Financial Strategy

EXECUTIVE BRIEFING
Ken Hicks, Chairman and CEO,
Foot Locker Inc.

After graduating from the U.S. Military Academy

and serving six years as an artillery officer, I earned
an MBA from Harvard Business School and went
to  work as a consultant for McKinsey. However, I
realized that I wanted to develop and implement
strategies, rather than just analyzing situations and
making recommendations. Through my consulting
experience, I recognized the exciting challenges and management team and I developed a four-year plan
opportunities retailing had to offer and took a posi- that set goals and developed strategies for achiev-
tion in strategic planning for May Department ing those goals. The goals we set for 2013 were in-
Stores. Prior to becoming the chairman and CEO of ventory turnover, 3.0; sales per square foot, $400;
Foot Locker, I had senior executive management sales, $6 billion; net profit margin, 5 percent; and
positions at Home Shopping Network, Payless Shoes, EBIT, 8 percent.
and JCPenney. The key strategic change we made was clearly
My career path is a bit unusual for a retail execu- differentiating our five retail brands—Foot Locker,
tive. There aren’t many jobs in the private sector for Footaction, Lady Foot Locker, Kids Foot Locker, and
artillery officers. But, in the military, I learned how Champs Sports. The brands were operating as inde-
to motivate people and coordinate their activities to pendent businesses, each trying to maximize their
achieve an organization’s goals, and I learned the own profits and sales. Over time, the five brands lost
importance of execution. These skills were particu- their identities. They all offered similar assortments
larly useful at Foot Locker when I became CEO in and stocked the most popular athletic shoes. Their
1999. Foot Locker was not meeting the expectations stores had the same look and feel, and they com-
of its customers, employees, and shareholders. Sales, peted vigorously against each other. We needed to
comparable store sales, and earnings per share had turn the guns outward and develop a unique posi-
declined significantly during the previous four years. tion for each brand, but still exploit the operational
To turn around this downward trend, the senior synergies among the five brands.
 CHAPTER 6

LEARNING OBJECTIVES
LO1 Review the strategic objectives of a LO4 Analyze the financial risks facing a retail
retail firm. firm.
LO2 Contrast the two paths to financial LO5 Review the measures retailers use to
performance using the strategic profit assess their performance.
model.
LO3 Illustrate the use of the strategic
profit model for analyzing growth
opportunities.

Our brands are like ice cream sundaes. They all www.footlocker-inc.com/. In retailing, some per-
have the same vanilla ice cream, but each specializes formance measures are available daily or even
in different toppings for customers who like hot hourly. But retailers need to balance their long-
fudge or banana sundaes. For example, Champs term goals with short-term measures. Foot Locker
focuses on customers engaged in team sports, Foot is now the leading global retailer of athletically
Locker on performance-oriented customers, and inspired shoes and apparel. We operate more than
Footaction for fashionable shoes and apparel. 3,400 stores in  23 countries and have a successful
In 2011, we exceeded all of our goals two years Internet channel and social media program. We
into our four-year plan. So we adopted some have more than 6 million Facebook fans and 65,000
more ambitious goals, which you can see at Twitter followers.

F
inancial objectives and goals are an integral part of a retailer’s market
strategy. In Chapter 5, we examined how retailers develop their strategy
and build a sustainable competitive advantage to generate a continuing
stream of profits. In this chapter, we look at how financial analysis is used to assess
the retailer’s market strategy—to monitor the retailer’s performance, assess the
reasons its performance is above or below expectations, and provide insights into
appropriate actions that can be taken if performance falls short of expectations.
For example, Kelly Bradford, the owner of Gifts To Go, whom we described in
Chapter 5, needs to know how well she is doing because she wants to stay in busi-
ness, be successful, increase the profitability of her company, and realize her goal
of generating an annual income of $100,000. To assess her performance, she can
156 SECTION II Retailing Strategy

add up the receipts at the end of each day. But this simple measure, sales, doesn’t
provide a complete assessment of how she is doing financially, and it may even be
misleading. For instance, she might find that sales meet expectations and her ac-
countant confirms that her business is profitable, but she doesn’t have the cash to
buy new merchandise or pay her employees. When this happens, Kelly needs to
analyze her business to determine the cause of the problem and what can be done
to overcome it.
In this chapter, we first review the types of objectives that retailers have. Then
we introduce the strategic profit model and use it to discuss the two paths for
achieving the desired financial performance. To illustrate the use of this model, we
examine and compare the factors affecting the financial performance of Costco
and Macy’s, two very successful retailers with different retail strategies. Then we
demonstrate how the model can be used to evaluate one of the growth opportuni-
ties Kelly Bradford is considering. In the last part of this chapter, we examine
productivity measures that assess the performance of merchandise management
and store operations decisions.

OBJECTIVES AND GOALS

LO1 As we discussed in Chapter 5, the first step in the strategic planning process
involves articulating the retailer’s objectives and the scope of activities it plans to
Review the strategic
objectives of a retail firm. undertake. These objectives guide the development of the retailer’s strategy and
the specific performance goals the retailer plans to achieve. When the goals are
not being achieved, the retailer knows that it must take corrective actions. Three
types of objectives that a retailer might have are (1) financial, (2) societal, and
(3) personal.

Financial Objectives
When assessing the financial performance of a firm, most people focus on profits:
What were the retailer’s profits or profit as a percentage of sales last year, and
what will they be this year and into the future? But the appropriate financial
performance measure is not profits but return on assets. Return on assets (ROA)
is the profit generated by the assets possessed by the firm. A retailer might set a
financial objective of making a profit of at least $1,000,000 a year, but the retailer
really needs to consider the assets it needs to employ to make the desired
$1,000,000. The retailer would be delighted if it made $1,000,000 and only needed
$5,000,000 in assets (a 20 percent ROA) but would be disappointed if it had to use
$40,000,000 in assets to make $1,000,000 profit (a 2.5 percent ROA).

Societal Objectives
Societal objectives are related to broader issues that make the world a better place
to live. For example, retailers might be concerned about providing employment
opportunities for people in a particular area or for minorities or for people with
REFACT disabilities. Other societal objectives might include offering people unique mer-
In 1946, George Nelson chandise, such as environmentally friendly products; providing an innovative ser-
Dayton, the son of Target vice to improve personal health, such as weight reduction programs; or sponsoring
Corporation’s founder, community events. Retailing View 6.1 describes a retail entrepreneur offering
established a standard of shoes for poor families.
contributing 5 percent of Compared with financial objectives, societal performance objectives are more
the corporation’s income difficult to measure. But explicit societal goals can be set, such as specific reduc-
to programs that serve the tions in energy usage and excess packaging, increased use of renewable resources,
communities in which it
and support for nonprofit organizations such as the United Way and Habitat for
has stores.1
Humanity.
 Financial Strategy CHAPTER 6 157

Personal Objectives
Many retailers, particularly owners of small, independent businesses, have impor-
tant personal objectives, including self-gratification, status, and respect. For
example, the owner/operator of a bookstore may find it rewarding to interact
with others who like reading and authors who visit the store for book-signing
promotions. By operating a popular store, a retailer might become recognized as a
well-respected business leader in the community.
While societal and personal objectives are important to some retailers, all
retailers need to be concerned about financial objectives or they will fail. Therefore,

RETAI L ING V IEW One for One to Achieve TOMS Shoes’ 6.1
Societal Objectives
In 2006, after competing on the
second season of The Amazing
Race, Blake Mycoskie visited
Argentina, where he was struck
by the poverty—including the
number of children walking
around without shoes. Because
the traditional Argentine alpar-
gata shoe offers a simple, revo-
lutionary solution for providing
footwear, he set out to provide
footwear for poor families by
reinventing the alpargata for
the U.S. market. To make the
connection, Mycoskie commit-
ted to providing one new pair
of shoes to a child living in pov-
erty for every pair of shoes that
consumers purchased from the
One for One website. As he re-
counted, “I was so overwhelmed
by the spirit of the South Ameri-
can people, especially those
who had so little. And I was in-
Achieving societal objectives is important to Blake Mycoskie, founder, CEO, and chief
stantly struck with the desire—
giving officer of TOMS shoes.
the responsibility—to do more.”
The success of the initial idea
pushed Mycoskie to move beyond just the Argentinean- fashion statement that also provides a public proclamation
styled classic alpargata shoes. Thus, TOMS today sells of their own social responsibility. Through their social
Cordones, for wear with or without laces; Botas, for both media networks, these TOMS afficionados, many of whom
women and men; Stitchouts, which are only for men; belong to the thousands of TOMS university clubs, affirm
Wedges and Wrap Boots for women; and of course, Youth their love for TOMS and encourage others to join the
and Tiny TOMS for children and tod- movement. With annual sales estimated at greater than
dlers. The social activist also decided $100  million, by 2012, TOMS had provided more than
REFACT that the company could increase the 1 million pairs of new shoes to children in more than 25
Eighty percent of number of shoes provided to needy countries—including the United States.
Millennials would be children by selling T-shirts, accessories,
likely to switch to a brand and hats—all of which spark the same
Sources: www.toms.com; Ricardo Lopez, “It’s Doing Well by Doing Good,”
associated with a good one-to-one exchange. Los Angeles Times, January 25, 2012, p. B.1; and Gregory Ferenstein, “TOMS
cause if product price and This socially responsible business Shoes Generation Y Strategy,” Fast Company, June 9, 2010.
quality were comparable; model appeals particularly to Millen-
53 percent had purchased nial consumers in developed econo- DISCUSSION QUESTIONS
a product or service tied to mies who want to be able to shop,
Does TOMS’s socially responsible business model make
a cause in the last year.2 socialize, and save the world, simulta-
you more likely to buy its shoes?
neously. Wearing TOMS shoes is a
158 SECTION II Retailing Strategy

the remaining sections of this chapter focus on financial objectives and the factors
affecting a retailer’s ability to achieve financial goals.

STRATEGIC PROFIT MODEL

LO2 The strategic profit model, illustrated in Exhibit 6–1, is a method for summariz-
Contrast the two paths to ing the factors that affect a firm’s financial performance, as measured by return on
financial performance using assets. Return on assets is an important performance measure for a firm and its
the strategic profit model. stockholders because it measures the profits that a firm makes relative to the assets
it possesses. Two retailers that each generate profits of $1 million, at first glance,
might look like they have comparable performance. But the performance of the
retailers looks quite different if one has $10 million in assets and the other has
$25 million. The performance of the first would be higher because it needs fewer
assets to earn its profit than does the other. Thus, a retailer cannot only concern
itself with making a profit. It must make a profit efficiently by balancing both
profit and the assets needed to make the profit.
The operating profit margin, also called earnings before interest, taxes, and
depreciation (EBITDA), is a measure of the profitability from continuing opera-
tions of a retailer and is a useful predictor of the retailer’s profitability in the future.
Asset turnover is the retailer’s net sales divided by its assets. This financial measure
assesses the productivity of a firm’s investment in its assets. It indicates how many
sales dollars are generated for each dollar of assets. Thus, if a retailer’s asset turnover
is 3.0, it generates $3 in sales for each dollar invested in the firm’s assets.
The retailer’s ROA is determined by multiplying the two components together:
Operating profit margin percent 3 Asset turnover 5 Return on assets (ROA)
Operating profit margin percent Net sales Operating profit margin
3 5
Net sales Total assets Total assets
The strategic profit model decomposes ROA into two components: (1) operat-
ing profit margin percentage and (2) asset turnover. These two components illus-
trate that ROA is determined by two sets of activities—profit margin management
and asset turnover management—and that a high ROA can be achieved by various
combinations of operating profit margins and asset turnover levels.

Operating
profit margin
EXHIBIT 6–1 percent
Strategic Profit Model (EBITDA)
Net profit
Profit
margin
management
percent
path

Net sales

Return
on assets

Net sales
Asset
management Asset
path turnover

Total assets
 Financial Strategy CHAPTER 6 159

Net Profit Margin 3 Asset Turnover 5 Return on Assets EXHIBIT 6–2

Different Approaches
La Chatelaine Bakery 1% 10 times 10% for Achieving an
Lehring Jewelry 10% 1 time 10% Acceptable ROA

To illustrate the different approaches for achieving a high ROA, consider the
financial performance of two very different hypothetical retailers, as shown in
Exhibit 6–2. La Chatelaine Bakery has a net operating profit margin percentage of
only 1 percent and an asset turnover of 10, resulting in an ROA of 10 percent. Its
operating profit margin percentage is low because it is in a highly competitive mar-
ket with little opportunity to differentiate its offering. Consumers can buy basically
the same baked goods from a wide variety of retailers, as well as from the other
bakeries in the area. However, its asset turnover is relatively high because the firm
has a very low level of inventory assets—it sells everything the same day it is baked.
On the other hand, Lehring Jewelry Store has a net operating profit margin
percentage of 10 percent—10 times higher than that of the bakery. Even though it
has a much higher operating profit margin percentage, the jewelry store has the
same ROA because it has a very low asset turnover of 1. Lehring’s asset turnover is
low compared with the bakery’s because Lehring has a high level of inventory and
stocks a lot of items that take many months to sell.
In the following sections, we take a closer look at these two components of ROA.
We examine the relationship between these ratios and a firm’s retail strategy and
describe how these financial measures can be used to assess performance with
traditional accounting information. To illustrate the financial implications of differ-
ent retail strategies, we compare the financial performance of Costco and Macy’s.
The retail strategies of these two retailers are described in Retailing View 6.2.

RETAI L ING V IEW Macy’s and Costco—Successful Retailers Using 6.2

Different Retail Strategies

Costco (left) and Macy’s (right) have very different retail strategies and financial performance measures. Costco focuses on the
asset management path for achieving a high ROA, while Macy’s focuses on the profit management path.

Costco Rico, as well as 162 stores in Canada, the United Kingdom,

Costco pioneered the membership warehouse club for- Korea, Taiwan, Japan, Australia, and Mexico. The member-
mat when it opened its first store in 1983. It is now the oriented stores promises low prices on a limited range of
largest warehouse club chain, generating annual sales of around 4,000 branded and private-label products, across
$89 billion from its 433 locations in 40 states and Puerto (continued)
160 SECTION II Retailing Strategy

a vast span of merchandise categories. In addition to States with annual sales of more
commodity items, such as dairy products and toilet pa- than $26 billion. Its typical store an- REFACT
per, the stores stock special, unique items that are always chors an enclosed mall and includes Macy’s was the first
a surprise. The “treasure hunt” environment created by 180,000 square feet of selling space retailer to promote a
opportunistic buying gives the customer a sense of stocking 50,000 SKUs. woman to an executive
urgency to buy the item immediately. Some of these Macy’s primary target market is position and establish a
products with limited availability could be a four-carat females between 25 and 54 years fixed price for merchan-
diamond ring, a Louis Vuitton handbag, or a Versace old who typically work outside the dise that was advertised in
china set. Costco is committed to delivering the customer house, have children, and have an a newspaper. Its buyers
a good value—low prices and high quality. average family income of more than designed and launched
Costco’s unusually high inventory turnover—combined FPO
$75,000. Macy’s has been particularly innovative products such
with operating efficiencies achieved by volume purchasing, effective in developing private
as the tea bag, the Idaho
efficient distribution, and reduced handling of merchan- brands such as I.N.C., Charter Club,
baked potato, and colored
dise in no-frills, self-service warehouse facilities—enables it Club Room, Ideology, Jenna, Tasso
bath towels.3
to operate profitably at significantly lower gross margins Elba, Style & Co., JM Collection, Epic
than traditional wholesalers, mass merchandisers, super- Threads, and First Impressions. Its
markets, and supercenters. The small number of SKUs store brands presently account for 20 percent of annual
allows Costco’s buyers to have a strong grasp on the move- sales with exclusive, limited distribution brands account-
ment and quality of the goods. In turn, its customers un- ing for an additional 23 percent of annual sales.
derstand and appreciate its assortment better than they Three key strategic initiatives for Macy’s are (1) My
would if they were shopping at a supermarket or discount Macy’s localization, (2) multichannel integration, and
store that would carry many more SKUs. (3)  MAGIC Selling. First, the localization initiative in-
Its private-labeled merchandise accounts for 20 percent volves tailoring the merchandise assortment and shop-
of its sales. Costco is concentrating on growing its private- ping experience to the needs of the local market.
label, Kirkland Signature, products. It has a diverse selec- Second, through multichannel integration, Macy’s seeks
tion of Kirkland-branded products ranging from wines to combine its store, Internet, and mobile operations,
and champagnes to bakery items. Its buyers make quality mainly to optimize its inventory offerings. An out-of-
relationships with its vendors and can thus capitalize on a stock situation in a local store prompts sales associates to
trend to develop products for the store. Many of its items seek replacement merchandise from the online fulfill-
are co-branded with manufacturers such as Hormel bacon, ment centers and have the items shipped to the custom-
Stonyfield Farm’s organic smoothies, Dannon’s Activia, and er’s home address; online fulfillment centers also can
Borghese upscale cosmetics. The co-branded products sig- turn to store inventories to fill orders that originate on-
nal to customers that they are receiving a quality product line or through mobile devices. Third, “MAGIC Selling”
from a trusted name at a value price. refers to an acronym used in sales training that seeks to
Costco’s target market is not limited to low-income improve customers’ shopping experiences: “Meet and
customers who have to shop for the lowest prices. It has a make a connection; Ask questions and listen; Give
loyal, upscale clientele who also enjoy bargains. The re- options, give advice; Inspire to buy . . . and sell more;
tailer marks products up no more than 14 percent, giving and Celebrate the purchase.”
its customers true value, whether the product is a quart of Together with these strategic initiatives, Macy’s is
ketchup or an LCD television. experimenting with various new in-store and online
Costco also is committed to carrying healthy products technologies. For example, tablet computers located in
and being environmentally friendly. It ensures that the departments throughout the store provide customers
raw materials that are used in the products that it sells with additional information, give them the option of
(e.g., cocoa, coffee, seafood, etc.) are all grown and pro- obtaining paperless receipts, engage them with QR code
duced in a fair and healthy way. It is also trying to cut technology, link to a smartphone app with which custom-
down on the packaging used. The company evaluates its ers can use their phones to “tap, pay, and save,” and
suppliers closely so it knows how everything is being pro- deliver special offers to them through social media (e.g.,
cessed. For example, Costco inspects a seafood supplier by Foursquare, Shopkick, Google, Facebook).
meeting the boats when they come in to see how the
products were being iced, how they are unloaded, and Sources: 2012 Macy’s Factbook; 2011 Costco Annual Report; Karen Talley,
how they maintain the temperature from the dock to the “Three Stores, Three Scenes; Fortunes Diverge for Macy’s, Penney and
plant. It is protocols such as this allow the company to Kohl’s,” The Wall Street Journal (Online), August 12, 2012; and Annie
Gasparro and Timothy Martin, “What’s Wrong With America’s Supermarkets?
maintain consistent quality. Traditional Grocery Stores Are Caught in the Middle,” The Wall Street Journal
(Online), July 12, 2012.
Macy’s
Macy’s, established in 1858, is the Great American Depart- DISCUSSION QUESTION
ment Store—an iconic retailing brand with more than 800
What are the differences in the retailing mixes used by
stores operating coast-to-coast and online at macys.com.
Costco and Macy’s?
It is the largest department store retailer in the United
 Financial Strategy CHAPTER 6 161

Profit Margin Management Path

The information used to examine the profit margin management path comes from
the retailer’s income statement, also called the statement of operations. The
income statement summarizes a firm’s financial performance over a period of
time, typically a quarter (three months) or year. To capture all the sales, gift card
purchases, and returns from the holiday season, Macy’s, like many retailers, sets its
fiscal year as beginning on February 1 and ending on January 31 of the following
year. So its 2012 Annual Report actually focuses on 11 months in 2011 and 1 month
in 2012. Costco’s fiscal year begins on October 1, so most recent annual report
includes 9 months in 2012 and 3 months in 2011.
Exhibit 6–3 shows income statements adapted from the annual reports of
Macy’s and Costco. The components in the profit margin management path
portion of the strategic profit model are summarized for both retailers in
Exhibit 6–4.

Components in the Profit Management Path The four components in

the profit margin management path are net sales, cost of goods sold (COGS),
gross margin, and operating profit margin. Net sales are the total revenues re-
ceived by a retailer that are related to selling merchandise during a given time
period minus returns, discounts, and credits for damaged merchandise.
Sources of revenue that are not considered part of net sales are special charges
to customers, membership fees, and credit card interest. For example, warehouse
clubs generate revenue from annual membership fees, and retailers with frequent
shopper programs may charge customers for enrolling in the program. Costco
does not consider membership fees as part of its net sales because they reflect
business activities unrelated to its primary activity of selling merchandise. Macy’s
has its own credit card on which it receives revenues from late payments, which
are therefore also not part of net sales.
Some retailers have additional revenue sources related to merchandise sales,
such as payments from vendors. For example, retailers often charge vendors for
space in their stores known as a slotting fee or slotting allowance. Retailers
may also require that vendors pay a fee, known as a chargeback fee when the
merchandise bought from the vendor does not meet all the terms of the

Costco Income Statement Macy’s Income Statement EXHIBIT 6–3

2012 2012 Income Statements for
Macy’s and Costco
Net sales 97,062 26,405
Membership fees 2,075
Total revenue 99,137 26,405
Cost of goods sold (COGS) (86,823) (15,738)
Gross margin 12,314 10,667
Selling, general, and administrative (SG&A) 9,518 8,281
Operating profit 2,796 2,386
Other income (expenses) (95) 25
Interest income 103 (447)
Provision for income tax (712)
Net profit 2,720 1,252
g 5 1 Gross margin percent 10.5% 40.4%
SG&A percent of sales 9.8% 31.4%
Operating profit percent 2.9% 9.0%
Net profit percent 2.8% 4.7%

Sources: 10-K filings with the SEC.

162 SECTION II Retailing Strategy

purchase agreement, such as those regarding delivery. Such payments from

vendors are typically incorporated into the income statement as a reduction in
the COGS.
Cost of goods sold (COGS) is the amount a retailer pays to vendors for the
merchandise the retailer sells. Gross margin, also called gross profit, is the net
sales minus the cost of the goods sold. It is an important measure in retailing be-
cause it indicates how much profit the retailer is making on merchandise sold,
without considering the expenses associated with operating the store and corpo-
rate overhead expenses.
Gross margin 5 Net sales 2 Cost of goods sold
Operating expenses include selling, general, and administrative (SG&A)
expenses. SG&A expenses are overhead costs associated with normal business
operations, such as salaries for sales associates and managers, advertising, utili-
ties, office supplies, transportation from the retailer’s warehouses to its stores,
and rent.
Some retailers include other expenses, such as the cost of opening or closing
stores and/or the cost of integrating an acquisition in their operations, as a part
of their operating expenses. When estimating a retailer’s operating expenses,
one needs to decide whether these other expenses are related to the normal
operations of the retailer or are extraordinary nonrecurring expenses that arise
only during the year in which they are incurred. For example, the expenses for
store openings might occur each year as a growing retailer opens new stores,
while expenses related to an acquisition probably occur only in the specific year
of the acquisition and may not reflect the operating income the retailer will
realize in the future.
Operating profit margin, also called earnings before interest, taxes, and depreciation
(EBITDA), is the gross margin minus operating and extraordinary recurring ex-
penses. Finally, net profit margin is the operating profit margin minus interest,
taxes, and depreciation. We focus on the operating profit margin (EBITDA) be-
cause it reflects the performance of retailers’ fundamental operations, not the fi-
nancial decisions retailers make concerning depreciation of assets, taxes and capital
structure (borrowing money versus selling stock to raise capital).
Operating profit margin 5 Gross margin 2 Operating expenses 2 Extraordinary
(recurring) operating expenses
Net profit margin 5 Operating profit margin 2 Extraordinary
nonrecurring expenses 2 Interest 2 Taxes 2
Depreciation

Analyzing Performance on the Profit Margin Management Path The

level of sales, gross margin, and operating profit in Exhibit 6–4 provide some
useful information about the financial performance of the two retailers. How-
ever, it is difficult to compare the performance of the retailers when they differ
in size. If Costco was interested in comparing its performance with Walmart, it
would expect that Walmart would have a much greater gross margin and operat-
ing profit margin because it has five times greater sales than Costco. Thus, some
of the differences in the income statement numbers will be due to differences in
size, not in the performance of the retailers. Thus, it is useful to consider ratios
with net sales in the denominator when evaluating a retailer’s performance and
comparing it to other retailers. Three useful ratios in the profit management
path are gross margin percentage, operating profit margin percentage, and
SG&A as a percentage of sales.
Gross margin percentage is gross margin divided by net sales. Retailers use
this ratio to compare (1) the performance of various types of merchandise and
 Financial Strategy CHAPTER 6 163

EXHIBIT 6–4
Net sales Profit Management
$97,062 Path of Strategic Profit
$26,405 Model
Gross margin
– $10,239
$10,667

Cost of goods sold

$86,823
$15,738
Net operating profit
before tax
–
$721
$2,386

Operating
expenses
$9,518
Costco $8,281
Macy’s

(2) their own performance with that of other retailers with higher or lower levels
of sales.
Gross margin
5 Gross margin percent
Net sales
$12,314
Costco: 5 12.7%
$97,062
$10,667
Macy’s: 5 40.4%
$26,405
Even though Costco has more than double the sales of Macy’s, Macy’s has a much
higher gross margin percentage. This difference in gross margin percentage can be
traced back to the retail strategies of the companies. Department stores generally
have higher gross margin percentages than warehouse clubs because they target less-
price-sensitive customers who are interested in branded fashion merchandise and
personal service and are willing to pay for it. Warehouse club stores sell primarily
staples, which are not as easy to differentiate as fashion apparel. That is, customers
are more willing to pay a premium price for a high-fashion dress by a famous de-
signer than for a 16-pack of kitchen towels or a quart of peanut butter. It is important
for department stores to achieve a relatively high gross margin because their operat-
ing expenses are typically higher than those of some other retail formats.
Operating expenses are costs, other than the cost of merchandise, incurred in
the normal course of doing business, such as salaries for sales associates and
managers, advertising, utilities, office supplies, and rent. These costs are typically
referred to as selling, general and administrative expenses (SG&A).
Neither Costco nor Macy’s indicate other expenses or income besides the nor-
mal SG&A expenses, and all their overhead expenses are included in SG&A.
However, retailers will often have other expenses. Macy’s income statement shows
expenses related to the acquisition of the May Company—income and expenses
from inventory reevaluation, integration expenses and income from selling its
accounts receivable (the money it is owed by customers who buy on credit), and
expenses for opening new stores.
Like the gross margin, operating expenses are expressed as a percentage of net
sales to facilitate comparisons across items, stores, and merchandise categories
164 SECTION II Retailing Strategy

within firms and between firms. Costco has significantly lower operating expenses
as a percentage of net sales than Macy’s does. Retailing View 6.3 reviews the
creative ways that Costco reduces its SG&A costs.
Operating expenses
5 Operating expenses %
Net sales
$9,518
Costco: 5 9.8%
$97,062
$8,281
Macy’s : 5 31.4%
$26,405
The operating expenses percentage is operating expenses (i.e., SG&A)
divided by net sales. Costco’s operating expense percentage is about a third as
large as that for Macy’s because Costco has lower customer service and selling
expenses, and it spends less on maintaining the appearance of its stores. For store
spaces that are rented, the rental expense per square foot is lower for Costco be-
cause its standalone locations are less expensive than Macy’s anchor mall locations.
Also, warehouse club stores operate with a smaller administrative staff than do
department stores. For instance, Costco’s buying expenses are much lower because
fewer buyers are needed due to the simpler buying process and fewer SKUs for
commodity-type merchandise, like packaged foods and fresh meat and produce,

6.3 RETAI LING V IEW Cutting Costs at Costco

Costco’s retail strategy focuses on offering its customer
a good value—quality products at a reasonable price—
on a wide merchandise assortment ranging from wheels
of Parmesan cheese to 60-inch flat-screen TVs. Keeping
prices low is challenging in light of increasing commod-
ity prices, so Costco works with its vendors to control
costs.
For example, Costco typically buys 70 percent of the
large, premium macadamia nuts produced by Mauna Loa,
a division of Hershey, leaving Mauna Loa with an inven-
tory of small nuts. Costco buyers have worked with Mauna
Loa to use smaller nuts in a new chocolate-nut cluster that
will be sold exclusively at Costco. Because Mauna Loa
won’t have to face the uncertainty of selling those smaller
nuts at a steep discount, it can afford to offer Costco bet-
ter prices for its premium nuts.
Simple packaging changes can result in cost savings.
For example, packaging cashews into square containers
instead of traditional round ones enables Costco to in-
crease the number of units it can stack on a pallet from
280 to 426. This relatively minor change to a product sell-
ing $100 million a year decreases the number of pallets
shipped annually by 24,000 and decreases the number of
Changing this jar of nuts from a round shape to a square
truck trips by 600. shape made a significant reduction in Costco’s SG&A.
However, Costco does not scrimp on its employees.
Eighty-six percent of its employees get health care and Sources: Zeynep Ton, “Why ‘Good Jobs’ Are Good for Retailers,” Harvard
other benefits, even though half of its employees are Business Review, January–February 2012; Christopher Matthews, “Future of
part-timers. The average compensation of store employ- Retail: Companies That Profit by Investing in Employees,” Time, June 18,
2012; and “Costco’s Artful Discounts,” Business Week, October 20, 2008.
ees is $20 an hour, more than 50 percent higher than the
industry average. No Costco employees were laid off as a
result of the recent recession. Costco believes that treat- DISCUSSION QUESTION
ing its employees well actually reduces labor costs in the
What are advantages and disadvantages of paying
long run. Its employee turnover is only 13 percent, among
employees more than they can earn at comparable firms?
the lowest in the retail industry.
 Financial Strategy CHAPTER 6 165
compared with fashion apparel. Finally, its buyers don’t have to travel to fashion
markets around the world like department store buyers do.
Like the gross margin and operating expenses, operating profit is often expressed
as a percentage of net sales to facilitate comparisons across items, merchandise cate-
gories, and departments within and between firms. Operating income percentage
is gross margin minus operating expenses divided by net sales.
Gross margin 2 Operating expenses
5 Operating income %
Net sales
$12,314 2 $9,518
Costco: 5 2.9%
$97,062
$10,667 2 $8,281
Macy’s: 5 9.0%
$26,405
Macy’s operating profit margin percentage is more than three times greater
than Costco’s. Thus, this component of the strategic profit model suggests that
Macy’s is outperforming Costco. But the following discussion of the asset manage-
ment path tells a different story.

Asset Management Path

The information used to analyze a retailer’s asset management path primarily
comes from the retailer’s balance sheet. While the income statement summarizes
financial performance over a period of time (usually a year or quarter), the balance
sheet summarizes a retailer’s financial position at a given point in time, typically
the end of its fiscal year. Costco’s and Macy’s balance sheets are shown in Exhibit 6–5,
and the asset management path components in the strategic profit model are
shown in Exhibit 6–6.
Components in the Asset Management Path Assets are economic re-
sources (e.g., inventory, buildings, computers, store fixtures) owned or controlled
by a firm. There are two types of assets, current and fixed.
Current assets are assets that can normally be converted to cash within one
year. For retailers, current assets are primarily cash, accounts receivable, and mer-
chandise inventory.
Current assets 5 Cash 1 Accounts receivable 1 Merchandise inventory 1
Other current assets

Costco Macy’s EXHIBIT 6–5

Balance Sheet for
Cash and cash equivalents 4,009 2,827 Macy’s and Costco
Short-term investments 1,604
Accounts receivable 965 368
Merchandise inventory 6,638 5,117
Other current assets 490 465
Total current assets 13,706 8,777
Property and equipment (net) 12,432 8,400
Other assets 623 4,918
Total assets 26,761 22,095
Current liabilities 12,050 6,263
Long-term debt 1,253 6,655
Other liabilities 885 2,344
Total liabilities 14,188 15,262
Stockholder equity 12,573 6,833

Sources: 10-K reports filed with the SEC.

166 SECTION II Retailing Strategy

EXHIBIT 6–6 Accounts

Asset Management receivable
Path in Strategic $965
Profit Model $368

Merchandise
Net sales
inventory
$97,062
$6,638
$26,405
$5,117
Total current
Asset turnover
assets
+ 4 3.633
$13,706
1.203
$8,777
Cash Total assets
$4,009 + $26,761
$2,827 $22,095

Fixed assets
+ $13,026
$13,318
Other current
assets
$2,094
$465

Costco
Macy’s

Merchandise inventory is a critical retailer asset that provides benefits to cus-

tomers. It enables customers to get the right merchandise at the right time and
place. Stocking more merchandise increases sales because it increases the chances
that customers will find something they want. But increasing the level of inven-
tory also increases the amount that retailers need to invest in this asset.
Inventory turnover, which measures how effectively retailers utilize their
investment in inventory, is another important ratio for assessing retail performance.
Inventory turnover is COGS during a time period, typically a year, divided by the
average level of inventory (expressed at cost) during the time period. A surrogate
measure for average inventory is the inventory value at the end of the fiscal year
reported on the balance sheet. Note that the inventory level reported on the bal-
ance sheet is the level on the last day of the fiscal year, not the average level. To
measure the average inventory level more accurately, you would have to measure
the level on each day of the year and divide by 365 or each month (see Chapter 12).
COGS
5 Inventory turnover
Average inventory at cost
$86,823
Costco: 5 13.08
6,638
$15,738
Macy’s: 5 3.08
5,117
Inventory turnover is a measure of the productivity of inventory. It shows how
many times, on average, inventory cycles through the store during a specific
period of time (usually a year). Costco’s higher inventory turnover is expected
due to the nature of its retail strategy and the merchandise it sells. That is, most
items in Costco are commodities and staples such as food, batteries, house-
wares, and basic apparel items. Unlike apparel fashions that are the mainstay for
 Financial Strategy CHAPTER 6 167
department stores like Macy’s, these staples can be replenished quickly. Costco
stores typically have only 4,000 SKUs in total; for example, it may only offer one
brand of ketchup in two different sizes, which represents two inventory items.
Department stores, on the other hand, usually stock more than 100,000 SKUs.
This store format may stock 500 SKUs of just men’s dress shirts (different colors,
sizes, styles, and brands). Larger assortments, like those in department stores, re-
quire relatively higher inventory investments, which slows inventory turnover.
Fixed assets are assets that require more than a year to convert to cash. In re-
tailing, the principal fixed assets are buildings (if store property is owned by the
retailer rather than leased), distribution centers, fixtures (e.g., display racks), and
equipment (e.g., computers, delivery trucks).
Asset turnover is net sales divided by total assets. It is a measure assessing the
performance of the asset management component in the strategic profit model.
Net sales
5 Asset turnover
Total assets
97,062
Costco: 5 3.63
26,761
26,405
Macy’s: 22,095 5 1.20

Intangible Assets Notice that the balance sheet does not include most of the
critical assets used by retailers to develop a sustainable competitive advantage (dis-
cussed in Chapter 5) such as brand image, customer loyalty, customer service, in-
formation and supply chain systems, human resources (committed, knowledgeable
employees), and a database of customer buying behaviors and preferences. Due to
accounting rules, the balance sheet includes only tangible assets for which there is
an objective measure of value. For example, the value of a building is based on the
amount the firm paid for the asset, less depreciation, not what it is worth at the
end of the fiscal year.
The assets discussed in Chapter 5 are largely intangible. They cannot be objec-
tively measured and thus are not included in the balance sheet assets. However,
these intangible assets are important in generating long-term financial perfor-
mance. As discussed in Retailing View 6.4, private equity firms are making signifi-
cant investments in retail firms because of these intangible assets and other
characteristics of the retail industry.
Analyzing the Performance of the Asset Management Path Costco’s
asset turnover is more than two times greater than that of Macy’s. The difference
in their asset turnovers is largely due to Costco’s higher inventory turnover. Typi-
cally, retailers like Costco that sell a limited assortment of commodity-type prod-
ucts have a higher inventory turnover than fashion apparel sold by retailers like
Macy’s. The sales of commodity-type products are easier to forecast accurately
and thus makes it easier to control inventory levels.

Combining the Profit and Asset Management Paths

In terms of the profit management path, Macy’s has a higher operating profit mar-
gin and thus performs better than Costco. But Costco has a higher asset turnover
than Macy’s and thus performs better on the asset management path. Although
this type of performance is expected, given their overall strategy and retail for-
mats, both retailers strive to increase their performance on these key ratios. For
example, department stores like Macy’s develop supply chains and buying systems
that allow less merchandise to be delivered more often—more closely matching
supply and demand. This lowers average inventory and, in turn, total assets, while
at the same time may actually increase sales, resulting in higher inventory and
168 SECTION II Retailing Strategy

asset turnovers. Warehouse club stores like Costco attempt to increase their gross
margins by carrying more fresh produce, meat, and prepared foods. To further
increase its margins, Costco in particular creates a treasure hunt environment by
offering branded apparel and jewelry.

6.4 RETAILING VIEW Private Equity Firms Invest in Retailers

Private equity firms make investments in retail chains such as Krispy Kreme and Neiman Marcus because retail firms typically
have a high cash flow and intangible assets.

Private equity firms such as Bain Capital, the Blackstone Often, private equity owners split the retail chain into
Group, and Texas Pacific have made substantial invest- an operating company that operates the stores and a
ments in retail firms. For example, KKR teamed with property company that owns all of the chain’s real estate
several other private equity firms to buy Toys “R” Us for assets. Proceeds from the sale of the real estate assets are
$6.6 billion. Some other major retailers owned by private used to repay the private equity owners for their initial
equity firms are Neiman Marcus, Burger King, Container investment, guaranteeing that the private equity partners
Store, Dollar General, Domino’s, Gymboree, Hilton Hotels, will prosper regardless of whether the retail chain is
Krispy Kreme, Michaels, and Sports Authority. successful. For example, Cerberus Capital Management LP
Rather than buying stock in companies, private equity and a group of private equity investors bought the
firms buy the entire company from its stockholders, Mervyn’s chain of discount department stores from Target
improve the efficiency of the firm (often by hiring new Corp. for $1.25 billion. The investor group structured the
senior managers), and/or simply restructure the firm’s buyout as two separate purchases—one for the retail
financial structure, and then sell shares in the acquired operations and one for the chain’s valuable real-estate
company several years later. Because shares for the ac- holdings. It earned more than $250 million in fees for
quired company after the acquisition are not traded on managing the real estate transactions. But the retail
the stock exchange, the company can take a long-term operation was liquidated because of poor performance,
perspective toward improving the firm’s operations; that eventually closing 177 stores, cutting the jobs of 18,000
is, it does not have to justify its investments to stockholders employees.
or issue the quarterly reports required by the Securities
and Exchange Commission (SEC). Sources: Karen Talley, “Sears to License Names of Kenmore, Craftsman
Private equity firms find retailers attractive invest- Brands,” The Wall Street Journal, April 5, 2012; Dan McCrum and Stanley
ments because many of them have strong cash flows, lit- Pignal, “New KKR Funds to Target Retail Investors,” FT.com, July 19, 2012;
Eileen Appelbaum and Rosemary Batt, A Primer on Private Equity at Work:
tle debt, and undervalued assets and respond quickly to Management, Employment, and Sustainability (Washington, DC: Center
efficiency improvements and changes in strategic direc- for Economic and Policy Research, February 2012); Elaine Misonzhnik,
tion. Undervalued assets include well-known store “Private Equity Firms Are Hungry for Retailers, But Only the Best of Them,”
Retailtraffic.com, September 27, 2012; and Peg Brickley, “Mervyns Creditors
brands, leases for space in attractive locations, or the Are Offered a Deal,” The Wall Street Journal, October 26, 2012.
land on which their stores are located. A private equity
company can sell these assets after it acquires a retailer
or use the assets as collateral to get loans to finance the
acquisition. For example, a private equity firm might sell
the rights to use a well-known store brand like Sears’ DISCUSSION QUESTION
Kenmore appliances, Craftsman tools, and DieHard bat-
What are the benefits to a retailer of being owned by a
teries to another company that would license the brand
private equity firm?
to other firms.
 Financial Strategy CHAPTER 6 169
Strategic Profit Model Ratio for Selected Retailers EXHIBIT 6–7

Sales Operating Profit Total Assets Operating Profit Percentage Asset Turnover ROA (Operating Profit)

Department Stores
JCPenney 17,260 1,109 11,424 6.4% 1.51 9.7%
Kohl’s 18,804 2,936 14,094 15.6% 1.33 20.8%
Macy’s 26,405 2,386 22,095 9.0% 1.20 10.8%
Discount Stores
Costco 87,048 2,494 27,261 2.9% 3.19 9.1%
Walmart 443,854 26,558 193,406 6.0% 2.29 13.7%
Target 65,786 6,592 43,705 10.0% 1.51 15.1%
Specialty—Appparel
The Gap 14,549 1,438 7,422 9.9% 1.96 19.4%
Abercrombie & Fitch 4,158 194 1,489 4.7% 2.79 13.0%
American Eagle
Outfitter 3,160 393 3,048 12.4% 1.04 12.9%
Specialty—Category
Home Depot 70,395 8,234 40,518 11.7% 1.74 20.3%
Lowe’s 50,208 4,757 33,559 9.5% 1.50 14.2%
Best Buy 50,705 2,331 16,005 4.6% 3.17 14.6%
Office Depot 11,489 34 4,250 0.3% 2.70 0.8%
Staples 25,022 1,693 13,430 6.8% 1.86 12.6%
Supermarket
Kroger 90,347 410 23,478 0.5% 3.85 1.7%
Safeway 43,630 1,134 15,074 2.6% 2.89 7.5%

Sources: SEC 10-K filings.

The two retailers’ overall performance, as measured by ROA, is determined by

considering the effects of both paths, that is, by multiplying the net profit margin
by asset turnover:
Profit operating
Asset turnover 3 margin percent 5 Return on assets
Costco: 3.63 3 2.9% 5 10.5%
Macy’s: 1.20 3 9.0% 5 10.8%
Exhibit 6–7 shows the strategic profit model ratios for a variety of retailers. The
exhibit illustrates that supermarket and discount chains typically have higher asset
turnovers and lower operating profit margin percentages. The apparel specialty
retailers have lower asset turnovers and higher net profit margin percentages.
These differences in asset turnover and operating profit margin arise because
the needs and buying behavior of customers patronizing these retailers differ, and
thus, retailers targeting these customers use different approaches. Discount stores
and supermarkets target more price-sensitive consumers, and they need to keep
prices low. In addition, the products offered by supermarkets and discount stores
are more commodity-like and face intense price competition. Thus, their profit
margins are lower and they have to have higher asset turnover to provide an ade-
quate ROA. On the other hand, specialty apparel and department stores are pa-
tronized by less-price-sensitive consumers who are looking for more customer
service and deeper assortments. To satisfy these needs, inventory levels and turn-
over, administrative expenses, and margins are higher.

Implications for Improving Financial Performance

The profit management and asset management paths in the strategic profit model
suggest different approaches for improving financial performance. Focusing on
the profit management path, the operating profit margin could be increased by
170 SECTION II Retailing Strategy

increasing sales or reducing COGS or operating expenses. For example, Costco

could increase its sales by increasing advertising to attract more customers. The
increase in sales will have a positive effect on Costco’s operating profit margin
percentage and its ROA as long as the increase in advertising expense generates
more gross margin dollars than the advertising costs. In addition, the increase in
sales will increase Costco’s asset turnover because sales will increase but assets will
remain the same. The net effect will have a positive impact on ROA.
Looking at the asset management path, Macy’s could increase its asset turnover
by decreasing the amount of inventory in its stores. However, decreasing the level
of inventory could actually decrease sales because customers might not find the
product they want to buy, causing them to shop elsewhere. If they tell their friends,
post negative online reviews, or use social media like Twitter to voice their discon-
tent, the lack of salable inventory could have a cascading deleterious impact on
sales and profits.
The strategic profit model illustrates two important issues. First, retailers and
investors should consider both operating and net profit margin and asset turnover
when evaluating their financial performance. Firms can achieve high performance
(high ROA) by effectively managing both profit margin and asset turnover. Sec-
ond, retailers need to consider the implications of their strategic decisions on both
components of the strategic profit model. For example, increasing prices might
increase the gross margin and operating profit margin in the profit margin man-
agement path. However, increasing prices could also result in fewer sales, thereby
having a negative impact on both gross margin and net operating profit margin. At
the same time, assuming the level of assets stays the same, asset turnover will de-
crease. Thus, a simple change in one strategic variable, such as pricing, has multi-
ple repercussions on the strategic profit model, all of which need to be considered
when determining the impact on ROA.

EVALUATING GROWTH OPPORTUNITIES

LO3 To illustrate the use of the strategic profit model for evaluating a growth opportu-
Illustrate the use of the
nity, let’s look at the opportunity that Kelly Bradford, from Chapter 5, is consider-
strategic profit model for ing. Recall that Kelly Bradford owns Gifts To Go, a two-store chain in the Chicago
analyzing growth area. She’s considering several growth options, one of which is to open an Internet
opportunities. channel called www.Gifts-To-Go.com. She has determined that the market size
for this channel is large but very competitive. Now she needs to conduct a finan-
cial analysis for the proposed online channel, compare the projections with Gifts
To Go stores, and determine the financial performance of the combined busi-
nesses. We’ll first look at the profit margin management path, followed by the as-
set turnover management path. Exhibit 6–8 shows income statement information
for Kelly’s Gifts To Go stores, her estimates for Gifts-To-Go.com, and the com-
bined businesses.

Profit Margin Management Path

Kelly thinks she can develop Gifts-To-Go.com into a business that will generate
annual sales of $440,000. She anticipates some cannibalization of her store sales by
the Internet channel; some customers who would have bought merchandise at
Gifts To Go will no longer go into her stores to make their purchases. She also
thinks the Internet channel will stimulate some store sales; customers who see gift
items on her website will visit the stores and make their purchases there. Thus, she
decides to perform the analysis with the assumption that her store sales will remain
the same after the introduction of the Internet channel.

Gross Margin Percentage Kelly plans to charge the same prices and sell basi-
cally the same merchandise, with an extended assortment, on Gifts-To-Go.com as
 Financial Strategy CHAPTER 6 171

Gifts To Gifts-To-Go.com Businesses EXHIBIT 6–8

Go Stores (Projected) Combined Income Statement
Information of
Income Statement Analysis of Gifts To Go
Net sales $700,000 $440,000 $1,140,000 Growth Opportunities
Less: Cost of goods sold 350,000 220,000 570,000
Gross margin 350,000 220,000 570,000
Less: Operating expenses (SG&A) 250,000 150,000 400,000
Net operating profit before tax and interest 100,000 70,000 170,000
Less: Taxes 32,200 24,500 56,700
Less: Interest 8,000 0 8,000
Net profit after taxes 24,200 24,500 48,700
Gross margin % 50% 50% 50%
Operating expenses % 36% 34% 35%
Net operating profit % 14% 16% 15%
Net operating income % 3% 6% 4%

in her stores. Thus, she expects the gross margin percentage for store sales will be
the same as the gross margin percentage for Gifts-To-Go.com sales.
Gross margin
5 Gross margin %
Net sales
350,000
Stores: 5 50%
$700,000
220,000
Gifts-To-Go.com: 5 50%
$440,000
Operating Expenses Initially, Kelly thought that her operating expenses as a
percentage of sales would be lower for Gifts-To-Go.com because she would not
need to pay rent or have highly trained salespeople. But she discovered that her
operating expenses as a percentage of sales will be only slightly lower for Gifts-
To-Go.com because she needs to hire a firm to maintain the website, process
orders, and get orders ready for shipment. Also, Gifts To Go stores have an estab-
lished clientele and highly trafficked locations with good visibility. Although some
of her current customers will learn about the website from her in-store promo-
tions, Kelly will have to invest in advertising and promotions to create awareness
for her new channel and inform people who are unfamiliar with her stores.

Net Profit Margin Because the gross margin and operating expenses as a per-
centage of sales for the two operations are projected to be about the same, Gifts-To-
Go.com is expected to generate a slightly higher net profit margin percentage:
Net profit
5 Net profit %
Net sales
$100,000
Stores: 5 14.3%
$700,000
70,000
Gifts-To-Go.com: 5 15.9%
$440,000

Asset Turnover Management Path

Now let’s compare the two operations using the asset turnover management path
with the balance sheet information in Exhibit 6–9. Because the percentage of credit
card sales is higher over the Internet channel than in stores, Kelly expects that the
accounts receivable will be higher for the Internet channel than for the store channel.
172 SECTION II Retailing Strategy

EXHIBIT 6–9 Gifts To Gifts-To-Go.com Businesses

Balance Sheet Go Stores (Projected) Combined
Information of Analysis
of Gifts To Go Growth Accounts receivable $140,000 $120,000 $260,000
Opportunities Merchandise inventory 175,000 70,000 245,000
Cash 35,000 11,000 46,000
Total current assets 350,000 201,000 551,000
Fixed assets 30,000 10,000 40,000
Total assets 380,000 211,000 591,000
Ratios
Inventory turnover 2.00 3.1 2.3
Asset turnover 1.84 2.09 1.93
ROA (%) 25.29% 33.25% 28.77%

Kelly estimates that Gifts-To-Go.com will have a higher inventory turnover

than Gifts To Go stores because it will consolidate the inventory at one central-
ized distribution center that serves a large sales volume, as opposed to Gifts to Go,
which has inventory sitting in several stores with relatively lower sales volumes.
Additionally, Gifts-To-Go.com will have relationships with several of its vendors
in which they “drop ship,” or send merchandise directly from the vendor to the
customer. In these situations, Gifts-to-Go.com has no inventory investment.
Cost of goods
5 Inventory turnover
Average inventory
350,000
Stores: 5 2.0
$175,000
220,000
Gifts-To-Go.com: 5 3.1
$70,000
Gifts To Go’s store space is rented. Thus, Kelly’s fixed assets consist of the fix-
tures, lighting, and other leasehold improvements for her stores, as well as equip-
ment such as point-of-sale terminals. Kelly also has invested in assets that make
her stores aesthetically pleasing. Gifts-To-Go.com is outsourcing the fulfillment
of orders placed on its website, so it has no warehouse assets. Thus, its fixed assets
are its website and order-processing computer system.
As she expects, Gifts-To-Go.com’s projected asset turnover is higher than that
of Gifts To Go’s stores because Kelly estimates that Gifts-To-Go.com will have a
higher inventory turnover, and its other assets are lower.
Net sales
5 Asset turnover
Total assets
700,000
Stores: 5 1.84
$380,000
440,000
Gifts-To-Go.com: 5 2.09
$211,000
Because Kelly’s estimates for the net profit margin and asset turnover for Gifts-
To-Go.com are higher than those for her stores, Gifts-To-Go.com achieves a
higher ROA. Thus, this strategic profit model analysis indicates that Gifts-To-Go.
com is a financially viable growth opportunity for Kelly.
Net profit margin 3 Asset turnover 5 Return on assets
Stores: 14.29% 3 1.84 5 26.29%
Gifts-To-Go.com: 15.91% 3 2.09 5 33.25%
 Financial Strategy CHAPTER 6 173

Using the Strategic Profit Model to Analyze

Other Decisions
Another investment that Kelly might consider is installing a computerized inven-
tory control system that would help her make better decisions about which mer-
chandise to order, when to reorder merchandise, and when to lower prices on
merchandise that is not being bought.
If she buys the system, her sales will increase because she will have a greater
percentage of merchandise that is selling well and fewer stockouts. Her gross mar-
gin percentage will also increase because she won’t have to mark down as much
slow-selling merchandise.
Looking at the asset turnover management path, the purchase of the computer
system will increase her fixed assets by the amount of the system, but her inven-
tory turnover will increase and the level of inventory assets will decrease because
she is able to buy more efficiently. Thus, her asset turnover will probably increase
because sales will increase at a greater percentage than will total assets. Total assets
may actually decrease if the additional cost of the inventory system is less than the
reduction in inventory.

ANALYSIS OF FINANCIAL RISK

The previous sections have illustrated how the strategic profit model can be used LO4
to analyze the factors affecting some key retail performance ratios—operating Analyze the financial risks
profit margin percentage and asset turnover. The model provides insights into facing a retail firm.
how retailers can improve their performance. However, retailing is a highly com-
petitive industry, and thus major bankruptcies are common. Exhibit 6–10 lists
some retailers of significant size that have filed for bankruptcy protection since
2000. Retailers, vendors, and investors need to assess the financial strength of a
firm. Specifically, what are the chances that the retailer will continue to operate or
will go bankrupt? In this section, we discuss measures used to assess the financial
risk of retailers—the probability that they will go bankrupt. These measures in-
clude cash flow, debt-to-equity ratio, quick ratio, and current ratio.

Cash Flow Analysis

You might think that a retailer’s profits determine its financial strength. If a retailer
is profitable, there is little chance it will go bankrupt; but if it incurs losses for an
extended period of time, the chances of its going bankrupt are significant. How-
ever, retailers can be forced to declare bankruptcy even when they show a profit

Filing Year Assets ($ bililons) EXHIBIT 6–10

Largest U.S. Retail
Kmart 2002 14.60 Bankruptcies since
Circuit City 2008 3.76 2000
Montgomery Ward 2000 3.49
A&P 2010 2.53
Ames Department Stores 2001 2.00
Spiegel 2003 1.89
U.S. Office Products 2001 1.75
Linens ‘n’ Things 2008 1.74
Heilig-Meyers 2000 1.46
Borders 2011 1.28
Blockbuster 2010 1.02

Source: “FACTBOX—Largest U.S. Retailer Bankruptcies since 2000,” Reuters,

February 16, 2011.
174 SECTION II Retailing Strategy

on their income statements. Retailers become insolvent and declare bankruptcy

when they do not have the cash needed to meet their obligations—when they can-
not pay their employees, their landlords (rent), and/or their vendors.
Profits are not the same as cash flow. For example, a retailer might borrow
money from a bank. The loan appears as a liability on its balance sheet. The inter-
est on the loan, a relatively small percentage of the loan value, appears as an inter-
est expense on the retailer’s income statement and reduces the retailer’s profits
slightly. However, when the retailer is required to pay back the loan to the bank,
the retailer must have a significant amount of cash available to pay for the entire
amount of the loan.
Retailers have cash coming in from the sales of merchandise, and they use
this cash to pay vendors, employees, developers, utilities, and the like. The
amount of cash coming into the business, and when it comes into the business,
is crucial because the availability of cash allows retailers to continue operating
in the longer term.
The cash receipts and expenditures tend to be fairly stable. Employee salaries,
vendor invoices, and rent, for example, are paid monthly or weekly. Sometimes,
however, retailers face radical changes in the flow of cash. During the holiday sea-
son, for instance, retailers have to buy and pay for more merchandise to support
the higher-than-normal level of sales. One measure of financial strength is cash
flow. In addition to providing a balance sheet and income statement, firms also
provide a cash flow statement as another indicator of the financial strength of
the firm.

Debt-to-Equity Ratio
The debt-to-equity ratio is the retailer’s short- and long-term debt divided by the
value of the owners’ or stockholders’ equity in the firm. Owners’ equity is the differ-
ence after subtracting all liabilities from assets. Liabilities are a company’s debts,
such as its accounts payable, which is the money it owes its vendors for merchandise.
Owners’ equity is the owners’ (or stockholders’) investment in the business. The
debt-to-equity ratio measures how much money a company can safely borrow over
long periods of time. A high ratio means the retailer faces greater risk and more
potential for bankruptcy. Generally, when retailers that have a debt-to-equity ratio
of more than 40 to 50 percent, they face significant risk of financial problems.

Current Ratio
The current ratio is probably the best-known and most often used measure of
financial strength. The current ratio is short-term assets divided by short-term
liabilities. It evaluates the retailer’s ability to pay its short-term debt obligations,
such as accounts payable (payments to suppliers) and short-term loans payable to
a bank, with short-term assets such as cash, accounts receivable, and inventory.

Quick Ratio
The quick ratio, sometimes called the acid-test ratio, is short-term assets less
inventory divided by short-term liabilities. It is a more stringent test of financial
strength than the current ratio because it removes inventory from the short-term
assets. Inventory is the short-term asset that takes the longest to convert into cash.
Thus, if a retailer needs cash to pay its short-term liabilities, it cannot rely on
inventory to provide an immediate source for cash.
The financial strength measures for Costco and Macy’s are shown in
Exhibit 6–11. These measures of financial strength indicate that Costco and
Macy’s are in relatively strong financial positions. Both have a significant posi-
tive cash flow. Macy’s has a higher debt-to-equity ratio but strong current and
quick ratios.
 Financial Strategy CHAPTER 6 175

Costco Macy’s EXHIBIT 6–11

8/29/2011 1/30/2012 Financial Risk
Measures for Costco
Net profit ($ billions) 16.1 1.25 and Macy’s
Cash flow ($ billions) 530 1.36
Debt-to-equity .10 .97
Current ratio 1.51 2.01
Quick ratio 1.14 1.40

Source: Calculations from financial statements in 10-K reports filed with SEC.

SETTING AND MEASURING PERFORMANCE OBJECTIVES

In the previous sections, we discussed the measures used to evaluate the overall LO5
financial performance of a retailer—ROA and its components, as well as measures Review the measures
for determining its financial risk. In this section, we review some measures used to retailers use to assess their
assess the performance of specific assets possessed by a retailer—its employees, performance.
real estate, and merchandise inventory. Retailers use these measures to evaluate
the firm’s performance and set objectives.
Setting performance objectives is a necessary component of any firm’s strategic
management process. Performance objectives should include (1) a numerical index
of the performance desired against which progress may be measured, (2) a time
frame within which the objective is to be achieved, and (3) the resources needed to
achieve the objective. For example, “earning reasonable profits” isn’t a good objec-
tive. It doesn’t provide specific goals that can be used to evaluate performance.
What’s reasonable? When do you want to realize the profits? A better objective
would be “earning $100,000 in profit during calendar year 2014 on a $500,000
investment in inventory and building.”

Top-Down versus Bottom-Up Process

Setting objectives in large retail organizations entails a combination of the top-down
and bottom-up approaches to planning. Top-down planning means that goals get
set at the top of the organization and are passed down to the lower operating levels.
In a retailing organization, top-down planning involves corporate officers develop-
ing an overall retail strategy and assessing broad economic, competitive, and con-
sumer trends. With this information, they develop performance objectives for the
corporation. These overall objectives are then broken down into specific objectives
for each buyer and merchandise category and for each region, store, and even de-
partment within stores and the sales associates working in those departments.
The overall strategy determines the merchandise variety, assortment, and prod-
uct availability, plus the store size, location, and level of customer service. Then
the merchandise vice presidents decide which types of merchandise are expected
to grow, stay the same, or shrink. Next, performance goals are established for each
buyer and merchandise manager. This process is reviewed in Chapter 12.
Similarly, regional store vice presidents translate the company’s performance
objectives into objectives for each district manager, who then develops objectives
with the store managers. The process then trickles down to department managers
in the stores and individual sales associates. The process of setting objectives for
sales associates in stores is discussed in Chapter 16.
This top-down planning is complemented by a bottom-up planning approach.
Bottom-up planning involves lower levels in the company developing perfor-
mance objectives that are aggregated up to develop overall company objectives.
Buyers and store managers estimate what they can achieve, and their estimates are
transmitted up the organization to the corporate executives.
Frequently there are disagreements between the goals that have trickled down
from the top and those set by lower-level employees of the organization. For example,
176 SECTION II Retailing Strategy

a store manager may not be able to achieve the 10 percent sales growth set for his or
her region because a major employer in the area has announced plans to lay off 2,000
employees. The differences between bottom-up and top-down plans are resolved
through a negotiation process involving corporate executives and operating manag-
ers. If the operating managers aren’t involved in the objective-setting process, they
won’t accept the objectives and thus will be less motivated to achieve them.

Who Is Accountable for Performance?

At each level of the retail organization, the business unit and its manager should
be held accountable only for the revenues, expenses, cash flow, and contribution to
ROA that they can control. Thus, expenses that affect several levels of the organi-
zation (e.g., labor and capital expenses associated with operating a corporate head-
quarters) shouldn’t be arbitrarily assigned to lower levels. In the case of a store, for
example, it may be appropriate to set performance objectives based on sales, sales
associate productivity, store inventory shrinkage due to employee theft and shop-
lifting, and energy costs. If the buyer makes poor decisions and has to lower prices
to get rid of merchandise and therefore profits suffer, it is not fair to assess a store
manager’s performance on the basis of the resulting decline in store profit.
Performance objectives and measures can be used to pinpoint problem areas.
The reasons that performance may be above or below planned levels must be ex-
amined. Perhaps the managers involved in setting the objectives aren’t very good
at making estimates. If so, they may need to be trained in forecasting. Also, buyers
may misrepresent their business unit’s ability to contribute to the firm’s financial
goals to get a larger inventory budget than is warranted and consequently earn a
higher bonus. In either case, investment funds would be misallocated.
Actual performance may differ from what the plan predicts due to circum-
stances beyond the manager’s control. For example, there may have been a reces-
sion. Assuming the recession wasn’t predicted, or was more severe or lasted longer
than anticipated, there are several relevant questions: How quickly were plans ad-
justed? How rapidly and appropriately were pricing and promotional policies
modified? In short, did the manager react to salvage an adverse situation, or did
the reaction worsen the situation?

Performance Objectives and Measures

Many factors contribute to a retailer’s overall performance, and this makes it hard
to find a single measure to evaluate performance. For instance, sales are a global
measure of a retail store’s activity level. However, as illustrated by the strategic
profit model, a store manager could easily increase sales by lowering prices, but
the profit realized on that merchandise (gross margin) would suffer as a result. An
attempt to maximize one measure may lower another. Managers must therefore
understand how their actions affect multiple performance measures.
The measures used to evaluate retail operations vary depending on (1) the level of
the organization at which the decision is made and (2) the resources the manager
controls. For example, the principal resources controlled by store managers are space
and money for operating expenses (such as wages for sales associates and utility pay-
ments to light and heat the store). Thus, store managers focus on performance mea-
sures like sales per square foot, employee costs, and energy cost as a percent of sales.

Types of Measures
Exhibit 6–12 breaks down a variety of retailers’ performance measures into three
types: input measures, output measures, and productivity measures. Input
measures are the resources or money allocated by a retailer to achieve outputs, or
results. For example, the amount and selection of merchandise inventory, the
number of stores, the size of the stores, the employees, advertising, markdowns,
store hours, and promotions all require managerial decisions on inputs.
 Financial Strategy CHAPTER 6 177
Measure for Assessing the Performance of Retailers EXHIBIT 6–12

Level of Organization Output Input Productivity (Output/Input)

Corporate (measures for Net sales Square feet of store space Return on assets
entire corporation) Net profits Number of employees Asset turnover
Growth in sales, profits, Inventory Sales per employee
comparable-store sales Advertising expenditures Sales per square foot
Merchandise management Net sales Inventory level Gross margin return on investment (GMROI)
(measures for a merchandise Gross margin Markdowns Inventory turnover
category) Growth in sales Advertising expenses Advertising as a percentage of sales*
Cost of merchandise Markdown as a percentage of sales*
Store operations (measures Net sales Square feet of selling areas Net sales per square foot
for a store or department Gross margin Expenses for utilities Net sales per sales associate or per
within a store) Growth in sales Number of sales associates selling hour
Utility expenses as a percentage of sales*
Inventory shrinkage*

*These productivity measures are commonly expressed as an input-output ratio.

Output measures assess the results of a retailer’s investment decisions. For

example, sales revenue, gross margin, and net profit margin are all output measures
and ways to evaluate a retailer’s input or resource allocation decisions. A productiv-
ity measure (the ratio of an output to an input) determines how effectively retailers
use their resources—what return they get on their investments in inputs.
In general, because productivity measures are ratios of outputs to inputs, they
are very useful for comparing the performance of different business units. Suppose
Kelly Bradford’s two stores are different sizes: One has 5,000 square feet, and the
other has 10,000 square feet. It’s hard to compare the stores’ performances using
just output or input measures because the larger store will probably generate more
sales and have higher expenses. But if the larger store has lower space productivity
because it generates $210 net sales per square foot and the smaller store generates
$350 per square foot, Kelly knows that the smaller store is operating more
efficiently, even though it’s generating lower sales.
Corporate Performance At a corporate level, retail executives have three crit-
ical resources (inputs)—merchandise inventory, store space, and employees—that
they can manage to generate sales and profits (outputs). Thus, effective productiv-
ity measures of the utilization of these assets include asset and inventory turnover,
sales per square foot of selling space, and sales per employee.
As we have discussed, ROA is an overall productivity measure combining the
operating profit margin percentage and asset turnover. Another commonly used
measure of overall performance is comparable-store sales growth (also called
same-store sales growth), which compares sales growth in stores that have been
open for at least one year. Growth in sales can result from increasing the sales
generated per store or by increasing the number of stores. Growth in same-store
sales assesses the first component in sales growth, and thus indicates how well the
retailer is doing with its core business concept. New stores do not represent
growth from last year’s sales but, rather, new sales created where no other sales
existed the year before. Thus, a decrease in same-store sales indicates that the re-
tailer’s fundamental business approach is not being well received by its customers,
even if overall sales are growing because the retailer is opening more new stores.
Merchandise Management Measures The critical resource (input) con-
trolled by merchandise managers is merchandise inventory. Merchandise manag-
ers also have the authority to set initial prices and lower prices when merchandise
is not selling (i.e., take a markdown). Finally, they negotiate with vendors over the
price paid for merchandise.
178 SECTION II Retailing Strategy

Inventory turnover is a productivity measure of the management of inventory;

higher turnover means greater inventory management productivity. Gross margin
percentage indicates the performance of merchandise managers in negotiating
with vendors and buying merchandise that can generate a profit. Discounts (mark-
downs) as a percentage of sales are also a measure of the quality of the merchan-
dise buying decisions. If merchandise managers have a high percentage of
markdowns, they may not be buying the right merchandise or the right quantities,
because they weren’t able to sell some of it at its original retail price. Note that
gross margin and discount percentages are productivity measures, but they are
typically expressed as an input divided by an output as opposed to the typical pro-
ductivity measures that are outputs divided by inputs.

Store Operations Measures The critical assets controlled by store managers

are the use of the store space and the management of the store’s employees. Thus,
measures of store operations productivity include sales per square foot of selling
space and sales per employee (or sales per employee per working hour, to take into
account that some employees work part-time). Store management is also responsible
for controlling theft by employees and customers (referred to as inventory shrink-
age), store maintenance, and energy costs (lighting, heating, and air conditioning).
Thus, some other productivity measures used to assess the performance of store
managers are inventory shrinkage and energy costs as a percentage of sales.

Assessing Performance: The Role of Benchmarks

As we have discussed, the financial measures used to assess performance reflect the
retailer’s market strategy. For example, because Costco has a different business
strategy than Macy’s, it has a lower profit margin. But it earns an acceptable ROA
because it increases its inventory and asset turnovers by stocking a more limited
merchandise assortment of less fashionable, staple items. In contrast, Macy’s offers
a broad and deep merchandise assortment in fashionable apparel and accessories.
Thus, it has lower inventory and asset turnover but achieves an acceptable ROA
through its higher profit margins. In other words, the performance of a retailer
cannot be assessed accurately simply by looking at isolated measures because they
are affected by the retailer’s strategy. To get a better assessment of a retailer’s per-
formance, we need to compare it to a benchmark. Two commonly used bench-
marks are (1) the performance of the retailer over time and (2) the performance of
the retailer compared with that of its competitors.

Performance over Time One useful approach for assessing a retailer’s perfor-
mance compares its recent performance with its performance in the preceding
months, quarters, or years. Exhibit 6–13 shows the performance measures for
Costco and Macy’s over a three-year period.
Over the three years, the financial performance of both Costco and Macy’s has
improved. ROA for both retailers has increased; however, the increases in Macy’s ROA
are due primarily to improvements in operating profit percentage, while Costco’s
ROA improvements are due to an increasing asset turnover. Costco’s sales increases
and comparable-store sales percentages are greater than Macy’s. The gross margin
percentages for both retailers have remained the same over the three years. Both
retailers have reduced their SG&A and improved their labor and space productivity.

Performance Compared to Competitors A second approach for assessing

a  retailer’s performance involves comparing its performance with that of its
competitors. Exhibit 6–14 compares the performance of Macy’s with two other
national department store chains, Kohl’s and Nordstrom. Kohl’s has the highest
ROA but the lowest growth in sales and SG&A percent of sales. Macy’s has the
highest gross margin percent but also has the highest administrative costs.
Nordstrom has the highest space and labor productivity.
 Financial Strategy CHAPTER 6 179
Performance Measures for Costco and Macy’s over Time EXHIBIT 6–13
COSTCO MACY’S
2012 2011 2010 2012 2011 2010

Sales ($ millions) 97,062 87,048 76,255 26,405 25,003 23,489

Annual sales growth 11.5% 14.2% 9.1% 5.6% 6.4% 25.6%
Gross margin percentage 11.3% 10.7% 10.8% 40.4% 40.7% 40.5%
SG&A percent of sales 10.5% 10.0% 10.3% 31.4% 33.0% 34.3%
Operating profit percentage 2.8% 2.9% 2.8% 9.0% 7.7% 6.2%
Net profit percentage 1.8% 2.0% 1.8% 4.7% 3.4% 1.4%
Inventory turnover 12.2 11.71 12.06 3.08 3.12 3.03
Asset turnover 3.6 3.32 3.27 1.20 1.21 1.10
ROA 10.2% 9.3% 8.8% 10.8% 9.3% 6.8%
Sales per employee 557,830 540,671 518,741 154,415 150,620 145,894
Sales per store ($ millions) 159 147 141 31 29 28
Sales per square foot 1,117 1,031 986 174 162 152
Current ratio 1.10 1.14 1.04 1.40 1.38 0.81
Debt-to-equity ratio 0.11 0.11 0.12 2.23 2.73 8.62
Quick ratio 0.58 0.59 0.54 0.58 0.43 0.27
Cash flow ($ millions) 3,057 3,198 2,780 1,363 (222) 301
Comparable-store sales 8.1 7.0 10.0 3.5 3.0 4.6

Kohl’s Macy’s Nordstrom EXHIBIT 6–14

Financial Performance
Sales ($ millions) 10,497 26,405 18,804 of Macy’s Compared
Annual sales growth 2.2% 5.6% 12.7% with Kohl’s and
Gross margin percentage 38.2% 40.4% 37.9% Nordstrom
SG&A percent of sales 22.6% 31.4% 26.7%
Operating profit percentage 15.6% 9.0% 11.2%
Net profit percentage 6.2% 4.7% 6.5%
Inventory turnover 3.63 3.08 5.68
Asset turnover 1.33 1.20 1.24
ROA 20.8% 10.8% 13.8%
Sales per employee ($) 132,423 154,415 185,788
Sales per store ($ millions) 16.7 31.4 41.2
Sales per square foot ($) 229 174 424
Comparable-store sales 0.5 3.5 7.3

SUMMARY
LO1 Review the strategic objectives of a retail firm. LO2 Contrast the two paths to financial performance
This chapter explains some basic elements of the re- using the strategic profit model.
tailing financial strategy and examines how retailing The strategic profit model is used as a vehicle for
strategy affects the financial performance of a firm. understanding the complex interrelations between
The strategy undertaken by retailers is designed to financial ratios and retailing strategy. Different
achieve financial, societal, and personal objectives. types of retailers have different financial operating
However, the financial objectives are of greatest im- characteristics. Specifically, department store
portance to large, publicly owned retailers. chains like Macy’s generally have higher profit
180 SECTION II Retailing Strategy

margins and lower turnover ratios than warehouse probability of the business declaring bankruptcy.
club stores like Costco. Yet when margin and turn- Four measures of financial strength are cash flow,
over are combined into return on assets, it is pos- debt-to-equity ratio, current ratio, and quick ratio.
sible to achieve similar financial performance.
LO5 Review the measures retailers use to assess
LO3 Illustrate the use of the strategic profit model their performance.
for analyzing growth opportunities. Some financial performance measures are used to
In addition to helping retailers understand the fi- evaluate different aspects of a retailing organiza-
nancial implications of the tradeoffs they face in tion. Although the return-on-assets ratio in the
developing a retail strategy, this chapter illustrates strategic profit model is appropriate for evaluating
how the strategic profit model can be used to eval- the performance of the retail executives responsi-
uate growth and investment opportunities. ble for managing the firm, other measures are
more appropriate for more specific activities. For
LO4 Analyze the financial risks facing a retail firm.
instance, inventory turnover and gross margin are
In addition to assessing the performance of a retail appropriate for buyers, whereas store managers
operation, the chapter also examines measures used should be concerned with sales or gross margin
to assess the financial strength of a retailer—the per square foot or per employee.

KEY TERMS
accounts receivable, 163 fixed assets, 167 operating income percentage, 165
acid-test ratio, 174 gross margin, 162 operating profit margin, 158
assets, 165 gross margin percentage, 162 output measures, 177
asset turnover, 158 gross profit, 162 productivity measures, 177
bottom-up planning, 175 income statement, 161 quick ratio, 174
cash flow statement, 174 input measures, 176 return on assets (ROA), 156
chargeback fee, 161 inventory turnover, 166 same-store sales growth, 177
comparable-store sales growth, 177 liabilities, 174 selling, general, and administrative
cost of goods sold (COGS), 162 merchandise inventory, 166 (SG&A) expenses, 162
current assets, 165 net profit margin, 162 slotting allowance, 161
current ratio, 174 net sales, 161 slotting fee, 161
debt-to-equity ratio, 174 operating expenses, 162 statement of operations, 161
earnings before interest, taxes, and operating expenses strategic profit model, 158
depreciation (EBITDA), 158 percentage, 164 top-down planning, 175

GET OUT AND DO IT!

1. CONTINUING CASE ASSIGNMENT Evaluate 2. INTERNET EXERCISE Go to the latest annual
the financial performance of the retailer you have reports, and use the financial information to update the
selected for the Continuing Case Assignment and of numbers in the net profit margin management model
another store that sells similar merchandise categories and the asset turnover management model for Costco
but to a very different target market. If yours is a and Macy’s. Have there been any significant changes in
high-margin–low-turnover store, compare it with a their financial performance? Why are the key financial
low-margin–high-turnover store. You can get this ratios for these two retailers so different?
information from your chosen store’s latest annual 3. GO SHOPPING Go to your favorite store, and in-
report, available in the “investor relations” area of its terview the manager. Determine how the retailer sets
website, at Hoovers Online, or in the Edgar files at its performance objectives. Evaluate its procedures
www.sec.gov. Explain why you would expect the gross relative to the procedures presented in the text.
margin percentage, expense-to-sales ratio, net profit 4. WEB OLC EXERCISE Go to the strategic profit
margin percentage, inventory turnover, asset turnover, model (SPM) on the student side of the book’s web-
and return on assets to differ between the two stores. site. The SPM tutorial was designed to provide a re-
Which retailer achieves better overall financial fresher course on the basic financial ratios leading to
performance?
 Financial Strategy CHAPTER 6 181
return on assets and walks you through the process current financial figures. You can also access an Excel
step-by-step. A calculation page is also included that spreadsheet for SPM calculations. The calculation
will calculate all the ratios. You can type in the num- page or the Excel spreadsheet can be used for Case 11,
bers from a firm’s balance sheet and income state- “Tiffany’s and TJX: Comparing Financial Perfor-
ment to see the financial results produced with the mance,” page 563.

DISCUSSION QUESTIONS AND PROBLEMS

1. What are the key productivity ratios for measuring 8. Blue Nile is a jewelry retailer than only uses an Inter-
the retailer as a whole, its merchandise management net channel for interacting with its customers. What
activities, and its store operations activities? Why are differences would you expect in the strategic profit
these ratios appropriate for one area of the retailer’s model and key productivity ratios for Blue Nile and
operation and inappropriate for others? Zales, a multichannel jewelry retailer?
2. What are examples of the types of objectives that en- 9. Using the following information taken from the 2012
trepreneurs might have for a retail business they are balance sheet and income statement for Urban Out-
launching? fitters, develop a strategic profit model. (Figures are
3. Buyers’ performance is often measured by the gross in millions of dollars.) You can access an Excel spread-
margin percentage. Why is this measure more appro- sheet for SPM calculations on the student portion of
priate than operating or net profit percentage? the book’s website.
Net sales $2473.8
4. A supermarket retailer is considering the installation
of self-checkout POS terminals. How would the re- Cost of goods sold $1316.2
placement of cashiers with these self-checkouts affect Operating expenses $ 575.8
the elements in the retailer’s strategic profit model? Inventory $ 250.1
5. Neiman Marcus (a chain of high-service department Accounts receivable $ 36.7
stores) and Walmart target different customer seg- Other current assets $ 68.9
ments. Which retailer would you expect to have a Fixed assets $ 690.0
higher gross margin? Higher expense-to-sales ratio?
10. A friend of yours is considering buying some stock in
Higher net profit margin percentage? Higher inven-
retail companies. Your friend knows that you are tak-
tory turnover? Higher asset turnover? Why?
ing a course in retailing and ask for your opinion
6. Why do investors place more weight on comparable- about Costco. Your friend is concerned that Costco is
store sales than growth in sales? not a good firm to invest in because it has such a low
7. What metrics should be used to measure the financial net operating profit. What advice would you give
risk of a retailer? How is each metric used? your friend? Why?

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