SQUARE FOOT

Gross Profit (Rs)No. of square feet

This is the same type of ratio as Sales per Square Foot, except this time it’s based onprofitability, which is more important. It might be just a little tougher for some retailers tocalculate.

11.2 SALES PER LINEAR FOOT

Fixture/Department SalesNo. of linear feet

This statistic is usually used for merchandise displayed vertically along walls or, insome cases, gondolas.

Once the retailer has measured his productivity in each department, he can determinewhich ones are doing well and which are not. This allows him to decide those that warrantexpansion and those that might just as well be eliminated, and take the most feasible decisions.

Knowing the facts is an essential part of retail management. If the retailer becomes alittle more scientific and detail-oriented, he can produce far superior results.

12. CASH FLOW FORECASTING

Cash flow projections are an essential part of running any business. In retail, wherecash flow is often more important than profitability, this is especially true.

A cash flow forecast is designed to predict as accurately as possible when cash willbe received (typically through sales) and when payments are needed to be made (expenses).

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If the retailer hopes to stay in business and get along with his banker at the same time,he has to complete a cash flow projection each and every month.

There are numerous inexpensive software programs on the market that facilitate cashflow forecasting. To illustrate, an example of a very basic and simple cash flow forecastingform is given below. While simplified, it will provide the retailer with an understanding ofthe mechanics of completing a cash flow forecast.

12.1 CASH FLOW PROJECTION

Summary

1. Analyze every number possible for the retail store.2. Recognize that information is the key to, not just understanding the business, but

also growing it.3. Do a cash flow forecast for the business every month.

12.2 CASE STUDY: PERFORMANCE EVALUATION

Following is the year end income statement for Murugan’s Department Store, alongwith sample benchmark figures for the industry.


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* Income Statement: Murugan’s Department Store Ltd. January 31.

* Note: Using the sample “Industry Average” as a benchmark, Murugan’s stacks uppretty close in most areas. The big differences are in administrative expense and occupancycosts. It’s a good thing they own the building and have no mortgage, or they would belooking at a substantial loss instead of this small profit. Now if they can increase sales and/or gross margin without greatly increasing expenses, they will see a pretty nice bottom line.

* Exercise 1: If Murugan’s were able to increase sales by 5% and gross margin by 3/4%over the next year, while holding total expenses to a 1/2% increase, what would the profitbefore tax be?

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* Answer: Profit before tax = Rs. 69,946.

The 5% increase in sales = Rs.1,418,760. The 3/4% increase in gross margin = 42.45%or Rs.602,264. The 1/2% increase in operating expenses = Rs.532,318 (Rs.1,418,760 x42.45% - Rs.532,318 = Rs.69,946). This represents a whopping 107% increase over theprevious year’s profit before tax of Rs.33,780.

* Cash Flow Forecasting for Murugan’s case

Cash flow projections are necessary for forecasting future cash requirements. A retailercan sleep better in the nights knowing that he has sufficient funds to handle the cash neededin the upcoming months. A cash flow forecast is designed to predict when the company willreceive cash and when payments must be made.

Back in month No.9, Murugan’s was considering opening a women’s wear conceptin a local mall. You volunteered to prepare a cash flow analysis to determine what the“cash required” consequences for this new venture would be. To start, you had to getmanagement to agree on some key figures and assumptions.

* Key Figures/Assumptions (for new location cash flow analysis):

1. Sales Projection: Rs.300,0002. Operating costs: Rs.12,000 per month (rent, wages, utilities advertising, taxes, etc.)3. Construction & Fixturing Costs: Rs.60,000 (terms 50% 30 days, 50% 60 days)4. Opening Inventory: Rs.50,000 (to be received in March, terms 50% 30 days, 50%

60 days)5. Stock Turn: 4 times per year (This means our average inventory will be Rs.75,000 at

retail value per month, which equals approximately Rs.37,500 at cost value, assuminga 50% markup.)

6. Terms on goods purchased in season: 30days (Merchandise received in March ispaid for in April.)


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7. Opening Date: 1st week in April.

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* Cash Flow Projection for Murugan’s case

* Cash Flow Projection* Exercise 2

A cash flow projection is a combination of many assumptions (i.e. sales forecasts, requiredinventory, etc.) and facts (i.e. rents, operating costs etc.). If any mistake is made in calculatingany of these, it can have a great effect on the cash reserves or bank balance. To illustratethis and better understand the formulas used in cash flow development, try your hand atthe following skill testing questions.1. If the operating costs are underestimated by Rs.500 per month (and everything else

is constant), what will the “Bank Balance” be at the end of March?2. If construction cost terms were negotiated to be 1/3 30 days, 1/3 60 days and 1/3 90

days, what would May’s bank borrowing requirements be changed to?3. If half of the opening inventory came from existing stock (which was already paid

for):a. What would be the highest month for bank borrowing?b. How much would it be?

4. If the average terms for fill- in orders during the season were 60 days instead of 30days, what would May’s bank borrowing requirements be?

5. If the sales projections are missed by an average shortfall of 5% per month (but stillfill-in purchases were adjusted to keep up the desired inventory levels), what wouldthe high month of November’s bank borrowing requirements be?


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* Answers:

1. -Rs.80,000: Rs.500 x 12 months = Rs.6000. Added to the Rs.74,000 in bank borrowing = -Rs.80,000.2. -Rs.84,000.3. a. November b. -Rs.85,000.4. -Rs.94,0005. -Rs.1,12,250.

13. COMPONENTS OF RETAIL COST

Just like any other business, in retail business also, the same components of cost –Material cost, labor cost and overhead costs will be there. And more or less, the format ofcost sheet also remains the same.

13.1 SPECIMEN OF A COST SHEET

Cost sheet of …..for the month of …….

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14. COST FACTORS AND PRICING

Every component of a service or product has a different, specific cost. Many smallfirms fail to analyze each component of their commodity’s total cost, and therefore fail toprice profitably. Once this analysis is done, prices can be set to maximize its profits andeliminate any unprofitable product or service.

Cost components include material, labor, and overhead costs:

• Material costs are costs of all materials found in the final product. For example,the wood used in the manufacturing of a chair is a direct material.

• Labor costs are the costs of the work that goes into the manufacturing of a product.An example would be the wages of all production-line workers producing a certaincommodity. The direct labor costs are derived by multiplying the cost of labor perhour by the number of personnel-hours needed to complete the job.

• It must be remembered that, the rupee value of the fringe benefits also must beused along with the hourly wage, which might include social security, workers’compensation, unemployment compensation, insurance, retirement benefits, etc.

• Overhead Costs are any costs not readily identifiable with a particular product.These costs include indirect materials, (e.g. supplies) utilities, depreciation, taxes,rent, advertising, transportation and insurance. Overhead costs also cover indirectlabor costs, such as clerical, legal and janitorial services. Apart from these, shipping,handling, and/or storage costs also are to be added along with the other costcomponents. Part of the overhead costs must be allocated to each serviceperformed or product produced. The overhead rate can be expressed as apercentage or an hourly rate. This is a complex task. It is best to consult with anexpert in this area. It is important to review the overhead costs periodically. Chargesmust be revised to reflect inflation and higher benefit rates. It’s best to project thecosts quarterly, including increased executive salaries and other projected costs.

14.1 EXAMPLE OF FIGURING THE COSTS AND PROFITS FOR ACONSULTANT SERVICE

A consultant, might most likely price his service by the hour. He must remember tocharge for an adequate number of hours. Travel time is usually listed as an extra charge.It’s unlikely that all his time will be billed to clients. Therefore, hourly or contract fees mustbe set high enough to cover expenses during slow periods. That is why one-half of the totalnormal working hours for a given year are used in figuring overhead rates. Hence, as far aspossible, he must try to get long-term, monthly, or contract assignments whenever possible.

14.2 COST OF GOODS SOLD / COST OF SALES

The cost of goods sold for a retail business includes the direct cost associated withmanufacturing /procuring the merchandise for the business. These direct costs includetransportation costs and costs which are directly related to producing or purchasing the


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goods. In essence, the cost of goods sold for a retailer represents the price he has paid toproduce or acquire the products for sale.

14.3 EXPENSES

In a retail business, expenses may be of two types – interest and operating expenses.Interest expenses refer to interest payments that have to be paid periodically for the financingprovided by lenders or creditors. Operating expenses refer to expenses incurred by theretailer for his day-to-day operations.

Further going into detail, operating expenses may be sub divided into three maincategories – administrative expenses (examples – salaries of staff other than sales people,office supplies, postage, electricity charges etc), general expenses (examples – rent, utilities,other miscellaneous expenses) and selling expenses (examples – salaries of sales staff,sales commissions etc).

Generally, expenses of department stores are higher than those of discount storesand warehouse clubs etc. This might be because, the department stores are located inprime areas where rent and other operational expenses are very high. Apart from this, toprovide for a high level of customer service, department stores incur expenses for retainingexperienced sales people and maintaining good ambience in the store. The expenses of adiscount store are lower because they are located in less expensive areas and they offerminimal customer services.

15. MARGINS AND MARKUPS

A markup is commonly used in a bidding situation as a factor in the form of a percentor decimal multiplied by a direct cost or combination of direct costs. For instance, alldirect costs (materials, sales tax, direct labor and labor burden, equipment andsubcontractors) might be increased by 25% to achieve the final selling price for a job.Mathematically it plays out as follows:

Rs.10,000 (total direct costs, TDC for short) X 1.25 (or 125%) = Rs.12,500

The markup applied to all direct costs is 25%. So the process is, if the retailer desiresto have a 25% gross profit margin (GPM) for his business at the end of the year, he has tomark up all of his direct bid costs by 25%.

A margin, on the other hand, is slightly different. To achieve a 25% margin, themathematical formula differs slightly from that for the markup. The total costs are dividedby 1 minus the desired margin:

Rs.10,000 (TDC) / (1-.25) = Rs.10,000/.75 = Rs.13,333

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Notice the difference in the final price for the two examples. The second has actuallyachieved a 25% margin on top of all costs (if the margin amount is divided by the price, theresult is .25 or 25%).

Rs.3,333/13,333 = .25 or 25%

However, when the first example is used and the markup amount is divided by theprice…there will be a loss of 5%.

Rs.2,500/12,500 = .2 or 20%.

We can conclude in this case that a 25% markup translates into a true 20% margin.

Markups and margins are different as commonly used in the construction and serviceindustry. Mathematical misconceptions ranging from simple quirks in arithmetic to faultyassumptions in complex indirect G&A overhead recovery cost formulas can cause theuninitiated estimator to overstate or understate important cost components in a bid. Accuratecost estimating is the real issue.

Once properly understood and used, markups and margins can provide useful toolsfor the contractor to not only analyze individual bids, but they can also help analyze marketsand market trends. These tools can not only help assure that today’s jobs are bid accuratelyand competitively, they can help ensure that the contractor will be around to bid ontomorrow’s jobs as well.

They are terms given to the way a business works out how much money it will makeor has made on a product. It’s the difference between the buying price and the selling priceas a percentage. Mark ups and margins are all about percentages.

Wikipedia defines a Markup as a term used in marketing to indicate how much theprice of a product is above the cost of producing and distributing the product. It can beexpressed as a fixed amount or as a percentage. There are numerous variations of each.

In general markup may be understood as the difference (reflected in both rupee valueand the percentage) between what a retailer will pay for a product and its retail price (whatthe end user will pay. For example, if Britannia company sells a bag of cookies to thegrocery store for Rs.100 and the grocery store charges Rs.150, the markup is Rs.50 perbag.

Gross margin on the other hand is the percentage of profit derived from a transaction.Both the manufacturer and the retailer expect their own gross margins in all transactions.Retailers often have minimum margin requirements. So the calculation of markups andmargins will help them decide their price for their products or services. These minimumrequirements vary from retailer to retailer, but, in most cases, a retailer expects a minimumgross margin of 50%, which is often referred to as a ‘Key stone’ markup. An easy way to


NOTES


figure out this number is to double the wholesale price. For example, if the product is soldwholesale to the retailer for Rs.5, the retailer will need to charge the consumer Rs.10 toachieve a keystone markup. When it is worked backwards to figure out a price that givesthe retailer the desired margin, the keystone expectation of 50% is always helpful as astarting point. High end specialty retailers often require an even higher gross margin thanthe keystone 50%.

16. CUSTOMER SERVICE COST AND BENEFITS

The total cost of providing service to the customers has many components whichinclude the following.

In case of new customer acquisition,

16.1 COST OF AN AVERAGE SALES CALL

It is a cost to the retailer and includes the expenditure spent on account of salesmen’ssalary, their sales commission, the other employee benefits and expenses offered to them.This average sales call cost should be multiplied with the number of sales calls to be madeto win a customer. This is the cost of customer acquisition. Compared to this, customerlife time value must be calculated, which is done by multiplying the annual customer revenuewith the average number of loyal years with the retailer’s profit margin. Whenever the costof acquisition is less than the customer life time value, it is a feasible activity to be undertakenby the retailer.

16.2 COST OF KEEPING A CUSTOMER

The cost of keeping a customer include – the employees’ salaries, employee benefits,cost of the employee training, time spent on serving of the customer(s), infrastructuralcosts, other overhead costs such as – rent of the store (if rented), electricity expenditure,water costs, cost of the brochures distributed, cost of advertisements etc. In case of retainingthe current customer, the retailer’s costs may include the following.

17. SUMMARY

* Retailers usually come across situations where they have to revise (drop or add) variousstock keeping units (SKUs), vendors, or departments during merchandise management.These decisions impact the profitability of retail outlets to a great extent.

* In the words of Paul T. McGurr,(Ashland University), in his article ‘Retail grossprofit: A stage by stage analysis’, concluded that the determination of a store’s final achievedgross profit is the responsibility of not only corporate management which sets overall profitguidelines but also of the activities of purchasing, merchandising and store operationsfunctions, each of which has a specific impact on the final achieved gross profit.

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* To determine the accurate value of the gross profit of a retail store, its physical inventoriesmust be taken into account. However, because of the costs of physical inventories and thedifficulties in converting the physical retail inventory to accurate historic cost, estimationsare almost always used in the gross profit determination and the financial statement recordingof a retail organization’s gross profit. Different methods are used by retail organizations todevelop estimations. These differences make it difficult to compare gross profit percentagesof retail organizations. Gross profit percentage comparison is further complicated becausedifferent retail organizations include different cost centers and cost components in theiraccounting for gross profit. For these reasons, analysts must take care when attempting tocompare gross profit percentages based on financial statement presentation alone.

* High inventory levels, long hours, expensive fixtures, extensive customer services andwidespread advertising may lead to higher revenues. But at what cost? If a store paysnight shift workers a 25 percent premium, is being open 24 hours per day worthwhile (dohigher sales justify the costs and add to overall profit)?

* A profit and loss (income) statement is a summary of a retailer’s revenues and expensesover a given period of time, usually a month, quarter, or year. By having frequent statements,a firm can monitor progress toward goals, update performance estimates, and revisestrategies and tactics.

* A profit and loss statement consists of these major components:- (1) Net sales (ii) Grossprofit (margin) (iii) Operating expenses (iv) Taxes (v) Net profit after taxes

* Each retailer has assets to manage and liabilities to control. A balance sheet itemizes aretailer’s assets, liabilities and net worth at a specific time – based on the principle thatassets = liabilities + net worth.

* Net profit margin is a performance measure based on a retailer’s net profit and netsales. To enhance its net profit margin, a retailer must either raise gross profit as a percentageof sales or reduce expenses as a percentage of sales. It could lift gross profit by purchasingopportunistically, selling exclusive products, avoiding price competition through excellentservice, and adding items with higher margins. It could reduce operating costs by stressingself-service, lowering labor costs, refinancing the mortgage, cutting energy costs, and soon. The firm must be careful not to lessen customer service to the extent that sales andprofit would decline.

* Asset turnover is a performance measure based on a retailer’s net sales and totalassets. To improve the asset turnover ratio, a firm must generate increased sales from thesame level of assets or keep the same sales with fewer assets. A firm might increase salesby having longer hours, accepting web orders, training employees to sell additional products,or stocking better-known brands. None of these tactics requires expanding the assetbase. Or a firm might maintain its sales on a lower asset base by moving to a smaller store,


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simplifying fixtures (or having suppliers install fixtures), keeping a smaller inventory andnegotiating for the property owner to pay part of the costs of a renovation.

* By looking at the relationship between net profit margin and asset turnover, return onassets (ROA) can be computed.

* Financial Leverage is a performance measure based on the relationship between a retailer’stotal assets and net worth

* A retailer with a high financial leverage ratio has substantial debt, while a ratio of 1 meansit has no debt – assets equal net worth. If the ratio is too high, there may be an excessivefocus on cost-cutting and short-run sales so as to make interest payments, net profit marginsmay suffer, and a firm may be forced into bankruptcy if debts cannot be paid. Whenfinancial leverage is low, a retailer may be overly conservative – limiting its ability to renovateand expand existing stores and to enter new markets. Leverage is too low if owner’sequity is relatively high; equity could be partly replaced by increasing short and long termloans and / or accounts payable. Some equity funds could be taken out of a business bythe owner (stock holders if a public firm)

* The relationship among net profit margin, asset turnover and financial leverage is expressedby the strategic profit model, which reflects a performance measure known as return onnet worth (RONW). The strategic profit model can be used in planning or controllingassets. Thus, a retailer could learn that the major cause of its poor return on net worth isweak asset turnover or financial leverage that is too low. A firm can raise its return on networth by lifting the net profit margin, asset turnover or financial leverage. Because thesemeasures are multiplied to determine return on net worth, doubling any of them woulddouble the return on net worth.

* Other ratios also measure the success or failure of a retailer in achieving his performancegoals. These ratios deal mainly with the overall financial performance of a retail business.They include some of the most common standards for measuring profitability, growth,liquidity and costs.

* Percent Profitability: This ratio can be used for setting profitability targets, forecastingthe desirable targets based on the past data or comparing data belonging to differentoperating periods. A higher percentage implies higher profitability and vice versa. As far asnet profit is concerned, it may be expressed as either before or after interest and taxes, aslong as there is consistency in the method chosen. To allow for comparison over differenttime periods, any extraordinary gains such as sale of a major asset etc, or losses, or anynon-operational income and expenses should be removed.

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* Percent Profit Growth: This ratio helps a retailer to track the growth of his company’sprofit over a time period. It can be used to compare annual results or to check monthlyperformance against an earlier month. Net profit can be defined as before or after interestand taxes figure and before or after extraordinary items.

* Percent Sales Growth: This ratio may be used to track the growth of sales of a company/division / department over a time period. This can be calculated in either current or constantrupee value. Constant rupee value includes an adjustment to correct for the impact ofinflation on costs and prices. Some retailers use the Consumer Price Index (CPI) or specificretail sector indices with which they have become familiar.

* Percent Return on Investment: Return on Investment (ROI) is one of the mostcommon performance measures used in retailing. It gives the percentage return on capitalinvested in the business. It also provides a standard for comparing such an investment withthe cost of investment capital and with the rate of return offered by competing investmentopportunities. For small businesses, the owners’ intake (salary and bonus if applicable),may greatly affect this ratio.

* Percent Return on Sales: This percentage indicates how much return is being generatedthrough sales before taking into account the operating expenses not directly related to themerchandise. A drop in this percentage could mean problems with pricing, inventorymanagement or markdowns.

* Measures of Cash Flow and Liquidity: These measures may be of two types. Theyare – (1) Key Measures include – (a) Working Capital (b) Short-Term Liquidity: (2)Additional Measures include (a) Quick or Acid Test Ratio (b) Days Outstanding inReceivables (c) Days Outstanding In Payables

* Measures of Costs: These measures are of two types. They are – (1) Key Measure,which include – (a) Operating Costs as Percent of Net Sales (2) Additional Measureswhich include – (a) Administrative Costs as Percent of Net Sales (b) Occupancy Costas Percent of Net Sales

* Sales and profitability: Sales and profitability are considered as the standard measuresfor measuring the success of a retail outlet. The same can also be used to measure thesuccessful space management of the retail outlet. The measures of retail space performanceindicate the productivity of retail space. The three commonly used retail space performancemeasures are – (i) sales per square meter or profit per square meter (ii) sales per linearmeter or profit per linear meter and, (iii) sales per cubic meter or profit per cubic meter,(iv) Sales by Department or Product Category


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* Measuring Productivity of Staff: The performance measures of staff or employee standardsdeal with a retailer’s employee efficiency. They include methods of developing performancetargets and ways of evaluating the -volume of work employees are handling. There areapproximately 5 measures which deal with this topic. They are – (a) Sales per Transaction(b) Sales per Employee, (c) Sales per employee, (d) Gross margin per FTE (sales)employees, (e) Suppliers per buyer.

* Calculating Retail Selling Space: What size building or store does a retailer need? Whenplanning his retail store, the amount of selling space will be one of the most importantfactors in selecting a location. It is can also be one of the most difficult to determine.

* Overall Financial and Administrative Standards: overall financial and administrativestandards may be related to either marketing or merchandising. Hence, there are twostandards in existence, which are – (i) Marketing and Merchandising Standards (ii) Measuresof Marketing Performance- Under these measures, again there are two sub standards– (a) Key Measures (Transactions per Customer, Returns to Net Sales) and (b)Additional Measures (Transactions per Hour, Sales per Transaction, HourlyCustomer Traffic)

* Measures of Merchandising Performance: These measures are related to theperformance of the merchandise. Here also there are two major measures – (i) KeyMeasures, which include Markdown Goods Percentage, Percent Devoted toMerchandising Costs and (ii) Additional Measures, which include Percent Utilizationof Discounts.

* Inventory Standards: Investment in inventory typically represents 40 to 60 per cent ofa retailer’s total assets. Hence, any improvements in inventory management can have asignificant impact on retail profitability. The performance measures related to this aspect,which will help a retailer in monitoring his efficiency at managing inventory, are – (i) Measuresof Inventory, (i) Key Measures, which include Inventory Turnover Rate, PercentInventory Carrying Costs, Gross Margin Return on Inventory, and (ii) AdditionalMeasures, which include Shrinkage to Net Sales.

* Facilities Standards: These performance measures are designed to help retailers trackthe value they are getting from their expenditure on space. These ratios can be calculatedwith either Imperial or metric measures. Ex: - Measures of Space Performance – (i)Key Measures, which include Occupancy Cost per Square Meter Selling Space,Sales per Square Meter, and (ii) Additional Measures, which include PercentSelling Space.

* Establishing a Performance Measurement Program: As a business man, the retailerhas to design and establish an efficient performance measurement program toensure that his performance goals are achieved. There are various steps that he

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can take to establish a performance measurement program. The various stepsare – (i) Step I: The Most Important Measures for the Firm must be selected; (ii)Step II: Information must be gathered, (iii) Step III: Performance Indicators mustbe calculated, (iv) Step IV: The Results must be Interpreted, (v) Step V: The retailerhas to set performance goals.

* Sales Management activity includes many things such as – (i) Tracking of Key Indicators,which include - (i) Sales per Hour, (ii) Average Sale, (iii) Items per Sale, (iv) ConversionRate.

* Performance Evaluation: A retailer has to measure his performance by using variousmethods available in order to ensure his attaining his goals.

* All retailers know that Sales are the lifeblood of their business. Unfortunately, the realityis that measuring Sales alone is not nearly enough. To compete, even the smallest retailersneed to create and manage a series of reports, statistics and measurements for their stores.There are a myriad of Key Performance Indicators(KPIs) that he need to understand,track and manage if he is going to succeed at growing his own business.

* Reference guide for Retail Performance Indicators: retail performance indicators can bebuilt for – Sales statistics, Inventory statistics, Payroll Statistics, Financial Statistics andCustomer Service Terminology.

* Measuring the retail shop’s Productivity: Measuring the productivity of the retail storeand its various departments is based on three key statistics: Profit per square foot andsales per linear foot.

* Cash Flow Forecasting: Cash flow projections are an essential part of running anybusiness. In retail, where cash flow is often more important than profitability, this is especiallytrue. A cash flow forecast is designed to predict as accurately as possible when cash willbe received (typically through sales) and when payments are needed to be made (expenses).

* Cash Flow Projection: While projecting the cash flows, a retailer has to analyze everynumber possible for the retail store, recognize that information is the key to, not justunderstanding the business, but also growing it and Do a cash flow forecast for the businessevery month.

* A cash flow projection is a combination of many assumptions (i.e. sales forecasts, requiredinventory, etc.) and facts (i.e. rents, operating costs etc.). If any mistake is made in calculatingany of these, it can have a great effect on the cash reserves or bank balance.

* Components of retail cost: Just like any other business, in retail business also, the samecomponents of cost – Material cost, labor cost and overhead costs will be there. Andmore or less, the format of cost sheet also remains the same.


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* Cost factors and pricing: Every component of a service or product has a different,specific cost. Many small firms fail to analyze each component of their commodity’s totalcost, and therefore fail to price profitably. Once this analysis is done, prices can be set tomaximize its profits and eliminate any unprofitable product or service. Cost componentsinclude material, labor, and overhead costs.

* Cost of goods sold / cost of sales: The cost of goods sold for a retail business includesthe direct cost associated with manufacturing /procuring the merchandise for the business.These direct costs include transportation costs and costs which are directly related toproducing or purchasing the goods. In essence, the cost of goods sold for a retailerrepresents the price he has paid to produce or acquire the products for sale.

* Expenses: In a retail business, expenses may be of two types – interest and operatingexpenses. Interest expenses refer to interest payments that have to be paid periodicallyfor the financing provided by lenders or creditors. Operating expenses refer to expensesincurred by the retailer for his day-to-day operations.

* Further going into detail, operating expenses may be sub divided into three main categories– administrative expenses (examples – salaries of staff other than sales people, officesupplies, postage, electricity charges etc), general expenses (examples – rent, utilities,other miscellaneous expenses) and selling expenses (examples – salaries of sales staff,sales commissions etc).

* Generally, expenses of department stores are higher than those of discount stores andwarehouse clubs etc. This might be because, the department stores are located in primeareas where rent and other operational expenses are very high. Apart from this, to providefor a high level of customer service, department stores incur expenses for retainingexperienced sales people and maintaining good ambience in the store. The expenses of adiscount store are lower because they are located in less expensive areas and they offerminimal customer services.

* Margins and Markups: A markup is commonly used in a bidding situation as a factor inthe form of a percent or decimal multiplied by a direct cost or combination of direct costs.For instance, all direct costs (materials, sales tax, direct labor and labor burden, equipmentand subcontractors) might be increased by 25% to achieve the final selling price for a job.

* A margin, on the other hand, is slightly different. To achieve a 25% margin, the mathematicalformula differs slightly from that for the markup. The total costs are divided by 1 minus thedesired margin

* Markups and margins are different as commonly used in the construction and serviceindustry. Mathematical misconceptions ranging from simple quirks in arithmetic to faultyassumptions in complex indirect G&A overhead recovery cost formulas can cause theuninitiated estimator to overstate or understate important cost components in a bid. Accuratecost estimating is the real issue.

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* Once properly understood and used, markups and margins can provide useful tools forthe contractor to not only analyze individual bids, but they can also help analyze marketsand market trends. These tools can not only help assure that today’s jobs are bid accuratelyand competitively, they can help ensure that the contractor will be around to bid ontomorrow’s jobs as well.

* They are terms given to the way a business works out how much money it will make orhas made on a product. It’s the difference between the buying price and the selling price asa percentage. Mark ups and margins are all about percentages.

* In general markup may be understood as the difference (reflected in both rupee valueand the percentage) between what a retailer will pay for a product and its retail price (whatthe end user will pay.

* Gross margin on the other hand is the percentage of profit derived from a transaction.Both the manufacturer and the retailer expect their own gross margins in all transactions.Retailers often have minimum margin requirements. So the calculation of markups andmargins will help them decide their price for their products or services. These minimumrequirements vary from retailer to retailer, but, in most cases, a retailer expects a minimumgross margin of 50%, which is often referred to as a ‘Key stone’ markup. An easy way tofigure out this number is to double the wholesale price. High end specialty retailers oftenrequire an even higher gross margin than the keystone 50%.

* Customer service cost and benefits: The total cost of providing service to the customershas many components which include – (In case of new customer acquisition), Cost of anaverage sales call and (in the case of an existing customer) the cost of keeping the customer.

* Cost of an average call represents a cost to the retailer and includes the expenditurespent on account of salesmen’s salary, their sales commission, the other employee benefitsand expenses offered to them. This average sales call cost should be multiplied with thenumber of sales calls to be made to win a customer. This is the cost of customer acquisition.Compared to this, customer life time value must be calculated, which is done by multiplyingthe annual customer revenue with the average number of loyal years with the retailer’sprofit margin. Whenever the cost of acquisition is less than the customer life time value, itis a feasible activity to be undertaken by the retailer.

* The cost of keeping a customer include – the employees’ salaries, employee benefits,cost of the employee training, time spent on serving of the customer(s), infrastructuralcosts, other overhead costs such as – rent of the store (if rented), electricity expenditure,water costs, cost of the brochures distributed, cost of advertisements etc. In case of retainingthe current customer, the retailer’s costs may include the following.


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18. SHORT QUESTIONS

1. Explain the concept of strategic profit model.2. What do you mean by profit planning in retailing?3. Explain the concept of sales per square meter and sales per employee.4. How do you measure the space performance of a retail shop?5. What is cash flow forecast?6. What are the components of retail cost?7. How do you forecast the costs and profit for a consultant?8. Explain the term cost of goods sold.9. What are margins and markups in retail business?10. Explain the concept of cost of a sales call.

19. LONG QUESTIONS

1. Explain in detail the various financial retail performance measures.2. Write a note on – measures of profit and growth; measures of cash flow and liquidity

and measures of costs.3. Write a note on sales and profitability of a retailer.4. How do you measure the productivity of retail staff?5. How do you measure the market performance of a retail outlet?6. How do you measure the merchandising performance?7. Explain in detail the various steps in establishing a performance measurement program?8. How do you measure the productivity of a retail shop?9. Explain with an example the cash flow forecasting done by a retailer.10. Give the specimen of a cost sheet.

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UNIT V

FINANCIAL STATEMENTS1. INTRODUCTION

Accounting has been termed as the language of business. The basic function ofaccounting thus is to communicate the operating results of the business to the stake holdersand share holders of a business.

Even for a retail business also, accounting plays a major role in aiding the retailer toevaluate his business performance. This performance evaluation helps a retailer in framinghis growth strategies and plans of action. The basic process of accounting remains thesame for both a manufacturer and a retailer, even though one is in the first step of thesupply chain and the other is in the last step. Both of them follow in general the sameaccounting concepts and conventions, except for some minor differences.

Knowledge of bookkeeping is highly important to people who are engaged in anykind of mercantile activities. As every retail shop deals with never ending flow of cash andtransactions, there is a great need to establish efficient accounting systems to monitor andrecord the huge financial data. The business analysts have to look at numerous entries fromevery angle to ensure the profitability of the existing business. In such a situation, flaws intransactions can affect the profitability of the retail business, and hence, the retailer has toestablish a precise retail accounting system.

Since majority of the retailers follow single entry system, a day book may be maintainedby the retailer / accountant to keep record of every sold entity. For shopkeepers day bookis the most accurate way to manage their personal account. Daybooks are easily manageableand exhibit true state of accounts with every person with whom the firm has any dealing oncredit. A busy place like a retail shop demands extra concern and precision as severalfinancial activities take place at the same time. In spite of great attentiveness by shopowners, retail businesses often face the problems of flawed accounting data. Retailaccounting someway carries more cluttered transactions; accounting professional who tallyevery transaction on daily basis find day book a better way to make record keepingsimpler. It provides a retailer with a convenient method of monitoring daily sales as well asstock available. In case of newly launched products, often companies offer a good incentive

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to shopkeepers for achieving target sale. A daybook also helps a shopkeeper inaccomplishing this profitable task as it avail him a comprehensive detail about the sale ofevery individual product.

In retail accounting, there are many things that need to be analyzed regularly as ithelps in managing the day-to-day business and decision making on every aspect. It includesmaintaining records such as inventory, creditor book, defaulter book, sales books andprofit and loss for the month. These records are further used to prepare the final personalaccount. If the retailer is dealing with multiple wholesalers at a time, then he must makenote of every receipt and payment in his cash book. Particulars of the cash book includedefault payments also, which helps a retailer in deciding on reliability of wholesalers andagency representatives.

2. LEARNING OBJECTIVES


1. Understand what are the various financial accounting concepts and conventions2. Know the various records followed in a retail shop3. Understand the meaning and utility of branch account and joint venture accounting4. Understand the process of preparation of financial statements5. Understand the meaning of VAT6. Understand the various types of audit and auditing procedure7. Develop an idea about the various accounting software packages available in the

market.

3. FINANCIAL ACCOUNTING CONCEPTS AND PRINCIPLES:

Accountancy principles (gaap – generally accepted accounting principles)

Accounting principles, rules of conduct and action are described by various terms such asconcepts, conventions, tenets, assumptions, axioms, postulates, etc.

3.1 ACCOUNTING CONCEPTS

The term ‘Concept’ is used to mean necessary assumptions and ideas which arefundamental to accounting practice. The various accounting concepts are as follows:

• Business Entity concept : For accounting purposes, the proprietor of an entrepriseis always considered to be separate and distinct from the business which he/shecontrols

• Dual aspect concept : Every business transaction involves two aspects – a receiptand a payment. i.e, every debit has an equal and corresponding credit. The dualaspect concept is expressed as : Capital + Liabilities = Assets. This is known as ‘theaccouting equation’.

• Going concern concept :Under this assumption, the entreprise is normally viewedas a going concern. It is assumed that the entreprise has neither the intention nor the


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necessity of liquidation of of curtailing materially the scale of its operations. That iswhy assets are valued on the basis of going concern concept and are depreciated onthe basis of expected life rather than on the basis of market value.

• Accounting period concept : ‘Accounting year’ is the period of 12 months forwhich accounts are to be prepared under the Companies Act and Banking RegulationAct.

• Money measurement concept : In accounting, every event or transaction whichcan be expressed in terms of money is recorded in the books of accounts. Thisconcept doesnot record any fact or happening, however important it is to the business,in the books of accounts if it cannot be expressed in terms of money. And as per thisconcept, a transaction is recorded at its money value on the date of occurance andthe subsequent changes in the money value are conveniently ignored.

• Historical Cost concept : The underlying idea of cost concept is – I) asset isrecorded at the price paid to acquire it, that is, at cost and ii) this cost is the basis forall subsequent accounting for the asset. Fixed assets are shown in the books ofaccounts at cost less depreciation. Current assets are periodically valued at costprice or market price whichever is less.

• Revenue recognition concept : In accounting, ‘revenue’ is the gross inflow ofcash, receivables or other considerations arising in the course of an enterprise fromthe sale of goods, from the rendering of services and from the holding of assets. Inthe case of revenue, the important question is at what stage, the transaction should berecognised and recorded.

• Periodic matching of cost and revenue concept : After the revenue recognition,all costs, incurred in earning that revenue should be charged against that revenue inorder to determine the net income of the business.

• Verifiable objective evidence concept : As per this concept, all accounting mustbe based on objective evidence. I.e, the transactions should be supported by verifiabledocuments.

• Accrual concept : Under this concept, revenue recognition and costs for the relevantperiod, depends on their realisation and not on actual receipt or payment. In relationto revenue, the accounts should exclude amounts relating to subsequent period andprovide for revenue recognised, but not received in cash. Like wise, in relation tocosts, provide for costs incurred but not paid and exclude costs paid for subsequentperiod.

3.2 ACCOUNTING CONVENTIONS

The term ‘convention’ is used to signify customs or traditions as a guide to thepreparation of accounting statements. The various accounting conventions are as follows.

• Convention of disclosure : This convention implies that accounts must be honestlyprepared and all material information must be disclosed therein. The term ‘disclosure’implies that there is to be a sufficient disclosure of information which is of materialinterest to proprietors, present and potential creditors and investors. This conceptalso applies to events occuring after the balance sheet date and the date on which thefinancial statements are authorised for issue, which are likely to have a substantial

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influence on the earnings and financial position of the enterprise. Their non-disclosurewould affect the ability of the users of such statements to make proper evaluationsand decisions.

• Convention of materiality : As per this convention, financial statements shoulddisclose all items which are material enough to effect evaluations or decisions. TheAmerican Accounting Association (AAA) defines ‘ materiality’ as “an item should beregarded as material if there is reason to believe that knowledge of it would influencethe decision of informed investor”. Unimportant items can be either left out or mergedwith other items. Sometimes, items are shown as footnotes or in parentheses accordingto their relative importance.

• Convention of consistency : Consistency, as used in accounting means that persistantapplication of the same accounting procedures or method by a given firm from onetime period to the next so that the financial statements of different periods can becompared meaningfully. This convention thus implies that in order to enable themanagement to draw important and meaningful conclusions of performance over aperiod or between different firms, accounting practices should remain unchanged fora fairly long time.

• Convention of conservatism : According to this convention, the accountant shouldbe conservative in his/her approach in his estimated, opinions and selection ofprocedure. In accounting, conservatism refers to the early recognition of unfavourableevents. For instance, all possible and expected losses must be provided for. But onthe other hand, gains and other financial benefits should not be provided for unlessthey are realised. In other words, ‘anticipate no profit and provide for all possiblelosses’.

4. ACCOUNTING RECORDS IN RETAIL SHOPS

Retail shops also maintain the income statement and the balance sheet, which reflecttheir performance. Only very few retailers analyze these statements and who does aresuccessful in developing business models and generate profits leading to higher ROIs.Retailers use various financial ratios (ex. Gross margin, net profit margin, asset turnover,financial leverage etc) to measure their store performance. Some of the retailers use astrategic profit model (SPM) in pursuing their financial goal of earning a good ROI. SPMis a tool for planning and evaluating the retailers’ financial performance, by integrating theinformational content of both the income statement and the balance sheet. This modelestablishes a mathematical relationship among net profit margin, asset turnover and financialleverage.

5. AN OVERVIEW OF BRANCH AND JOINT VENTURE ACCOUNTING

5.1 BRANCH ACCOUNT

As a business grows, it often establishes branches in order to market its productsover a large territory. The accounting system adopted for the branch depends on the sizeand nature of branch and degree of control needed by the head office. For convenience of


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the study, branches may be divided into – (i) branch not keeping full system of accountingand (ii) branch keeping full system of accounting.

5.1.1 Branch not keeping full system of accounting

These types of branches have the following features.

1. These branches sell only such goods which are supplied by the head office. They arenormally not allowed to make purchases in the open market.

2. Goods to such branches are supplied by the head office at cost price and sometimesat invoice price

3. All branch expenses of regular nature, such as rent of the shop, etc are paid by thehead office.

4. Some petty expenses like entertainment etc are paid by the branch manager out ofthe petty cash balance. Petty cash account at the branch may be maintained either onsimple system or imprest system.

5. Such branches are instructed to deposit daily cash proceeds (both cash sales andcash received from debtors) into the bank account opened in the name of the headoffice.

6. Sales are normally made on cash basis but some branches are authorized to makecredit sales also.

7. Branches keep only some memorandum records such as – stock register.

Since such branches do not keep any account, accounts are maintained only in thehead office books. The system of accounting in the head office too in its turn depends onthe size of such branch, and the degree of control head office wants to exercise. Based onthe above factors, accounts of such branches may be kept by head office in any of thefollowing ways.

(1) Debtors system:

Under this system, head office opens only one account for one branch called ‘Branchaccount’. This system is normally adopted when branch is fairly small in size.

(2) Final account system:

Under this system, head office opens – i) branch trading and profit and loss accountand ii) branch account. The branch account opened under this system is different from thatopened under debtors system.

(3) Stock and debtors system:

Under this sytem, head office opens – (1) branch stock account, (2) branch debtorsaccount, (3) branch assets account (4) branch expenses account and (5) branch adjustmentaccount.

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(4) Whole sale branch account:

This system is adopted when the head office supplied goods to the branch at theprice at which it supplies to wholesalers. Thus, under this system, branch is treated at parwith the wholesale branch.

5.1.2 Abnormal losses – treatment

When goods are sent to branches, abnormal losses may arise due to loss of goods intransit or theft or pilferages at branch. In such cases, the branch stock account must becredited with such abnormal losses. This is necessary to find out stock discrepancies forother reasons. The loading on abnormal losses is to be debited to branch adjustmentaccount and the cost of goods to profit and loss account. Any losses, given as abnormallosses should be ignored. This is because, the gross profit must absorb such losses.

5.1.3 Branch keeping full system of accounting.

The characteristic features of independent branches are as follows.

1. They keep a full system of accounting and a trial balance can be extracted form theledger. Such a trial balance forms the basis for the branch to prepare its final accountsand the head office to incorporate the result of the branch.

2. In the branch books there will be a head office account and the balance in this willequal the branch assets minus branch liabilities. Therefore, the head office account isanalogous to capital account. Correspondingly, in the books of the head office, therewill be a branch account. When all items are adjusted and reconciled, both theaccounts show the same balance. However, while the head office account is usuallya credit balance, the branch account is a debit balance.

3. The branch does not confine its trading to the goods sent by the head office. It alsotrades in other goods. Subject to the broad policies framed by the head office, thebranch has the freedom to act like any other independent business.

4. There is no need for the branch to remit all cash. It can retain the cash out of whichit can make the payments. However, remittances to and from head office do takeplace according to the need.

Although the branch is independent, still there are some transactions between thehead office and the branch.

5.2 JOINT VENTURE ACCOUNTING

When two or more persons come together to do some specific contract or a specificbusiness venture, then it is called the joint venture relationship. Just like in partnership,there is no stipulation for profit sharing ratio. They share profits and losses in agreedproportions. This relationship comes to an end as soon as that work or venture or job isover. The persons are individually called co-venturers, and collectively are called as jointventure firm.


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Joint venture relationship is a temporary form of partnership. The main objective ofaccounting in joint venture is to ascertain the profit or loss of the venture and the calculationof the final amount due to or from the venturers for final settlement. This accounting can bedone by separate books or through co-venturers own books.

Distinction between partnership and joint venture

I. Partnership is a continuing profit seeking enterprise whereas joint venture is a profitseeking terminable venture.

II. The business of partnership is carried on under the style of a firm’s name, whereasthere is no such common name for joint venture.

III. In the case of partnership, the persons carrying on the business are called as partnerswhere in the case of joint venture, they are called as co-venturers.

IV. Partners have joint and several liabilities. In joint venture, it depends on the mode ofcontracting. Certain liabilities may be joint and several while others may be contractedin the individual capacity of each co-venturer.

V. For a partnership, accounts are prepared annually. One set of accounts till the closureof venture will suffice in the case of joint venture. However, where the venture is fora longer period (3 or 4 years), interim accounts may be prepared on an annual basis.

VI. Firms usually follow accrual system of accounting, whereas cash system is followedin case of joint venture.

VII. The doctrine of implied authority is applicable to partners, whereas co-venturershave no such implied authority.

VIII.In the case of joint ventures, profit is ascertained for each venture whereas in the caseof partnership, profit is ascertained annually.

Accounting of joint venture can be done under the following three methods.

(i) Separate books method(ii) Complete accounting in the books of the co-venturer(iii) Memorandum joint venture method.

The selection of the method of joint venture is discretionary and depends on thedecision of the co-venturers. The factors which will influence the selection of the methodare as follows.

(i) Volume of transactions and amount involved(ii) Time duration of venture expected(iii) Existence of own books of a/c of the co-venturer(iv) Location of activity and the location of co-venturers etc.

Under all the three methods, the entity concept is very crucial in interpreting a transactionand formulating double entry. These three methods of joint venture present unique ways ofdifferent entity concepts, even though the end result is the same.

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5.3 ACCOUNTING TREATMENT:

5.3.1 Separate books method

Under this method, the joint venture concern will be treated as a separate entity,maintaining its own books of accounts. It will be usually maintained by any concern.When co-venturers agree to keep separate set of books for recording the transactionsrelating to the joint venture, it takes the form of an ordinary accounting system in a business.A full double entry system is adopted for this purpose as in the case of any other business.Under this method, the following accounts are opened.

i. Joint bank accountii. Capital accounts of co-venturers, andiii. Joint venture account.

Joint bank account is used for recording cash transactions. Capital accounts of co-venturers are personal accounts in nature and used to record their dealing with the venture.Joint venture account is a nominal account in nature and is used to calculate the profit orloss made on joint venture. The concern’s profit or loss will be ascertained and transferredto co-venturer’s capital accounts. Then their final dues will be settled. The concern mayor may not have its own bank account. If there is joint bank account of the concern, thensettlement of co-venturers account will be done through it. If there is no bank account ofthe concern, then settlement will be done inter se among the co-venturers.

5.3.2 Complete accounting in the books of the co-venturer

Sometimes, the co-venturers may decide that instead of maintaining separate booksof account of the concern, one or more co-venturers can do the accounting in their ownbooks of account. In this case, it becomes the books of account of that co-venturer aswell as the concern. the joint venture account will show the profit or loss, the co-venturerin whose books accounting is done will transfer his share to his P & L a/c and others sharewill be credited to their a/cs. The balance in other coventurers account will be settled, ifdebt balance recovered from him and if credit balance is paid to him. If there is a jointbank account after setting others a/c, belongs to them or if there is a shortfall, then it is tobe contributed by the co-venturers.

The main accounts prepared under this method are as follows.(a) Joint venture a/c(b) Joint bank a/c(c) Other co-venturers a/c

5.3.3 Memorandum joint venture method.

When all parties keep accounts, the method adopted for recording the transactionsrelating to joint venture, is called as Joint venture Memorandum method. Under this method,


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each venturer opens one account in his books in which he records transactions relating tothe joint venture. This account is not a nominal account and must not be confused withjoint venture account in other methods. This method is possible when, the co-venturersare situated at different cities, then, instead of having separate books of accounts of theconcern, they may record only their transactions related to joint business in their ownbooks. Then because own books cannot show profit and loss, they will seat together andprepare memorandum joint venture a/c. it is prepared in the same manner as usual jointventurea/c, but it is a working sheet and not part of books of account. That is why thismethod is called as memorandum joint venture method.

6. FINANCIAL STATEMENTS

6.1 INCOME STATEMENT AND RELATED CONCEPTS:

The income statement of a retailer provides the operational results (revenues andexpenditure) for a period of time.The starting point in understanding the income statementis to be clear about the meaning of “profit”. Profit is the reward for taking risk. Profit hasan important role in allocating resources (land, labor, capital and enterprise). Put simply,falling profits signal that resources should be taken out of that business and put into anotherone; rising profits signal that resources should be moved into this business. The main taskof accounts, therefore, is to monitor and measure profits.

Profit = Revenues less Costs. Hence, monitoring profit also means monitoring andmeasuring of revenues and costs. There are two parts to this:-

1) Recording financial data. This is the ‘book-keeping’ part of accounting.2) Measuring the result. This is the ‘financial’ part of accounting.

The income statement is one of the most powerful and important financial statementprepared by a retailer which gives the financial performance of him at any given point oftime. This statement can be prepared for various divisions, departments, branches, or anyother division of a business such as geographic locality also. The analysis of this incomestatement gives an idea to the retailer about his performance in the select period. He canalso measure his performance against that of his competitors by comparing his result withthose of the industry, or a select group of competitors so that he knows his market positionin relation to his competitors.

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6.2 TYPICAL FORMAT OF INCOME STATEMENT OF A MERCHANDISER/ RETAILER

Income statement of XYZ stores for the month ended January 2008

6.3 COMPONENTS OF INCOME STATEMENT

This statement contains information about the sales, cost of goods sold/ cost of sales,expenses, gross margins, net profit etc.

The term “Sales” in a retail business represents income received by a retailer byselling his merchandise. This term is also known as ‘gross sales’. When the amount ofreturns (value of merchandise returned by customers either because they are defective orbecause they did not satisfy the customer) and allowances (additional discounts and pricereductions given to customers) are deducted from the gross sales, a retailer gets ‘netsales’. This sales figure, most of the time indicates the performance of the retailer. In atrend analysis of the past sales performance, if the trend is showing a down trend, it is anindication to the retailer that either the customers are not liking his merchandise or somethingis wrong with his assortment, category management, shelf spacing or the most popularbrands are not being stocked by the retailer or any other worthy reason, which the retailerhas to analyze and find out, so that he can change his strategies to hike up his sales figure.An uptrend of sales figure denotes that the retailer was successful in his sales strategies.


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Still, it has to be noted that the retailer has to take up strategies for maintaining his positionin the market.

The cost of goods sold for a retailer includes the direct cost associated with themanufacturing / procuring of merchandise for the retail outlet. The term ‘directs costs’ mayinclude the transportation costs, and all other expenses the retailer has paid to purchase hismerchandise. This term also is of great importance to the retailer because, it shows theefficiency of the retailer in making effective purchases so that his overall costs are controlledand thus profit might be magnified without increasing his sales. The difference between thenet sales and cost of goods sold given the gross margin of the retailer.

The term ‘gross margin’ in a retail business refers to the difference between netsales and the cost of goods sold / cost of sales. This gross margin can also be expressedas a percentage. Gross margin of a business indicates the profitability of a business. A highgross margin implies that high revenues are available with the business and the financialability of the business is healthy so its growth chances are very high. And a lower grossmargin implies that available revenue and financial ability of the business are restricted andimplies that the liquidity of the business is in doubt. A retailer can analyze the gross marginover a number of years to know how his business is doing. He can also compare his grossmargin with either that of the entire industry or with select competitors, so that he cananalyze his performance against others and understand his market position.

Gross margin = Net sales – cost of goods sold

Gross margin % = Gross margin x 100 Net sales

Another format for income statement of a retailer is as follows.

In this process, it follows the mercantile basis of accounting (i.e, it takes into accountall paid and payable expenses, and received and receivable receipts). The net result ofprofit and loss account is called as net profit. The main feature of profit and loss accountis that it takes into account all expenses and incomes that belong to the current accountingyear and excludes those expenses and incomes that belong either to the previous period orthe future period. The term net profit is also popularly known in corporate jargon as – the

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bottomline. The difference between the cost of goods sold along with operational expensesand the net sales is called as net profit. It can be expressed as before taxes or after taxes.There are two schools of thought amongst the experts – that net profit before taxes onlyshould be considered for corporate decision making and other that only net profit aftertaxes should be taken into consideration for decision making. These two views are basedon the role of tax on the distributable income of a retailer. The relevant ratio related withnet profit figure is – net profit margin.

Net profit = Net sales – (cost of goods sold + operational expenses)

Net profit margin = Net profit x 100Net sales

This concept of net profit is a very important concept in finance, which relates to thesurvival of the firm itself. It indicates the firm’s financial performance at a given period oftime. If a firm shows lower net profits or losses, the most direct implications are – eitherthe costs are more than the sales or the firm was not able to achieve its targeted salesperformance. Thus, net profit acts as a measuring rod for measuring the financial performanceof a retail firm.

The expenses of the retailer can be divided into two types - interest and operatingexpenses, based on their nature. The interest expenses (interest on loans, debentures etc)are related to the cost of financing the business where regular annual interest paymentarises. The operational expenses refer to the day to day expenses of the business, whichmay, further be divided into – administration expenses (salaries of staff, postage etc),general expenses (rent, electricity) and selling expenses (salaries of sales staff, commissionetc).

6.4 THE BALANCE SHEET AND RELATED CONCEPTS

According to Howard, a Balance sheet may be defined as – ‘a statement whichreports the values owned by the enterprise and the claims of the creditors and ownersagainst these properties’.

The balance sheet of a retailer indicates the financial status of a retailer at a givenpoint of time, which is usually at the end of the year). The balance sheet of a retailerconsists of three components – assets, liabilities and owner’s net worth. This statement isprepared on the basis of the accounting equation which says that assets = liabilities +owner’s equity.


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6.5 THE TYPICAL FORMAT OF A BALANCE SHEET OF A RETAIL BUSINESS

Balance sheet of XYZ stores as on 31st December 2007

The Balance sheet is a statement that is prepared usually on the last day of theaccounting year, showing the financial position of the concern as on that date. It comprisesof a list of assets, liabilities and capital. An asset is any right or thing that is owned by abusiness. Assets include land, buildings, equipment and anything else a business owns thatcan be given a value in money terms for the purpose of financial reporting. To acquire itsassets, a business may have to obtain money from various sources in addition to its owners(shareholders) or from retained profits. The various amounts of money owed by a businessare called its liabilities. To provide additional information to the user, assets and liabilitiesare usually classified in the balance sheet as:

- Current: those due to be repaid (Current liabilities) or converted into cash within 12months of the balance sheet date (Current Assets), and in a retail business, current assets= accounts receivables + merchandise inventory + cash + other current assets.

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Accounts receivable refers to the amount due from the customers who havepurchased on credit. This amount implies credit sales made by the retailer and is acontroversial point as the exact amount of credit sales which is safer for any business (toavoid the bad debt losses) could not be forecasted accurately. The retailer has to find abalance between the risk of selling on credit and incurring bad debt loss or insisting on cashsales and run the risk of losing the customers to the competitors who sell on credit. Apartfrom the decision to sell on credit or not, the retailer also has to decide how much to sell oncredit because, from the marketing and customer service point of view, even though it isimportant to provide for credit sales, it is not advisable for the retailer to have a largeamount of accounts receivables as they represent blocked cash / investment and potentialhigher losses on account of bad debts.

Some retailers offer credit to their customers through their own credit card system.These store charge the customer lower interest rates for providing credit.

If not managed properly, the receivables can turnout to be bad and may affect thefunctioning of the store. One of the methods of controlling receivables is ‘factoring’.Factoring is also known as cash for receivables, and implies a system where the act ofreceiving the money due is outsourced to another business (usually banks) for a commission.The business / bank which are taking the responsibility of receiving the accounts receivablesis known as a ‘factor’. Under this method, the retailer gets his cash immediately in returnfor his selling his receivables to a factor. The factor will assume the responsibility of recoveryof receivables. Another method of controlling the receivables is to accept third party creditcards like Visa card and Master card. By accepting such cards, retailers are completelyrelieved of the process of offering credit from their own resources.

Merchandise inventory is the most important asset of the retailer. It consists of themajor part of the total assets of the retailer. The most important ratios that measure theprofitability of the retailer are – inventory to assets ratio, inventory turnover ratio, etc. Theinventory turnover ratio indicates the speed with which the inventory is moving out of thestores. Usually it is used to measure or evaluate the efficiency of an organization in managingits investment in inventory. The inventory cycle of a retailer usually consists of severalstages such as – ordering of inventory, storage of inventory, and selling to the customers.

Cash and other current assets include assets such as – money in hand and bank,marketable securities etc. Other current assets include – prepaid expenses and othermiscellaneous expenses.

Operating cycle in the case of a retail business refers to the cycle of activities such as– cash invested by the retailer in procuring the various products and sale of the same to hiscustomers. The retailer reinvests the cash he receives from his cash sales and the cashreceived from his debtors in the business. The productivity of the various assets invested/ used in the business decides the profitability of the retailer. Whatever the form of current


NOTES


asset, the size of the asset should be maintained at an optimal level to maximize theprofitability.

- Long-term: Long term assets have been defined as - those assets or liabilities due to berepaid (Long term liabilities) or converted into cash more than 12 months after thebalance sheet date (Fixed Assets),

A further classification other than long-term or current is also used for assets. A “fixedasset” is an asset which is intended to be of a permanent nature and which is used by thebusiness to provide the capability to conduct its trade. Examples of “tangible fixed assets”include plant & machinery, land & buildings and motor vehicles. “Intangible fixed assets”may include goodwill, patents, trademarks and brands - although they may only be includedif they have been “acquired”. Investments in other companies which are intended to beheld for the long-term can also be shown under the fixed asset heading.

While assessing the value of a fixed asset, its cost must be calculated only afterproviding for its depreciation. The ratio which helps a retailer in calculating the profitabilityof the assets he had used in his business is – asset turnover ratio. This ratio measures howeffectively the retailer had used his assets. If the asset turnover is high, it implies that theretailer is using his assets effectively. If the asset turnover is low, it implies that the retaileris not using his assets effectively. Whenever the retailer is thinking of investing in fixedassets, he should calculate how many sales he can generate out of that asset / investment.

Current liabilities refer to all the payments which fall due for payment within a periodof one year. Non payment of these liabilities may even lead to insolvency of the retailer.Some of the common current liabilities are – accounts payable, notes payable, accruedexpenses etd.

Accounts payable for a retailer refers to the amounts he has to pay to the vendorswho had sold the products to him on credit. Vendors usually extend their credit based onseveral factors such as – the credit worthiness of the retailer, their relationship with eachother, the retailer’s debt capacity, the value of the consignment etc. This is the best form ofshort term credit for the retailer. Hence, he should use it wisely.

The current liabilities which a company owes to financial institutions are known asnotes payable. They include the principal and the interest payable to the lenders.

Accrued expenses arise when expenses are realized before the retailer had paidcash. Under mercantile method of recording, the accrued expenses are to be accountedfor in the year of incurring, irrespective of when the actual payment is made.

Capital

As well as borrowing from banks and other sources, all retail outlets receive financefrom the retailers. This money is generally available for the life of the business and is normally

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only repaid when the shop / business is “wound up”. To distinguish between the liabilitiesowed to third parties and to the business owners, the latter is referred to as the “capital”or “owner’s equity”. In addition, undistributed profits are re-invested in business assets(such as stocks, equipment and the bank balance). Although these “retained profits” maybe available for the retailer - they are added to the equity capital of the business in arrivingat the total “owner’s equity”. The common forms of owner’s equity consist of – commonstock and retained earnings.

Common stock refers to the type of stock usually issued by corporations. Owners ofcommon stock enjoy certain benefits like – right to vote and are entitled to a share in thebusiness profits.

Retained earnings refer to the undistributed profits of a retail business which is reinvestedin the business again. This retention percentage depends on the – need for funds or existenceof profitable investment projects for the business, and the growth potential of the business.The most important ratio in this regard is the financial leverage.

At any time, therefore, the capital of a business is equal to the assets (usually cash) investedby the retailer plus any profits made by him through trading that remain undistributed, thereinvested profits of the business and the outside liabilities.

6.6 THE BASIC FUNCTIONS OF A BALANCE SHEET ARE:

1. It gives the financial position of a company on any given date2. It gives the liquidity picture of the concern3. It gives the solvency position of the concern

6.7 COMMON ADJUSTMENTS AFFECTING THE PREPARATION OFBALANCE SHEET ARE:

1. Income received in advance: Income received in respect of which service hasnot been rendered is known as income received in advance. In order to calculatethe exact profit or less made during the year, such income should not be taken in toaccount while preparing profit and loss account. Hence this amount must bededucted from the respective income account in the profit and loss account andmust be treated as a liability in the balance sheet. The adjustment entry is

Income account Dr.To income received in advance.

2. Closing stock : Closing stock appears on the credit side of trading account andassets side of balance sheet if it is given in the adjustments. If it is given in the trialbalance it will appear only on the assets side of the balance sheet. The entrypassed is

Closing Stock A/c Dr.To Trading Account.


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3. Outstanding expenses : Outstanding expenses refer to those expenses whichhave become due during the accounting period for which financial statements arebeing prepared, but not yet have been paid. Such expenses if given in theadjustments, should be added to the respective expenditure account on the debitside of profit and loss account and must be shown as liabilities in the balancesheet. If such expenses are given in the trial balance they should be recorded onlyon the liability side of the balance sheet. The journal entry to be passed is

Respective Expenditure A/c Dr.To Outstanding Expenditure

4. Pre-paid expenses : They are those expenses which have been paid in advance.They are also known as un-expired expenses. If given in adjustments, theyshould be deducted from the respective expenditure account on the debit side ofthe profit and loss account and must be shown on the asset side of the balancesheet. If given in the trial balance, they must be shown only on the asset side of thebalance sheet. The adjustment entry is

Pre-paid expenditure A/c Dr.To Respective Expenditure

5. Outstanding or accrued income : This is the income which has been earnedduring the current accounting year and has become due but not yet received by thefirm. If given in the adjustments, it must be added to the respective income accounton the credit side of the profit and loss account and must be shown on the assetsside of the balance sheet. But if given in the trial balance, it must be shown only onthe asset side of the balance sheet. The entry is

Outstanding/Accrued Income A/c Dr.To Respective Income

6. Depreciation : It is a reduction in the value of the asset due to wear and tear,lapse of time, obsolescence, exhaustion and accident. It is charged on fixed assetsof the business. If given in the adjustments, it must be shown on the debit side ofthe profit and loss account and must be deducted from the respective asset accountin the balance sheet. If given in the trial balance, it must be shown only on the debitside of the profit and loss account. The entry is

Depreciation A/c Dr.To Respective Fixed Asset

7. Bad Debts : They represent that portion of credit sales (debtors) that had becomebad due to the inability of the debtor to repay the amount. It is a loss to thebusiness and gain to the debtor. This is a real loss to the business and as such mustbe deducted from the debtors before deducting any reserves created on debtors.If given in the adjustments it must be shown on the debit side of the profit and lossaccount and must be deducted from the debtors account on the asset side of the

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balance sheet. If given in the trial balance this amount must be shown only in theprofit and loss account. The entry is

Bad debts A/c Dr.To Debtor’s personal account

8. Provision for bad debts : This represents a provision made by the business forany potential bad debts. It is charged to the profit and loss account debit side andmust be deducted from the debtors after deducting the bad debts if any on theasset side of the balance sheet, if given in the adjustments. If given in the trialbalance, it must be considered only in preparing the profit and loss account. Theentry is

Profit and loss A/c Dr.To Provision for bad debts

9. Provision for doubtful debts : This represents a provision made by the businessfor any potential doubtful debts. If given in the adjustments, it must be charged tothe profit and loss account debit side and must be deducted from the debtors afterdeducting the bad debts (if any) and reserve for bad debts on the asset side of thebalance sheet. If given in the trial balance, it must be considered only in preparingthe profit and loss account. The entry is

Profit and loss A/c Dr.To Provision for doubtful debts

10. Provision for doubtful debts : This represents a provision made by the businessfor any potential discount to be allowed to the debtors. If given in the adjustments,it must be charged to the profit and loss account debit side and must be deductedfrom the debtors after deducting the bad debts (if any), reserve for bad debts (ifany) and reserve for doubtful debts (if any) on the asset side of the balance sheet.If given in the trial balance, it must be considered only in preparing the profit andloss account. The entry is

Profit and loss A/c Dr.To Provision for discount on debtors

11. Reserve for discount on creditors: This represents a provision made by thebusiness for any potential discount to be allowed by the creditors of the business.If given in the adjustments, it must be charged to the profit and loss account creditside and must be deducted from the creditors on the liabilities side of the balancesheet. If given in the trial balance, it must be considered only in preparing the profitand loss account. The entry is

Reserve for discount on creditors A/c DrTo Profit and Loss A/c

12. Interest on capital: This is the return the owners of the business will get forinvesting in the business. Usually it is paid or added to the capital at a fixed


NOTES


percentage. If given in the adjustments, it is shown on the debit side of the profitand loss account and is usually added to the capital account on the liabilities side ofthe balance sheet. If given in the trial balance, it must be shown on the debit sideof profit and loss account. The entries are :

Profit and Loss A/cTo Interest on capital

Interest on capital A/c DrTo capital A/c

13. Interest on Drawings: Drawings represents the withdrawals made by the ownersduring the accounting year either in the form of stock, cash or withdrawal frombank for personal use. They must be deducted from the capital account on theliabilities side of the balance sheet. Sometimes, firms charge interest on suchdrawings made by the owners to discourage them from withdrawing their investment.Usually it is levied as a fixed percentage. It is an income to the business and a lossto the owner. Hence, if given in the adjustments, it must be shown on the creditside of the profit and loss account and deducted from the capital in the balancesheet. If given in the trial balance, it must be shown only in the profit and lossaccount. The respective entries are:

Interest on Drawings A/c DrTo Profit and loss A/c

Interest on Drawings A/c DrTo capital A/c

7. VALUE ADDED TAX

The VAT was invented by a French economist, Maurice Laure, joint director of theFrench tax authority, in 1954. He was the first person to introduce VAT with effect from10th April 1954, for large businesses and extended to all business sectors over time

A Value Added Tax is a tax that is charged at each level of the manufacturing processand is considered as a hybrid tax initially because of its complexity. It was also expectedthat it will encourage savings and reduce consumption. Today around 160 countries utilizevalue added tax (VAT) while a number of countries adopt sales tax. Almost all countriesof the world rely upon taxes as the major source of revenue. VAT Rates in the participatingcountries generally range from 6.5% to 25% depending on the country. VAT may berefunded on: hotels, restaurants, car rentals, parking, gasoline, diesel fuel, transportationwithin country, business entertainment, telecommunications, conferences, trade shows,training courses, professional fees. VAT is not refundable such as on alcohol and laundryservices.

Value added tax (VAT),or goods and services tax (GST), is a tax on exchanges.It differs from sales tax because sales tax is levied on the total value of the exchange, and

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VAT is levied on the added value that results from each exchange. For this reason, a VATis neutral with respect to the number of passages there are between the producer and thefinal consumer. A VAT is an indirect tax, as it is collected from someone other than theperson who actually bears the cost of the tax (namely the seller rather than the consumer).To avoid double taxation on final consumption, exports (which by definition, are consumedabroad) are usually not subject to VAT and VAT charged under such circumstances isusually refundable.

VAT is a multi-stage tax levied at each stage of the value addition chain, with a provisionto allow input tax credit (ITC) on tax paid at an earlier stage, which can be appropriatedagainst the VAT liability on subsequent sale. VAT is intended to tax every stage of salewhere some value is added to raw materials, but taxpayers will receive credit for taxalready paid on procurement stages. Thus, VAT will be without the problem of doubletaxation as prevalent in the present tax laws.

The Indian model of VAT is different from VAT as it exists in most parts of the world.In India, VAT replaced the existing state sales tax system. One of the many reasons underlyingthe shift to VAT is to do away with the distortions in the existing tax structure that carve upthe country into a large number of small markets rather than one big common market. Inthe sales tax structure, tax was not levied on all the stages of value addition or sales anddistribution channel, which means the margins of distributors/dealers/retailers, were notsubject to sales tax. Thus, the pricing structure needed to factor only the single-point levycomponent of sales tax and the margins of manufacturers and dealers/retailers, etc. wereworked out accordingly. Under the VAT regime, due to multi-point levy on the price includingvalue additions at each and every resale, the margins of either the re-seller or the manufacturerare reduced unless the ultimate price is increased.

The VAT system ensures lesser paperwork for the retail community. There are nolocal statutory forms under VAT. The sales tax system required dealers to maintain anaccount of sales and purchases, which even the VAT system also requires. Further, theCentral Sales Tax Act was amended and there was a single-page return form common forlocal and Central Acts. The return was required to be filed quarterly.

7.1 GOODS COVERED UNDER VAT

All the goods including declared goods as mentioned in the Central Sales Tax Act,1956 are covered under VAT and will get the benefit of input tax credit.

Only few goods which have been kept outside VAT include - liquor, lottery tickets,petrol, diesel, aviation turbine fuel and other motor spirit since their prices are not fullymarket determined. These will continue to be taxed under the Sales Tax Act or any otherState Act or even by making special provisions in the VAT Act itself, and with uniform floorrates decided by the Empowered Committee.


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7.2 NECESSITY OF VALUE ADDED TAX

The General perception of the single point sales tax system was that it was highlycomplex with multiplicity of rates, plethora of explanations, many rates in some groups ofitems, extensive use of statutory forms, high and unrealistic quota of assessment, loss ofrevenue on value additions, Tax rate war between States, etc. The consensus was that anew system was needed and Value Added Tax has emerged as a principal instrument oftaxing domestic consumption world wide during last four decades.

7.3 IMPORTANCE OF VAT

In India, the trading community has accepted and adopted loopholes in the existingadministered tax system of the state/Centre. VAT closed the avenues for traders andbusinessmen to evade paying taxes, and they were compelled to keep proper records oftheir sales and purchases. Under the VAT system, no exemptions are given and a tax islevied at each stage of manufacture of a product. At each stage of value-addition, the taxlevied on the inputs can be claimed back from the tax authorities.

VAT system, when enforced properly at a macro level, forms part of the fiscalconsolidation strategy for the country. In fact, it helps in addressing the fiscal deficit problemand the revenues estimated to be collected could actually mean lowering of the fiscaldeficit burden for the government.

The World Bank had suggested with regard to India that the strategy of rateharmonization would promote simplicity in the tax regime but may not be worth the cost interms of loss of state tax autonomy and tax revenue keeping in view the tax/GDP rationeeds to be increased. The report had also suggested that individual states could beencouraged or at least allowed to graduate individually into VAT if a consensus cannot beestablished to guide the introduction of VAT.

In India, VAT replaced sales tax from 1st April 2005 in 20 out of 28 states in India ata rate of 12.5%. It was one of the large scale reforms of the country’s public finances.Value Added Tax is a multi point sales tax with set off for tax paid on purchases. It isbasically a tax on the value addition on the product. The burden of tax is ultimately born bythe consumer of goods. In many aspects it is equivalent to last point sales tax. It can alsobe called as a multi point sales tax levied as a proportion of Valued Added.

VAT is nothing but sales tax at source. Instead of collecting it after five months or so,the state governments would collect the same in advance and then allow set-offs to thebusinessmen. All tax paid on inputs, subject to rules made, shall be allowed to set-offagainst the tax on output. There would be exceptions like CST not allowed to be set off ifsales are made locally in some other state; octroi not to be set off against output tax, etc.

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The aims of VAT include - to make accounting more transparent, cut trade barriersand boost tax revenues. Haryana had adopted VAT from 1st April 2004. Due to itsfederal nature, the Indian constitution had empowered the Indian states to set their ownVAT rate.

7.4 ADVANTAGES OF VAT

• Removes the cascading of taxes due to its inherent features of offering set-off oftaxes paid already.

• Encourages widening of tax base and reduction in rates of tax.• A properly designed system of VAT does not distort trade and production methods

i.e. it does not induce shifting of production bases, vertical integration ordisintegration, or changes in constitution of the entity.

• Encourage better compliance due to the availability of set off of taxes paid, andthereby less evasion.

• Improves economic efficiency with its neutrality with respect to forms oforganizations, production facilities and location.

• Particularly improves export competitiveness of local industries due to ‘zero rating’of exports.

• It creates an audit trail due to its inherent nature where the purchase invoice formsthe basis for obtaining credit of tax. It also has a “self-policing effect” since itrequires proper maintenance of purchase and sale documents to avail the credit.

• The VAT has a self-enforcing effect in that buyers demand invoices from supplierswhich would otherwise not be sought by most buyers.

• VAT is usually accompanied by a lesser number of rates which makes administrationmuch easier and record keeping less tedious for traders.

7.5 CRITICISMS ON VAT

Chancal Kumar Sharma (2005:929) asserts that the VAT system in India clearlyprojects the Political compulsions of the government. ‘Indian VAT system is imperfect’ tothe extent it ‘goes against the basic premise of VAT’. India seems to have an ‘essencelessVAT’ because the very reasons for which VAT receives academic support have beendisregarded by the VAT-Indian Style, namely: removal of the distortions in movement ofgoods across states;Uniformity in tax structure (Sharma, 2005: 929). Chanchal KumarSharma( 2005:929)clearly states, “ Local or state level taxes like octroi, entry tax, leasetax, workers contract tax, entertainment tax and luxury tax are not integrated into the newregime which goes against the basic premise of VAT which is to have uniformity in the taxstructure. The fact that no tax credit will be allowed for inter-state trade seriously underminesthe basic benefit of enforcing a vat system, namely the removal of the distortions inmovementof goods across the states”.

“ Even the most essential prerequisite for success of VAT ie elimination of CST hasbeen deferred. CST is levied on basis of origin and collected by the exporting state; theconsumers of the importing state bear its incidence. CST creates tax barriers to integrate


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the Indian market and leads to cascading impact on cost of production. Further, the denialof input tax credit on inter-state sales and inter state transfers would affect free flow ofgoods.” (Sharma,2005:922)

Personal end-consumers of products and services cannot recover VAT on purchases, butbusinesses are able to recover VAT on the materials and services that they buy to makefurther supplies or services directly or indirectly sold to end-users. In this way, the total taxlevied at each stage in the economic chain of supply is a constant fraction of the valueadded by a business to its products, and most of the cost of collecting the tax is borne bybusiness, rather than by the state. VAT was invented because very high sales taxes andtariffs encourage cheating and smuggling. It has been criticized on the grounds that it is aregressive tax (the poor pay more, in comparison, than the rich).

The “value added tax” has been criticized as the burden of it relies on personal end-consumers of products. However, this calculation is derived when the tax paid is dividednot by the tax base (the amount spent) but by income, which is argued to create an arbitraryrelationship. The tax rate itself is proportional with higher income people paying more taxbut at the same rate as they consume more. If a value added tax is to be related to income,then the unspent income can be treated as deferred (spending savings at a later point intime), at which time it is taxed creating a proportional tax using an income base. Such taxescan have a progressive effect on the effective tax rate of consumption by using exemptions,rebates, or credits.

Revenues from a value added tax are frequently lower than expected because they aredifficult and costly to administer and collect. In many countries where collection of personalincome taxes and corporate profit taxes has been historically weak, VAT collection hasbeen more successful than other types of taxes. VAT has become more important in manyjurisdictions as tariff levels have fallen worldwide due to trade liberalization, as VAT hasessentially replaced lost tariff revenues.

Due to the fact that exports are generally zero-rated (and VAT refunded or offset againstother taxes), this is often where VAT fraud occurs. In sectors or countries where VATfraud is prevalent, attempts by authorities to control fraud may have unintendedconsequences, and raise costs for honest companies. Certain industries (small-scale services,for example) tend to have more VAT avoidance, particularly where cash transactionspredominate, and VAT may be criticized for encouraging this. From the perspective ofgovernment, however, VAT may be preferable because it captures at least some of thevalue-added.

In Europe, the main source of problems is called ‘carousel’ fraud. Large quantities ofvaluable goods (often microchips or mobile phones) are transported from one memberstate to the other. During these transactions, some companies owe VAT, other companiesacquire a right to reclaim VAT. The first companies, called ‘missing traders’ go bankrupt

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without paying. The second group of companies usually ‘pump’ money straight out of thenational treasuries. This kind of fraud originated in the 1970s in the Benelux-countries.

7.6 VAT VS. SALES TAX

VAT differs from a conventional sales tax in that, VAT is levied on every business asa fraction of the price of each taxable sale they make, but they are in turn reimbursedthrough VAT on their purchases, so the VAT is applied to the value added to the goods ateach stage of production.

Value added taxation has been gaining favor over traditional sales taxes worldwide.In principle, value added taxes apply to all commercial activities involving the productionand distribution of goods and the provision of services. VAT is assessed and collected onthe value added to goods in each business transaction.

Under this concept the government is paid tax on the gross margin of each transaction.VAT proposes to replace sales tax which in most developing countries is trying to shift tosome variant of VAT, like India, is the ‘only’ major revenue source for the regionalgovernments since low per capita income and unemployment render income tax inadequateas a revenue source. Thus the process of implementation of VAT in place of sales tax indeveloping federal countries (like India) will face constraints since it entails revenue lossand loss of autonomy for subcentral levels. (Sharma, 2005: 916 quoted in Muller, 2007:64).

Sales taxes are normally only charged on final sales to consumers: because ofreimbursement, VAT has the same overall economic effect on final prices. The main differenceis the extra accounting required by those in the middle of the supply chain; this disadvantageof VAT is balanced by application of the same tax to each member of the production chainregardless of its position in it and the position of its customers, reducing the effort requiredto check and certify their status.

A general economic idea is that if sales taxes exceed 10%, people start engaging inwidespread tax evading activity (like buying over the Internet, pretending to be a business,buying at wholesale, buying products through an employer etc.) On the other hand, totalVAT rates can rise above 10% without widespread evasion because of the novel collectionmechanism. However because of its particular mechanism of collection, VAT becomesquite easily the target of specific frauds like carousel fraud which can be very expensive interms of loss of tax incomes for states.

8. TYPES OF AUDIT AND AUDITING PROCEDURE

After devising and enacting the retail strategy, it should be continuously assessed andnecessary adjustments are to be made wherever necessary with the help of retail audit. Aretail audit systematically examines and evaluates a firm’s total retailing effort or a specificaspect of it. The purpose of this retail audit is to study a retailer’s performance and make


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recommendations for the future. A retail audit investigates a retailer’s objectives, strategy,implementation and organization. Retailer’s goals are reviewed and evaluated for theirclarity, consistency and appropriateness. The retailer’s strategy and the methods for derivingit are analyzed. The application of strategy and how the customers receive it is reviewed.The organizational structure is also analyzed with regard to lines of command and otherfactors.

8.1 ESSENTIALS OF A GOOD RETAIL AUDIT INVOLVES –

i) Regularity of auditsii) In-depth analysis and systematic collection and analysis of dataiii) Unbiased perspective of the auditoriv) Willing exploration of the strengths and weaknesses of the retailerv) Preparation of a comprehensive audit report by the auditors.

8.2 RETAIL AUDIT PROCESS

Retail audit process involves 6 steps. They are as follows.

Step I –Determination of who does the audit:Step II – Determining when and how often the audit is conductedStep III – Determining the areas to be auditedStep IV– Develop audit formsStep V– Conduct the auditStep VI – Report to the management

Step I –Determination of who does the audit:

For conducting an audit, one or a combination of three parties (a company auditspecialist, a company department manager and an outside auditor) can be involved. Eachcombination has its own advantages and disadvantages. For example, if a company auditspecialist is entrusted with the job of audit, the advantages include – expert auditing,thoroughness, knowledge about the firm, etc. and the various disadvantages include –costs in the form of regular auditor’s fees.

Step II – Determining when and how often the audit is conducted:

The most probable time for conducting a retail audit is the end of the fiscal year whenthe retailer has to submit his annual report, or when a complete physical inventory isconducted. Any of these times is appropriate to conduct a retail audit. But, an audit mustbe conducted atleast once in a year. Some of the retailers want to have frequent audits andsome don’t want frequent audits. It depends on the decision of the retailer how frequentlyan audit must be conducted.

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Step III – Determining the areas to be audited

A retail audit includes more than financial analysis, and it reviews various aspects ofthe firm’s strategies and operations to identify the strengths and weaknesses. For thisreason, there are two basic types of audits – a horizontal retail audit and a vertical retailaudit. These should be used in conjunction with both types because, most of the times,horizontal audit reveals areas which merit further investigation by a vertical retail audit. Ahorizontal audit refers to the activity of analyzing the firm’s overall performance, from theorganizational mission to goals to customer satisfaction to the basic retail strategy mix andits implementation in an integrated, consistent way. It is also known as retail strategy audit.A vertical retail audit is the process of analyzing in depth, a firm’s performance in one areaof the strategy mix or operations like customer service etc. A vertical audit is more focusedand specialized.

Step IV– Develop audit forms

To provide professionalism, a retailer should use detailed audit forms, which lists theareas to be studied and guides data collection. Usually it resembles a questionnaire and iscompleted by the auditor.

Step V– Conduct the audit

Management specifies how long the audit will take. Prior notification of employeesdepends on management’s perception of two factors; the need to compile some data inadvance to save time versus the desire to get an objective picture. With a disguised audit,employees are unaware that it is taking place. With a non-disguised audit, employeesknow an audit is being conducted. Some audits are to be done when the retailer is open,such as assessing in-store customer traffic etc. others may be done when the firm isclosed, in cases like assessing the inventory position, infrastructure etc. An audit reportmay be formal or informal, brief or long, oral or written, and a statement of findings or astatement of findings plus recommendations.

Step VI – Report to the management

The last stage in retail audit is to present the findings and recommendations to themanagement. It is the role of the management to see what adjustments to make or a whatdecisions to take.

8.3 TYPES OF AUDIT:

There are many types of audits in existence, each aiming at different areas to servedifferent purposes. The following provides examples of some of the audits that could beundertaken.


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1. Accounting audit

Accounting audit includes an independent assessment of how fair the managementhas been while making and presenting the company’s financial statements. It also includesevaluating an organization, its accounting system, processes etc. Accounting audit helps torun a company/ business efficiently and cost-effectively. It includes thorough examinationof how a company operates, how is keeps its stock levels, payments receivable period,creditors management etc. It helps a company to know its areas of improvement and alsohelps to avoid any financial errors and omissions. It is necessary for testing the companyperformance against industry standards and its direct competitors. This process helps inproviding and recommending ways to improve the company’s existing accounting practice.

2. Financial audit

A financial audit is an audit of financial statements, involving the examination of acompany’s balance sheet by a third party or a legal entity. It results in establishing anindependent & fair opinion on whether or not those financial statements are accurate,complete, and fairly presented.

A financial audit is a historically oriented, independent evaluation performed for thepurpose of attesting to the fairness, accuracy, and reliability of financial data. Internal auditalso conduct audits, which focus on a financial system’s controls to ensure that financialcontrols are adequate and effective. A Financial audit determines (a) whether an auditedagency’s financial statements present fairly the financial position, results of operations andcash flows or changes in financial position in accordance with generally accepted accountingprinciples or another comprehensive basis of accounting; and (b) whether the entity hascomplied with laws and regulations that may have a material effect on the financial statements.A financial audit, or more accurately, an audit of financial statements, is the examinationby an independent third party of the financial statements of a company or any other legalentity (including governments), resulting in the publication of an independent opinion onwhether or not those financial statements are relevant, accurate, complete, and fairlypresented.

Financial audits are typically performed by firms of practising accountants due tothe specialist financial reporting knowledge they require. The financial audit is one of manyassurance or attestation functions provided by accounting and auditing firms, wherebythe firm provides an independent opinion on published information.

Many organisations separately employ or hire internal auditors, who do not attest tofinancial reports but focus mainly on the internal controls of the organization. Externalauditors may choose to place limited reliance on the work of internal auditors.

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3. Performance audits

Performance audits determine (a) whether the firm is acquiring, protecting and usingits resources (such as personnel, property and space) economically and efficiently; (b) thecauses of inefficiencies or uneconomical practices (c) whether the firm has complied withlaws and regulations pertaining to economy and efficiency. (d) Whether the desired resultsor benefits that the Legislature or other authorizing bodies establish are being achieved;and (e) the effectiveness of organizations, programs, activities or functions, and whetherthe entity has complied with laws and regulations applicable to the program Generallyundertaken with a limited scope, these audits are designed to obtain information about aspecific activity or action that has occurred or is contemplated.

4. Internal Audit / Concurrent Audit

This type of audit involves assessing and evaluating a company’s system of internalcontrol. The service ensures improvement and value addition to company’s operations.The emphasis is always on strengthening the internal control systems for minimizing accidentalor deliberate accounting errors and omissions. It also involves protection of assets andensuing compliance with a company’s internal operating policies.

5. Management Audit

This audit involves assessing, checking and making sure that management proceduresare being conducted in a way to assure quality, integrity or standards of provision andoutcomes. It also includes maximizing the management performance by improving theinternal processes of an organization.

6. Operational Efficiency Audit

This audit involves ensuring that all the resources of an organization are being optimallyused for delivering maximum possible return/value. It also includes streamlining variousinternal processes, measuring the performance of management and staff and also ensureminimal waste.

7. Special Investigative Audit

This audit involves helping the businessmen or corporate clients to prevent situationsof fraud and financial impropriety. It involves assisting the clients in every possible mannerto find out cause for any frauds and preventing them.

8. Internal Auditing

The process involves examination, assessment and evaluation of a accountingprocesses, financial statements of a company or business by a company’s own employeeor by a team of competent professionals.


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9. External Auditing

The process involves examination, assessment and evaluation of accounting processes,financial statements of a company, and business by an independent professional. Variousgovernment agencies, investors, and public, rely on the services of an external auditor topresent an independent and fair evaluation on organizations.

10. Information Systems Audits

There are many types of information systems audits that focus on the controls thatgovern the development, operation, maintenance, and security of application systems in aparticular environment. This type of audit might involve reviewing a data center, an operatingsystem, a security software tool, or processes and procedures (such as the procedure forcontrolling production program changes), etc. Internal Audit Services may also review ofthe development of a new application system.

11. Compliance Audits

These audits address the specific department’s adherence to laws and regulations,policies and procedures, federal and provincial requirements, and restrictions imposed onendowments and grants etc.

12. Follow-up Audits

These are audits conducted after an internal or external audit report has been issued.They are designed to evaluate corrective action that has been taken on the audit issuesreported in the original report.

13. Operational Audits

Operational audits usually provide an objective evaluation of an area, department orfunctional operation. The process assesses the adequacy and effectiveness of controlsdesigned to manage risks and ensure objectives are met.

9. AN INTRODUCTION TO ACCOUNTING SOFTWARE PACKAGES

Like in any other business, retail business also is using computerized retail accountingsystem so that it may maintain accuracy of every transaction without any delay. For retailshops, computerized accounting is a great way to reduce workload and improve workefficiency. Definitely, computerized retail accounting system can reduce the monotony ofaccounting tasks. If a retail shopkeeper is planning to incorporate computerized system inhis business, then he has to make sure of what accounting software he is going to use. Incase the software is not according to requirements of his retail accounting system, he mayface problems in proper execution. Therefore, it is always better for a retailer to do a littleresearch whether the software is well matched to his requirement or not, as it will help himin choosing the best retail accounting software for his organization.

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Accounting software is an application software that records and processes accountingtransactions within functional modules such as accounts payable, accounts receivable, payroll,and trial balance. It functions as an accounting information system. It may be developed in-house by the company or organization using it, may be purchased from a third party, ormay be a combination of a third-party application software package with local modifications.It varies greatly in its complexity and cost. The market has been undergoing considerableconsolidation since the mid 1990s, with many suppliers ceasing to trade or being boughtby larger groups.

Modules

Accounting software is typically composed of various modules, different sections dealingwith particular areas of accounting. Among the most common are:

Core Modules

Accounts receivable—where the company enters money receivedAccounts payable—where the company enters its bills and pays money it owesGeneral ledger—the company’s “books”Billing—where the company produces invoices to clients/customersStock/Inventory—where the company keeps control of its inventoryPurchase Order—where the company orders inventorySales Order—where the company records customer order for the supply of inventory

Non Core Modules

Debt Collection—where the company tracks attempts to collect overdue bills (sometimespart of accounts receivable)Expense—where employee business-related expenses are enteredInquiries—where the company looks up information on screen without any edits or additionsPayroll—where the company tracks salary, wages, and related taxesReports—where the company prints out dataTimesheet—where professionals (such as attorneys and consultants) record time workedso that it can be billed to clientsPurchase Requisition—where requests for purchase orders are made, approved and tracked(Different vendors will use different names for these modules)

Some examples of the accounting software (Retail Business Solutions) are as follows:

XRBL

XBRL (eXtensible Business Reporting Language), an Internet business language, ispurported to revolutionize the way business reporting will be done in the next two or threeyears. The idea behind XBRL is - instead of treating financial information as a block of text- as in a standard internet page or a printed document - it provides an identifying tag for


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each individual item of data. XBRL is a language for the electronic communication ofbusiness and financial data which is revolutionizing business reporting around the world. Itprovides major benefits in the preparation, analysis and communication of businessinformation. It offers cost savings, greater efficiency and improved accuracy and reliabilityto all those involved in supplying or using financial data. It belongs to the family of “XML”languages and is being developed by an international non-profit consortium of approximately450 major companies, organizations and government agencies. It is an open standard, freeof license fees. It is already being put to practical use in a number of countries and isgrowing rapidly around the world.

XBRL provides an identifying tag for each individual item of data. This is computerreadable. For example, company net profit has its own unique tag. Computers can treatXBRL data “intelligently”. They can recognize the information in a XBRL document, select,analyze, store and exchange it with other computers and present it automatically in a varietyof ways for users. XBRL is a powerful and flexible version of XML which has been definedspecifically to meet the requirements of business and financial information. It enables uniqueidentifying tags to be applied to items of financial data, such as ‘net profit’. However, theseare more than simple identifiers. They provide a range of information about the item, suchas whether it is a monetary item, percentage or fraction. XBRL can show how items arerelated to one another. It can thus represent how they are calculated. It can also identifywhether they fall into particular groupings for organizational purposes. XBRL is also easilyextensible, so organizations can adapt it to meet a variety of special requirements.

XBRL tags enable automated processing of business information by computersoftware, cutting out laborious and costly processes of manual re-entry and comparison.XBRL greatly increases the speed of handling of financial data, reduces the chance oferror and permits automatic checking of information. Companies can use XBRL to savecosts and streamline their processes for collecting and reporting financial information. XBRLcan handle data in different languages and accounting standards. It can flexibly be adaptedto meet different requirements and uses.

TALLY

Successfully managing a retail business is no easy task. It involves several factors that gobeyond mere accounting and inventory management. In such a dynamic business situation,close tracking of the customers’ preferences and keeping pace with current trends isessential. Also, ensuring greater convenience for customers is a priority while keepingthem satisfied with attractive offers and discounts is a must.

Tally’s state-of-the-art retail solutions suite comprises of Shopper POS for retailoutlets and Shopper HO for retail chains that require central control for all connectedoutlets. These comprehensive solutions cater to every aspect of managing a retail business,

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with features that span billing, customer relationship management, inventory management,pricing, barcode generation and printing among several others.

With Shopper retail business solutions from Tally, managing a retail outlet or a retailchain has never been so simple. In addition, Shopper POS can work in conjunction withthe Tally Business Accounting and Inventory Management software, to offer a comprehensivebusiness solution.

Tally 9' is an accounting and inventory software with VAT (Value Added Tax)compliance for Tamil Nadu. The software, besides incorporating statutory features, offersenhanced performance with add-ons such as payroll and point of sale invoicing. The solutionwas a multilingual and integrated business accounting software that allowed users to maintainaccounts in any Indian language, view it in another, and print it in yet another language ofthe customer’s choice.TARGET SOFTWARE

* Target, is another complete accounting software that handles Financial Accounting,Billing including Excise , Inventory (batch wise / location wise ), Sales Tax Reports ,Excise reports / Registers , Job work management, consignment sales , customized billingformats and other documents. Besides the Standard modules of Target there are userspecific solutions and link it with the Accounting software.

Target is available in following modulesTarget Single UserTarget Multi-user

By default target uses MDB database but it is also available for SQL or Oracle as backend.

* Financial Accounting Software

• This is yet another accounting software, whose features are as following• Off-the-shelf Financial Accounting Software was developed specifically for Excise

paying traders.• This Software handles the complete Financial Accounting operations of a trader.• This Package has completely customizable Reporting facility.• The user can customize all the reports and the user could program variables in

Correct accounting software

Correct Accounting Software is a revolution in accounting applications. It has powerfulaccounting features with a very user-friendly interface. The features of this software are asfollows:

Complete Financial AccountingInventory & Invoicing


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Full VAT SupportBusiness AnalysisReport export to PDF & Excel format& much-much more.

This program uses Microsoft Access databases powered by Microsoft Jet DatabaseEngine for fast and efficient storage and retrieval of Data. These databases are at fingertipsthrough data control where the user can view and modify the data very easily. Automaticdata testing and backing up is performed to safeguard against accidental loss of data.

Multitasking (Carrying out two tasks at a time; i.e.) printing reports or invoices issimultaneously possible while viewing other reports or making new invoices. The programuses spreadsheet to display all the data on the screen at the same time for easy readability.

All the Grids (spreadsheets) have facility of removing the columns which the retailerdoes not want to see in the report. Also locating an item in the grids is very easy with instantsearch feature which is incorporated in all the grids.

Billing / making vouchers is fast and efficient and posting is fully automated. All thereports can be prepared and printed effortlessly in various fonts. Apart from the normalhigh quality window printing fast printing is also made available using fast printing fonts.This printing is as fast as draft mode printing as under DOS. All the reports can be customizedso that you are able to print and see only the columns you require in a report.

10. SUMMARY

* Accounting has been termed as the language of business. The basic function of accountingthus is to communicate the operating results of the business to the stakeholders andshareholders of a business.

* Even for a retail business also, accounting plays a major role in aiding the retailer toevaluate his business performance. This performance evaluation helps a retailer in framinghis growth strategies and plans of action. The basic process of accounting remains thesame for both a manufacturer and a retailer, even though one is in the first step of thesupply chain and the other is in the last step. Both of them follow in general the sameaccounting concepts and conventions, except for some minor differences.

* Knowledge of bookkeeping is highly important to people who are engaged in any kindof mercantile activities. As every retail shop deals with never ending flow of cash andtransactions, there is a great need to establish efficient accounting systems to monitor andrecord the huge financial data. The business analysts have to look at numerous entries fromevery angle to ensure the profitability of the existing business. In such a situation, flaws intransactions can affect the profitability of the retail business, and hence, the retailer has toestablish a precise retail accounting system.

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* Since majority of the retailers follow single entry system, a daybook may be maintainedby the retailer / accountant to keep record of every sold entity. Daybooks are easilymanageable and exhibit true state of accounts with every person with whom the firm hasany dealing on credit. A busy place like a retail shop demands extra concern and precisionas several financial activities take place at the same time.

* In spite of great attentiveness by shop owners, retail businesses often face the problemsof flawed accounting data. Retail accounting someway carries more cluttered transactions;accounting professional who tally every transaction on daily basis find the daybook abetter way to make record keeping simpler. It provides a retailer with a convenient methodof monitoring daily sales as well as stock available.

* In retail accounting, there are many things that need to be analyzed regularly as it helps inmanaging the day-to-day business and decision-making on every aspect. It includesmaintaining records such as inventory, creditor book, defaulter book, sales books andprofit and loss for the month. These records are further used to prepare the final personalaccount. If the retailer is dealing with multiple wholesalers at a time, then he must makenote of every receipt and payment in his cashbook. Particulars of the cashbook includedefault payments also, which helps a retailer in deciding on reliability of wholesalers andagency representatives.

* Accounting principles, rules of conduct and action are described by various terms suchas concepts, conventions, tenets, assumptions, axioms, postulates, etc.

* The term ‘Concept’ is used to mean necessary assumptions and ideas which arefundamental to accounting practice. The various accounting concepts are – Business entityconcept, dual aspect concept, going concern concept, accounting period concept, moneymeasurement concept, historical concept, revenue recognition concept, periodic matchingof cost and revenue concept, verifiable objective evidence concept and accrual concept.

* The term ‘convention’ is used to signify customs or traditions as a guide to the preparationof accounting statements. The various accounting conventions are – convention of disclosure,convention of materiality, convention of consistency and convention of conservatism.

* Retail shops also maintain the income statement and the balance sheet, which reflect theirperformance. Retailers use various financial ratios (ex. Gross margin, net profit margin,asset turnover, financial leverage etc) to measure their store performance. Some of theretailers use a strategic profit model (SPM) in pursuing their financial goal of earning agood ROI. SPM is a tool for planning and evaluating the retailers’ financial performance,by integrating the informational content of both the income statement and the balancesheet. This model establishes a mathematical relationship among net profit margin, assetturnover and financial leverage.


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* As a business grows, it often establishes branches in order to market its products over alarge territory. The accounting system adopted for the branch depends on the size andnature of branch and degree of control needed by the head office. For convenience of thestudy, branches may be divided into – (i) branch not keeping full system of accounting and(ii) branch keeping full system of accounting.

* As some types of branches do not keep full system of accounting, accounts are maintainedonly in the head office books. The system of accounting in the head office too in its turndepends on the size of such branch, and the degree of control head office wants to exercise.Based on the above factors, accounts of such branches may be kept by head office in anyof the following ways – debtors system, final account system, stock and debtors systemand whole sale branch account.

* When goods are sent to branches, abnormal losses may arise due to loss of goods intransit or theft or pilferages at branch. In such cases, the branch stock account must becredited with such abnormal losses. The loading on abnormal losses is to be debited tobranch adjustment account and the cost of goods to profit and loss account. Any losses,given as abnormal losses should be ignored.

* When two or more persons come together to do some specific contract or a specificbusiness venture, then it is called the joint venture relationship. Like in partnership, there isno stipulation for profit sharing ratio. They share profits and losses in agreed proportions.This relationship comes to an end as soon as that work or venture or job is over. Thepersons are individually called co-venturers, and collectively are called as joint venturefirm.

* Joint venture is different from partnership in certain aspects and from consignment incertain other aspects.

* Accounting of joint venture can be done under three methods, which are - Separatebooks method; complete accounting in the books of the co-venturer and Memorandumjoint venture method. The selection of the method of joint venture is discretionary anddepends on the decision of the co-venturers. The factors which will influence the selectionof the method are - Volume of transactions and amount involved; Time duration of ventureexpected; Existence of own books of a/c of the co-venturer and location of activity andthe location of co-venturers etc.

* The income statement of a retailer provides the operational results (revenues andexpenditure) for a period of time. Profit has an important role in allocating resources (land,labor, capital and enterprise). Falling profits signal that resources should be taken out ofthat business and put into another one; rising profits signal that resources should be movedinto this business. The main task of accounts, therefore, is to monitor and measure profits.

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* According to Howard, a Balance sheet may be defined as – ‘a statement which reportsthe values owned by the enterprise and the claims of the creditors and owners againstthese properties’.

* The balance sheet of a retailer indicates the financial status of a retailer at a given point oftime, which is usually at the end of the year. The balance sheet of a retailer consists of threecomponents – assets, liabilities and owner’s net worth. This statement is prepared on thebasis of the accounting equation which says that assets = liabilities + owner’s equity.

* The basic functions of a balance sheet are - It gives the financial position of a companyon any given date; It gives the liquidity picture of the concern and it gives the solvencyposition of the concern.

* There are several adjustments a retailer has to make while preparing his financialstatements. The various accounting concepts and conventions along with the accountingstandards will guide him in this activity.

* The VAT was invented by a French economist, Maurice Laure, joint director of theFrench tax authority, in 1954. He was the first person to introduce VAT with effect from10th April 1954, for large businesses and extended to all business sectors over time

* A Value Added Tax is a tax that is charged at each level of the manufacturing processand is considered as a hybrid tax initially because of its complexity. Today around 160countries utilize value added tax (VAT) while a number of countries adopt sales tax.Almost all countries of the world rely upon taxes as the major source of revenue. VATRates in the participating countries generally range from 6.5% to 25% depending on thecountry. VAT may be refunded on: hotels, restaurants, car rentals, parking, gasoline, dieselfuel, transportation within country, business entertainment, telecommunications, conferences,trade shows, training courses, professional fees. VAT is not refundable such as on alcoholand laundry services.

* VAT is a multi-stage tax levied at each stage of the value addition chain, with a provisionto allow input tax credit (ITC) on tax paid at an earlier stage, which can be appropriatedagainst the VAT liability on subsequent sale.

* The Indian model of VAT is different from VAT as it exists in most parts of the world. InIndia, VAT replaced the existing state sales tax system. One of the many reasons underlyingthe shift to VAT is to do away with the distortions in the existing tax structure that carve upthe country into a large number of small markets rather than one big common market.


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* The VAT system ensures lesser paperwork for the retail community. There are no localstatutory forms under VAT. The sales tax system required dealers to maintain an accountof sales and purchases, which even the VAT system also requires.

* All the goods including declared goods as mentioned in the Central Sales Tax Act, 1956are covered under VAT and will get the benefit of input tax credit. Only few goods whichhave been kept outside VAT include - liquor, lottery tickets, petrol, diesel, aviation turbinefuel and other motor spirit since their prices are not fully market determined.

* In India, VAT replaced sales tax from 1st April 2005 in 20 out of 28 states in India at arate of 12.5%. It was one of the large scale reforms of the country’s public finances. ValueAdded Tax is a multi point sales tax with set off for tax paid on purchases. It is basically atax on the value addition on the product. The burden of tax is ultimately born by theconsumer of goods. In many aspects it is equivalent to last point sales tax.

* VAT was the most talked about concept even before its introduction. It is different fromsales tax and consignment.

* A retail audit systematically examines and evaluates a firm’s total retailing effort or aspecific aspect of it. A retail audit investigates a retailer’s objectives, strategy, implementationand organization. Retailer’s goals are reviewed and evaluated for their clarity, consistencyand appropriateness. The retailer’s strategy and the methods for deriving it are analyzed.The application of strategy and how the customers receive it is reviewed. The organizationalstructure is also analyzed with regard to lines of command and other factors.

* Essentials of a good retail audit involve – Regularity of audits; In-depth analysis andsystematic collection and analysis of data; unbiased perspective of the auditor; willingexploration of the strengths and weaknesses of the retailer and preparation of acomprehensive audit report by the auditors.

* Retail audit process involves 6 steps. They are - Step I –Determination of who does theaudit: Step II – Determining when and how often the audit is conducted; Step III –Determining the areas to be audited; Step IV– Develop audit forms; Step V– Conduct theaudit; Step VI – Report to the management.

* There are many types of audits in existence, each aiming at different areas to servedifferent purposes. The following are some of the types of audit - Accounting audit; Financialaudit; Performance audit; Internal Audit / Concurrent Audit; Management Audit; OperationalEfficiency Audit; Special Investigative Audit; Internal Auditing; External Auditing;Information Systems Audits; Compliance Audits; Follow-up Audits and Operational Audits.

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* Like every other type of business, retail businesses are also using computerized retailaccounting system so that they may maintain accuracy of every transaction without anydelay. For retail shops, computerizes accounting is a great way to reduce workload andimprove work efficiency. If a retail shopkeeper is planning to incorporate computerizedsystem in his business, he has to make sure which accounting software he is going to use.In case the software is not according to the requirements of his retail accounting system, hemay face problems in proper execution. Therefore, a retailer always has to do a littleresearch whether the software is well matched to his requirement or not, as it will help himin choosing the best retail accounting software for his organization.

* Accounting software is application software that records and processes accountingtransactions within functional modules such as accounts payable, accounts receivable, payroll,and trial balance. It functions as an accounting information system. It may be developed in-house by the company or organization using it, may be purchased from a third party, ormay be a combination of a third-party application software package with local modifications.It varies greatly in its complexity and cost.

* Accounting software is typically composed of various modules, different sections dealingwith particular areas of accounting. Among the most common are: - among the core modules,Accounts receivable; Accounts payable; General ledger; Billing; Stock/Inventory; PurchaseOrder; Sales Order; and among the Non Core Modules, - Debt Collection; Expenses;Inquiries; Payroll; Reports; Timesheet; Purchase Requisition etc.

11. SHORT QUESTIONS

1. Define Accounting.2. What is GAAP?3. Write a short note on the various records maintained by a retailer.4. What do you mean by branch accounting?5. How are abnormal losses treated in branch accounts?6. What do you mean by joint venture accounting?7. Who is a co-venturer?8. Give the format of the income statement of a retailer9. Give the format of the balance sheet of a retailer10. What are the basic functions of a balance sheet?11. What is VAT?12. What are the various advantages of VAT?13. Mention the various stages of an audit process?14. Mention the various types of audit.15. What are the various essentials of a good retail audit?


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12. LONG QUESTIONS

1. Define accounting. Explain the various accounting conventions and concepts2. Give an overview of branch accounting3. Give an overview of joint venture accounting.4. Give the format of the income statement of a retailer. Explain the various components

of the income statement.5. Give the format of the balance sheet of a retailer. Also explain the various components

of the balance sheet.6. Explain the various adjustments to be made before preparing the balance sheet.7. Give a detailed note on VAT. What are its advantages and criticisms?8. In what ways VAT is different from sales tax?9. What is audit? Explain the various types of audits.10. Explain in detail the various stages in a retail audit procedure.11. What is agn audit? What are the essentials of a good retail audit procedure?12. Write a note on accounting software in India.

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Financial Management and Accounts

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