WHAT, WHY AND HOW OF RETAIL METHOD TO COST METHOD ACCOUNTING

Many companies started shifting their accounting method of valuating inventory from Retail method to Cost accounting. Cost accounting is better way to track inventory and also results in accurate financial reporting. 

WHAT?:

Retail Method of Accounting:

A recent study indicated that even now 50% of the retails use this old retail method of accounting. The retail method of accounting (or retail method), according to Investopedia, is “an accounting procedure for estimating the value of a store’s merchandise. It calculates a store’s total inventory value by taking the total retail value of the items that were originally in inventory, subtracting the total sales, [and] then multiplying that dollar amount by the cost-to-retail ratio (the percentage by which goods are marked up from their wholesale purchase price to their retail sales price).”

Loop holes in this valuation method:

 Retail leadership used to give targets to store manager’s in terms of selling inventory. Target for a sales manager can be $1000, 000.00 ($1 Million)

If the store manager gets an inventory worth $1million and unable to sell this, the prices can be marked down and be sold for $70,000. Manager can procure $30,000 worth of fast selling inventory and can complete the target by end of the period.

Unable to identify cash cow in business to make right business decisions: 

With this margin calculations, business cannot identify the exact product that is giving profit and ones creating loss as they are getting mixed up in one umbrella.

Cost Method of Accounting:

Inventory valuation in cost accounting is based is difference between sales and cost of goods sold including other adjustments. Cost of goods sold is calculated as part of moving average price calculation. Also called weighted average cost. This is calculated at every unit level at store. Every item sold is defined as a SKU and the cost of SKU keeps changing based on change in procuring cost.

Weighted Average Cost = Total Inventory Value / Balance on hand

HOW?:

Moving to Cost method requires a major change in the mindset of the planner who is used to planning using Retail Method. The change is even more difficult for fashion because it is seasonal based and generally has fixed cycles of Full-price sales, promotions and markdowns. Hence, the planner is accustomed to think in the same fashion – markdowns, which reduce inventory, increasing OTB thus giving way to flow of new merchandise.

WHY?:

Here is a list of some of the reasons why Cost Accounting is attractive to retailers.

1. Want item level visibility 2. Planning and management of gross margin and sell-thru become key
3. No longer requires planning and management of markdown budgets 4. Only selling creates open-to-buy, not markdowns 5. Fewer data points to manage, i.e. less KPIs to plan
6. Inventory values are based upon what you actually paid for the item 7. Accuracy
          1.      Cost value of inventory is independent of retail price changes           2.      Inventory values are based upon what you actually paid for the item           3.      Gross Margin: Cost Accounting -> at Item level, and in retail method of accounting -> blended at category 8. Does not require on hand counts when a retail price is changed

Subsidies V/S Fiscal Deficit

Government has decided to introduce food security bill recently which is something like NREGA that would definitely lifts up its image in front of commoner. But the consequences of these costly subsidies can be veritably gruesome. Having experienced the effects of fiscal deficit during 1991, it is not expected from a responsible fiscal policy designer.

The fiscal deficit of 3% is now a distant dream. The economy that is suffering from Inflation, Currency depreciation and high fiscal deficit should only teach how to fish and not give fish as freebies. Any leakages in implementation can lead to high corruption (and hence unstable economy) and any deviation from the noble intention might make people slothful (and hence unproductive economy).

Unless fiscal policy does not have political reasons as its impetus, controlling deficit is inconceivable.

One Global Trading Currency (GTC) can teach risk management to central banks?

With the fears of double dip recession around, I would like to say that this problem is well anticipated. In fact this is clearly visible from past many years looking at
1) The imbalances of spending and saving patterns of giant economies.
2) Currency wars going recently.
As suggested by many research papers and working papers of global bodies like World Bank and IMF, One global reserve currency might mitigate the pain of the bash. Having a global trading currency that is a proportional basket of currencies can keep things under control to an extent
For eg:
1 Global Trading Currency (GTC) =
1) 40% of USD+
2) 30% of YUAN+
3) 10% of YEN+
4) 20% of EURO.
This would make countries think twice while devaluating their currencies. The export or import advantages they get due to change in currency value would get offset by the GTC value to an extent. You might term it as against free trading, but regulation for the betterment of all is always welcome. And I doubt if USA agrees to replace USD with GTC, even if she gets benefited more from this!! J

A Pan Shop can be worth 10crores now!!

It is quite understandable to see some intangible assets in a company's balance sheet like patents, trademarks, licenses, copyrights etc.. But, it can be ridiculous to see companies evaluating some impalpable parameters like employees, clients, customers etc.. Companies even started discounting the future value derived from these people (Which in anyway has no guarantee) and arriving at huge figures which can assist them to inflate their balance sheets easily. (Though Brand valuation is a different permissible intangible asset)

In the world of highly volatile parameters, how far is it excusable to accept these amusing figures? Going with these comical calculations, even a Pan Shop can be worth 10Crores! Quicker reforms in Regulation of Corporate Governance are required. Hope Mr.U.K.Sinha comes to the rescue of investors.

Creation of Public Disturbance System (P-Di-S) by introducing Cash Transfers to the Needy

The recent proposal of the Finance Minister to replace the current Public Distribution System (PDS) with Cash Transfer mechanism to the poor to fund entitlements can, in my view, defeat the very purpose of doing it.

It is appreciable to see government’s willingness to thwart heavy diversions (About 66%) in the current PDS, but converting the whole system into a cash transfer mechanism by emulating economies like Brazil, Mexico, Jamaica etc.. is a huge miscalculation. Apart from the challenges of the meagerly inclusive banking system and complexity associated with India, there are few more issues entangled like:

1) The fund provided to the poor might get directed towards unproductive means. (Liquor, Smoking etc…) and poor might start resorting unhygienic sources of basic needs to save the money.

2) Leads to lethargy and hit the productivity of the labour (Repercussions of NREGA)

3) Instead of financial inclusion, we might end up having “Inflation inclusion” (Inflatory pressures due to more disposable income)

4) Disturbance in families due to fund mismanagement.

Why can’t the exchequer create a better reporting and fund flow mechanism in current PDS rather than going for a move that cannot be called back in future due to political pressures.

If government is looking for empowerment of local liquor stores, kirana stores, keep family courts and panchayats busy, then it can go ahead with P-Di-S (Public Disturbance System)

A CURIOUS CASE OF "POLICY RISK"

Needless to say, it is the crucial time for India in order project itself as a developed economy in future. Theory says, the commendable GDP growth that is being witnessed is the following of the precedence set by many developed economies during their past. But still investors are made to think many a times due to highly volatile policy environment.

An investor gets attracted to the SEZ (Special Economic Zone) model that is put on the table by Indian Government to encourage FDI, establish a unit and start operations. Before establishment, the financial projections done by the company takes into account, the prevailing tax laws and other parameters. Hoping fewer changes in policies and amendments, things begin. But it is only in a country like India (Out of all developing economies), amendments and bills can be grossly beyond the expected volatility in policy environment.

The recent financial bill and Direct Tax Code 2010 (DTC 2010) both support levying huge MAT (Minimum Alternate Tax) upon SEZ companies. This dilutes the very purpose of tax holiday and encouragement of FDIs, projecting India as a country with more “Country Risk” (POLICY RISK to be precise) as important policies keep on changing very frequently.

Media quote 2011 as year of financial reforms in the country. It would have been much better if things are in place by now. Hope the silver rain of high growth sustains till the time stable Acts like DTC, GST (Goods and Service Tax) come in place. And again let world not say..”Indians are always late” …

PS: High volatility in policies, bills, acts might not exactly come under country risk, but there is no word in semantics to describe this risk precisely. And here we coined a term “Policy Risk”.

Policy Risk: Risk due to frequent grossly unexpected changes in policies, bill and acts that affect the business.

Cricket in Financial Economics!!

As the economy grows, people gather interest in multiplying their money in forums of common interest. In India, cricket is a religion. It is powerful tool for national integrity. Why this can’t be diverted towards a legal platform for doing business through an authorized exchange. In the country where horse racing is legal at many places, futures and options, the instruments which are based on speculation are being traded profusely, why not bring something like “Cricket futures” on to the light in a regulated manner.

The main reason the government has to ban betting on cricket is that the low income groups get attracted to such alluring systems and lose their livelihood. But in a large country with 1.2 billion population, how far it is feasible for the government to ensure such a punt is not happening? There are sources that predicted Rs.10000crores ($2.2Bn USD) of cricket betting taken place during Mohali India Vs Pakistan cricket match!!!! Instead if it creates a regulatory forum for “cricket futures”, it can bring in better organized flow of interests.

Proper regulatory mechanism takes care of “match fixing” in cricket which is analogous to “internal trading” in companies. Innovation in financial economics can welcome growth in the economy provided channels are well cemented to avoid leaks... Comments are invited.. :)