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The purpose of the blog is to highlight some key differences between the Cost Method of Accounting and the Retail Method of Accounting in the context of Merchandise Planning. It will also explore the reasons behind why cost method is being adopted at a must faster pace when campared with RMA.

History – Invention of the Retail Method and it’s challenges

RMA was invented in the era of department stores when retailers did not have the benefit of technology; therefore each sale transaction had to be manually records in the ledger. Before RMA was born, the store had to record the sales prices as well as the cost price of the merchandise at the time of sale. Finding sales prices was relatively easy because it was visible on the merchandise.  However, to find the cost price one had to look up price that was paid for the merchandise at the time of its purchase. This was a tedious and a time consuming process, which could not keep up with increasing sales.

As a consequence, the retail method was born. This method eliminated a whole system of record keeping necessary to determine the valuation of inventory at cost. That is, the store to could simply record the retail price of the product and forego recording of the cost price at the time of sale. Because of its simplicity, high-volume retailers, selling many different items at low unit prices, quickly adopted it – retailers such as Wal-Mart, JC Penny and Target.

However, this ease of use came at a cost of reduced accuracy.  RMA is system of averages and therefor does not provide cost value of the inventory at its present cost price. For instance, all the inventory retailed key-figures such as End of Period Stock are calculated in Retail value and then converted to cost value using Cumulative markups. This Markup percentage is an approximation and hence the derived cost value is an approximation too. This inaccuracy also plagues the Gross Profit calculation because the base key-figure, Cost of Goods Sold, which used to calculate Gross Profit, is also an approximation.

Hence, the RMA method is method of approximations and has some drawbacks:

1. Buyers/ planner playing the system

Planners usually have their bonus linked to their category margins, which can be directly impacted by withholding shipments and delaying markdowns. Buyers could post shipments at the beginning of the fiscal month to delay the impact on purchases to the succeeding month, thus affecting Cost of goods sold and therefore affecting Gross Margin.

2. Manipulating Open to Buy to one’s advantage

“Open-to-buy is used to manage both inventory and purchases. Not just purchases, because markdown will not only help you get more money to buy fresh merchandise, but also help you get rid of the old stock to make space, keeping your average inventory  balanced”.

However, buyers can use markdowns to game the system to get more money. Because markdowns reduce the retail amount of inventory on hand, just as sales do, it is possible to  delay or take additional markdowns to affect Open to Buy. Not all buyers use this technique to cheat the system, but cost method accounting will completely eliminate this possibility.

3. Where are we making money?

Unlike CMA where Gross Margin can be calculate at a Store – SKU level, Gross margin, In RMA Gross Margin is calculated at a merchandise category level, which does not really tell which exact products are contributing most to the gross margin. For instance, in shoe retailing it is seen than just 10 to 15% of the merchandise usually results in more than 50% of the margin. Hence, the important of SKU level data cannot be ignored.

Moreover, having data on Store – SKU level is hugely beneficial because it also allows the retailers the flexibility to aggregate the data the way he wants. It could on a Merchandise Hierarchy, an Article Hierarchy, Vendors and wholesale customers.

Cost method of Accounting in contrast with the Retail Method

Unlike Retail method where Inventory dollars are tracked at higher levels than SKU, usually Department and Category, Cost method assigns a true product cost (usually weighted average) to each sales transaction based on the selling SKU.

What does this change mean to the Merchandise Planning Process?

1. Inventory expressed in Cost Dollars

With Cost method Inventory KPIs, such as Goods Receipts and Ending Inventory are no longer planned in Retail Dollars. They are planned directly in cost value.

2. Simplified calculation

The calculations for some key-figures are also simplified. For instance, the Margin Calculation is simplified because cost of goods sold calculation is simplified (eliminates impact on markdowns on calculation).

3. Change in the Planner’s mindset

The biggest impact with the move to CMA is the change in the fundamental change planning process. With CMA, the planning process is driven by margin and sell-through rather than markdown liquidation, as it is in RMA. 

In CMA, the markdowns no longer impact Cost of Inventory sold, and the gross margin calculation and even the GMROI are more accurate. Hence, the planner’s primary focus shifts from getting rid of the merchandise via markdowns to make way for new merchandise, to gross margin/profitability of the category his/she owns.

4. Simpler Method with fewer data points to manage

With planned reductions such as shrinkage, Return To Vendor and markdowns no longer impact the Ending Inventory, and thus the cost of goods sold, there a few data points to manage.  This also means that the in-season tweaks required to plans are also less.

5. Open to Buy

OTB increases with Sales instead of markdown. (Because Markdowns no longer impact Ending inventory calculation, hence Planned Goods Receipts/OTB, are not impacted with markdowns)

Example 1 : Moving Average Cost (MAC) calculation comparison

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Example 2 : Effect of change in MAC on Margin

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Summary

No doubt the cost method is simpler and based on metrics that are more accurate. It is because it is the cost value of the product as it is sold and not a moving average. However, to conclude that moving to CMA will result in better planning would be wrong.

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.

Here is a list of some of the reasons why CMA 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: CMA -> at Item level, and in RMA -> blended at category
8. Does not require on hand counts when a retail price is changed

Ultimately, the success of the planning process will depend upon how well the planning process is embraced by the planning team.

Look forward for your comments !

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2 Comments

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  1. TARUN GULATI

    excellent explanation. A question is – do you think using extended retail method of accounting creates two versions of the truth – inventory valued using CMA and retail metrics at RMA ?

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