Why the Retail Method of Accounting is Obsolete, and What Makes Sense Today

According to Paula Rosenblum, Managing Director of Retail Systems Research, “the retail method is a troublesome anachronism which had its day, its purpose, and its value – all of which have passed.”

In your retail career, you may have found that Paula’s message rings true – the retail method does a poor job measuring margin, encourages “gaming the system,” and fails to set the proper accounting foundation for multi-channel retailers. Despite this, a March 2008 research study on retail accounting practices reported that half of all respondents still employ the retail method.

In this edition of our newsletter, we’ll explore the history of the retail method, why it is outdated, and how business intelligence can help retailers transition to a method that provides more insight for today’s retail industry.

Enlarge Image

Before we delve into these topics, you are probably wondering why we, as a Business Intelligence software vendor, have a strong opinion about accounting methods. At QuantiSense, our core function is measuring performance of every aspect of a retailer’s business. We want our clients to gain insight about margin erosion that will lead to corrective action. However, the retail method of accounting interferes with this ideal by limiting gross margin reporting to monthly snapshots that are insufficient in depth and detail. If you want your professionals to fully benefit from the modern tools and technology you’ve invested in, you should consider transitioning to the cost approach.

The Retail Method Was Designed for Different Era

Almost a century ago when the US economy was roaring into the 20’s and department stores dominated the retail scene, the retail inventory method of accounting was born. At this time, retail transactions were conducted largely over the counter. The consumer approached a clerk who worked behind the counter and explained what she wanted. Merchandise was showcased in counter displays. Generally speaking, the sales clerk had to take the desired item out of the case for the customer to get a closer look. Before the retail method was invented, the clerk was required to find and record the item’s actual cost to the retailer before completing the sales check.

As the pace of life quickened and consumer options exploded, shoppers tired of these laborious procedures of having to cost-out each sale. Retail practices looked primitive compared to the streamlined self-service methods pioneered by the early grocery chains and five-and-dime stores which had begun averaging cost over broad merchandise categories.

As a result, the department store sector introduced the retail method, which allowed them to forego the cumbersome cost look-up process at the point of purchase. This innovation untethered the merchandise from behind the counters, and merchandise cost was typically recorded in purchase journals prior to placement on the sales floor. With this new method of figuring cost, retailers could transfer the merchandise from store to store, open new locations, and be much more innovative with their visual merchandising.

When merchandise was sold, retailers simply recorded the selling price, punching the department key on the new mechanical cash registers. At the end of the month, the accounting department would value the ending inventory for the department based on the starting mark-on percent after adjusting for all of reductions and purchases for the month. The revised mark-on percent was then applied to each sale to arrive at monthly gross margin for the department.

Overall, this method was a great approach for its day. However, a number of changes in the retail industry have rendered this method obsolete, yet many retailers are still hanging on. Let’s discuss the shortcomings of the retail method, and then we’ll take a look at the solution.

Drawbacks of the Retail Method of Accounting

There are three major drawbacks of the retail method that simply don’t fit today’s retail environment.

1. Gaming the system
   
   
   
   Enlarge image

   With this method, retailers cannot accurately figure their margin until the end of each month. And because bonuses often ride on margin performance, otherwise responsible people could use this method to “game the system” by withholding shipments and delaying necessary markdowns. For example, a merchant might stage shipments at the beginning of the accounting period to delay the impact on purchases to the succeeding month. The consequences can range from nuisance to very serious, and while not everyone takes advantage of this loophole, using a different method could ensure that no one does.

2. Where are we making money?
   
   

   Using the retail method, you can’t truly know where you are making money at a detailed enough level to make a difference. Retailers have dedicated themselves to their merchandise classification system because that’s where gross margin is measured. But merchandising and operational decisions are often made with different merchandise groupings in mind , such as vendor, brand, assortment, customer, promotional campaign, fashion theme or color.

   By replacing the retail method, retailers can compute cost and thus, gross margin at the SKU-store level. This enables the retailer to roll up totals to any meaningful level in the merchandise, location, customer, and vendor hierarchies.

   “I don’t know of any retail startup over the last 15 years that has adopted the retail method,” said Rosenblum.

3. Co-mingling of off-shore and domestic goods
   
   

   Retailers are sourcing more inventory than ever from off-shore suppliers. This fact challenges the core assumption of the retail method that cost-to-retail ratios are homogeneous across a category. They simply aren’t. The drive to more favorable ratios is what started the whole phenomenon; however, if your company uses the retail method, your offshore vendors are comingled with the domestic ones in your cost calculations.

   The private label and off-shoring movement has made landed cost management more complicated than it was in the days when the retail method was invented.

A Better Approach: The Cost Method

The best approach in today’s retail environment is to use the weighted average cost method of valuing inventory. With this method, margin is attached to each consumer purchase. Thus, managers throughout the organization can measure margin consistently. Retailers can then learn who the most valuable customers are, which employees are making the most profitable sales, which vendors are most cost-effective, and which marketing campaigns bring in the highest margin. All of these insights can be gained without having to wait for the month to close.

It is important that all elements of cost, including inbound freight and vendor allowances, are included in the weighted costs calculation. The cost method sets up a foundation for more accurate accounting in years ahead. Progressive retailers will want to distribute labor costs down to the SKU or store level and load the unique selling costs for each channel.

Old Habits Die Hard, but it’s Worth Your While

Converting to the cost method has been accomplished in recent years by many leading retailers. Making the transition requires operating under both accounting methods for a period of time, and a one-time charge to the inventory. After first converting to the cost method, many retail professionals find it challenging to manage the business from a cost perspective. “They have trouble running an open-to-buy because IMU (Initial Markup percentage) and MMU (Maintained Markup percentage) no longer make sense,” Rosenblum continued.

Yet, the short term challenges associated with the conversion are well worth it in the end. Additionally, a retail-specific BI application like QuantiSense that supports both methods can help ease the transition by providing a simultaneous view of both Retail and Cost method calculations. Making this transition is as important in today’s retail world as marketing in multiple channels or focusing on customer centricity. Why? Because it allows retailers to:

• Accurately measure where and how they are making money
• Keep managers from playing games that can jeopardize the business
• Fully leverage their technology portfolio, from POS to Business Intelligence

About the Author:
As a Senior Advisor and Strategist for QuantiSense Bill draws from his 35 years of experience in providing technology-based solutions to retailers. Prior to joining QuantiSense, Bill served as Vice President of Marketing for STS Systems, a leading provider of retail technology solutions with more than 300 clients. Throughout his career Bill pioneered successful applications in all areas of retailing including Point of Sale, Business Intelligence, and Supply Chain Management. Bill's passion for the retail industry guides QuantiSense in delivering results-oriented business intelligence and data warehousing solutions for retail organizations. Bill is based in Baltimore, MD, where he pursues his passions of jazz piano, gardening and golf. Bill is also a Professor of Marketing at Towson University in Towson, MD.

Questions?
Questions, comments, or thoughts about our newsletter? Contact Bill and the rest of the QuantiSense team at retailinsight@quantisense.com.

Amidst the economic turmoil, some retailers are managing to thrive and prosper – so what are they doing differently? Are they marketing smarter? Reducing their inventory levels and out-of-stocks? Investing in the right technology, or the right people? All of these companies have one thing in common: they have a deep understanding of their business – what’s working, and what needs to be changed – and take steps to react from this insight with agility and confidence.

As many of these successful retailers have proven, Business Intelligence (BI) is truly the driving force to gain the kind of insight needed for getting the right merchandise in the right place, knowing who your customers are and marketing to them effectively, and ensuring that your inventory levels are balanced. BI can help retailers get more out of existing business systems to avoid costly upgrades before they’re necessary – just one reason why it continues to be at the top of many retailers’ IT investment lists.

In this edition of Retailing with Insight, QuantiSense Senior Advisor Bill Robinson will discuss another emerging trend among best-in-class retailers – the conversion from a retail method to a cost method of accounting – and focus on the positive implications for retailers, including how BI can make it a seamless transition.

Cheers,

Jeff Buck, CEO

October 14, 2008 at 2pm ET: Webinar featuring Casual Male
Leading a BI Revolution at Casual Male: A webcast hosted by STORES Thought Leadership Series and sponsored by QuantiSense

January 11-14, 2009: NRF Retail’s Big Show 2009 (Booth #1471)
NRF 98th Annual Convention & EXPO 2009 at Javits Center in New York City

January 13-16, 2009: MicroStrategy World 2009
MicroStrategy’s 12th annual user’s conference at Wynn Las Vegas

The Secret Recipe for Unbeatable Competitive Advantage
DMReview.com (July 2008)

Casual Male and QuantiSense Featured in BI Scorecard
RIS News (July 2008)

Case Study with Casual Male
(PDF - October 2008)

QuantiSense
Web Site
Ph: 866.880.4200
Fx: 928.832.9798
info@quantisense.com

Atlanta Headquarters:
3350 Riverwood Parkway
Suite 1700
Atlanta, GA 30339

Sales
sales@quantisense.com

Support
support@quantisense.com

QuantiSense is the leading provider of business intelligence and data warehousing applications exclusively for specialty retailers. The company was formed in 2001 by a team of experienced data warehousing professionals who recognized the need for a retail-specific data warehousing and BI solution that was low risk, cost effective and could be quickly implemented.