GROSS MARGIN MANAGEMENT FRAMEWORK FOR MERCHANDISING DECISIONS IN COMPANIES WITH LARGE ASSORTMENT OF PRODUCTS

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1 ECONOMICS AND MANAGEMENT: (1) ISSN (ONLINE) FOR MERCHANDISING DECISIONS IN COMPANIES WITH LARGE ASSORTMENT OF PRODUCTS Gedimias Jagelavicius Kauas Uiversity of Techology, Lithuaia Abstract Gross margi maagemet is a complex task as gross margi ca t be too high or too low i order to deliver maximum sales ad profit. Objective of the article is to preset framework which allows uderstadig ad maagig gross margi ad i compaies with large assortmet of. The framework has defied basic margi variaces pricig, cost, volume ad mix. These variaces eable to uderstad ad iterpret strategic ad merchadisig decisios of the compay. Formulas are preseted which traslate specific merchadisig decisios impact o gross margi ad gross profit, formulas allow to simplify calculatios without the eed to recalculate all assortmet o product by product basis multiple times. Derivatios of algebraic formulas are used to obtai gross margi variaces impact o gross margi ad. Cause ad effect model is used as a method to itegrate gross margi variace ito the gross margi maagemet framework. Bosto Cosultig Group matrix priciple is used to establish ad aalyse typical gross margi maagemet situatios ad iterpret behavior of customers. Coclusios compaies with large assortmet of have to maage fiacial results ad through gross margi maagemet by evaluatig merchadisig decisios impact o both ad gross margi. Four ad margi variaces, cost, volume ad mix, eed to be used to uderstad busiess situatios related to gross margi maagemet ad these four variaces ca be used as buildig blocks to aalyse specific merchadisig offers ad strategic decisios. The type of the article: Methodological article Keywords: gross margi maagemet, maagemet, variace aalyses, merchadisig decisios. JEL Classificatio: G39, M Itroductio Gross Margi maagemet is oe of the most importat ad oe of the most complex areas i maagig fiacial results of the compaies. Compaies which have higher gross margi ted to be more profitable ad ted to have stroger free cash flow - high cash flow ca be retured to shareholders or re-ivested ito the busiess, allowig the busiess to expad, without havig to rely o debt. These compaies are more resiliet to exteral eviromet impact from chage i macroecoomics or actios of competitors. Gross margi maagemet is complex task especially because gross margi ca t be too high or too low i order to deliver maximum sales ad profit ad this is differet comparig to maagemet of operatig expeses or cash flow where i may cases miimisig expeses or ivetory, accouts receivable etc. meas maximisig profit ad cash flow. Gross margi maagemet is eve more complex i compaies with large assortmet of customers behaviour iflueced by merchadisig decisios of the compay impact product mix, product mix impacts actual cost of merchadisig decisios ad actual gross margi ad. Nowadays gross margi is quite widely discussed i busiess cotext it is preseted ad 6

2 Gedimias Jagelavicius explaied by compaies to shareholders ad aalysts, cosultig compaies are ready to propose gross margi icrease strategies as well exists quite extesive scietific research aalysig separate gross margi aspects or decisios which impact gross margi. The problem is that due to the reaso the subject is very wide therefore there is a lack of itegrated approach to gross margi where gross margi aalysis are liked to decisios ad compay strategy which should help select eeded decisios. Cost accoutig theory provides aalyses of cotributio or expressed i moey terms but does ot traslate it to margi impact expressed i percetage poits which is extremely importat for compaies with large product assortmet. As well cost accoutig is focusig o fiacial aspect i this way loosig lik to merchadisig ad sales promotio. O the other side merchadisig ad sales promotio researches are focusig o sales ad marketig side without the lik to fiace. The objective of this article is to preset framework which would allow uderstadig gross margi ad drivers, likig it to product merchadisig ad strategic decisios ad allowig usig it i compaies which have big assortmet of. Gross profit ad gross margi as performace idicators are chose i order to make the framework practically easy applicable. Classical cost accoutig (Horgre, Datar, Raja, 2010) proposes cotributio margi idicator which additioally takes ito accout expeses directly related to aalysed situatio or decisio. I this article ad i my proposed solutio I limit aalyses to the ad gross margi without takig ito accout operatig expeses for the simplicity purposes: Compaies with large assortmet is complex eough therefore busiess ad decisio aalyses should be split ito smaller steps. Gross profit ad gross margi aalyses should be oe of the first steps. Compaies which do ot have developed sophisticated performace aalyses system as a step 1 ca start with my proposed gross margi aalyses. Later o after the compay is used ad fully uderstad ad gross margi it ca add o operatig expeses to their aalyses ad move to cotributio margi idicator as a step 2. Oly those merchadisig decisios which directly impact fiacial result are i scope for this article, the impacts of these decisios ca be measured by the proposed framework. So impacts of pricig, offers ad promotios, up-sell, cross-sell, samplig ad similar decisios are measured by the proposed framework. Merchadisig elemets such as visualisatio, store desig etc. with o direct attributio to fiacial result is out of scope for the proposed gross margi maagemet framework. Research o differet aspects of Gross Margi or Merchadisig decisios impactig gross margi is quite extesive, I would like to metio those most related to this article Hurlbut (2005) states importat aspects of gross margi maagemet ad lists most commo mistakes related to gross margi i retail idustry; Cushma (2011) liks merchadisig decisios to fiacials mostly for small busiess; Shah & Kumar (2012) aalyse merchadisig decisios, specifically cross-sellig, impact o customers behaviour ad impact o compay profit; Goldratt, Eshkoli & Browleer (2009) preset a problem whe icorrect merchadisig ad sales promotio decisios dilute fiacial performace of large assortmet sellig busiess, solutio based o theory of costraits aligs merchadisig decisios to right strategy which allows cosiderably improve profit, margi ad retur. Cosultig compaies propose ready to implemet solutios directed to gross margi maagemet e.g. Boulder group s itegrated gross margi improvemet program focuses o gross margi maagemet process, strategic ad tactical decisios; Siburg Compay has a margi icrease solutio focusig o pricig, cost ad other gross margi drivers. 2. Theoretical backgroud - Gross profit, Gross Margi ad its variaces i the cotext of merchadisig decisios Gross profit is the differece betwee reveue ad cost of goods sold. Gross Margi is the ratio of to reveue. Depeds o situatio or decisio aalyzed both or oe of these two performace idicators ca be more suitable. For merchadisig decisios i compay with large 7

3 Gedimias Jagelavicius assortmet of expressed i moey terms eeds to be used whe measurig fiacial result o the level of all product assortmet or o the level of big product group. This allows to see what is the overall fiacial result without diggig ito details. Gross margi expressed i percetage is more useful whe we look at the details e.g. we ca t pla exactly the from particular product because we do t kow exact quatities we are goig to sell because customer has wide rage of similar to choose i compaies with large assortmet. Differetly to gross profit, gross margi ca be plaed quite exact o product level as compay itself sets, defies discout, promotioal offer etc. ad compay kows the cost to produce or buy. As well margis expressed i percetage are more suitable whe compariso betwee or product groups eeds to be doe as expressed i moey terms ca vary very much depedig o product is expesive or ot, is o promotio or sold at regular etc. Therefore both idicators gross profit ad margi are importat to track whe makig ad aalyzig merchadisig decisios. Cost accoutig theory has variace aalyses which ca split profit variace ito groups based o ature of variace. Bhimai, Horgre (2008) defie sellig, cost per uit ad quatities sold variaces. Sold quatities variace is further split ito sales-mix variace ad salesvolume variace. I am usig these classical cost accoutig variaces as a buildig blocks for the gross margi maagemet framework. Table 1 presets how the proposed framework simplifies (marked grey) ad ehaces (marked light blue) the variaces of cost accoutig. Table 1. Compariso of Variace aalyses the gross margi framework vs. classical cost accoutig Variaces: Variace expressed i Variace measures differece i Variaces of Actual vs. pla or last year are calculated at the level of Variace for aalysig potetial ivestmet or savig decisio i plaig stage is doe at the level of Classical Cost acc. Cost Quatity: - Mix - volume Absolute profit (moey) Cotributio by product ad summed up by product ad summed up Proposed framework Cost Quatity: - Mix - volume Absolute profit (moey) & Gross Margi poits Gross profit ad Gross Margi Oe of the compoet (e.g. Gross profit variaces) is calculated at product by product basis. Traslatio to other compoet (e.g. Gross margi) is doe with simple formula with o eed to recalculate at product by product level Assumptio ca be directly traslated ito variace by usig formula Commet No differece More coveiet to pla ad make assumptios for large assortmet of Classical cost acc. takes ito accout expeses; the framework proposes practical solutio for compaies with large assortmet ad does ot take i scope operatig expeses No differece i effort Less effort, o eed to recalculate o product by product basis 8

4 Gedimias Jagelavicius 3. Gross profit ad Gross margi variaces From (1) ad gross margi (2) formulas we ca see that variace ca occur due to chage i, Cost ad quatities or i other words differet mix sold. GP Reveue CostofGoods Q ( P C ) (1) GM GP Reveue Q ( P GP - ; GM - gross margi; P - of specific product excl. value added tax; C cost of specific product per uit; Q - quatity of specific product sold. Q P C ) To calculate variaces formulas (3-6) should be used, alteratively 4 scearios eed to be calculated ad differece of ad margi betwee scearios would show variace: quatity or variace ca be obtaied by proportioally reducig all the uits i base sceario i order to arrive at actual uits sold while s per product ad costs per uit eed to stay as i base sceario. Differece of Gross profit ad margi betwee this recalculated sceario (example i Table 4) ad base sceario (Table 2) would give variace. Mix variace ca be obtaied by keepig s per product ad cost per uit as i budget sceario but uits sold replacig with actual quatities. Differece of this sceario (Table 5) ad previously described volume variace sceario would give Mix variace. variace ca be calculated by keepig actual quatities sold ad actual s per product ad just cost are as i budget. Differece of this sceario (Table 6) versus Mix calculatio sceario would give variace. Cost variace is calculated by deductig Gross profit ad gross margi of Actual sceario from variace sceario. Graphical presetatio ad summary of example aalysed i Tables 2-7 is i Figure 1. Var Q ( P P ) (3) A A A A B CostVar Q ( C C ) (4) B Var ( Q Q ) M GP (5) A BT MixVar Q ( M M ) GP (6) QA B B - quatity i uits of product actually sold; Q - total quatity of all uits actually sold, from product 1 to product ; QBT B B - total quatity of uits projected to sell i base sceario, e.g. budget or last year; PA - Actual per uit of product ; PB - per uit of product i base sceario; CA - Actual cost per uit of product ; CB - uit of product i base sceario; M B - Mix percetage i base sceario of product, e.g. if pla is to sell 3 uits of specific product ad total uits sold pla is 100 the mix percetage of this product is 3%; (2) 9

5 Gedimias Jagelavicius M A - Mix percetage of product i actual sceario; GPB - of 1 uit of product i base sceario. Table 2. Budget Sceario Budget Quatity uit Profit Margi A % B % Total % Table 3. Actual Sceario Actual Quatity uit Profit Margi A % B % Total % Table 4. variace Sceario Variace sceario Quatity uit Profit Margi variace A % % B % % Total % % Table 5. Mix variace Sceario Mix Variace sceario Quatity uit Profit Margi Mix variace A % % B % (210) 0.0% Total % % Table 6. variace Sceario Variace sceario Quatity uit Profit Margi variace A % (275) -5.0% B % % Total % (225) -3.9% Table 7. Cost variace Sceario Variace sceario Quatity uit Profit Margi Cost variace A % (165) -20.0% B % - 0.0% Total % (165) -17.8% 10

6 Gedimias Jagelavicius It is very importat to make calculatios i the order as described above first calculate volume the mix the ad lastly cost variace. Calculatio of scearios i differet order would give differet result ad would ot have ecoomic sese e.g. if by mistake we calculate variace by keepig budgeted uits ad costs, replacig s to actual ad comparig it to budget sceario the i case of icreases we would observe overestimated pricig impact as differece i we would multiply by budgeted volume which probably was higher whe icrease was ot plaed. I compaies with large assortmet of volume variace ca be meaigless if compay sells very differet especially whe poits are very differet. I such case decrease i volume of expesive product does ot have equal ecoomic meaig as decrease i volume of cheap product. Solutio would be to measure volume variace by comparable product categories ad after that to group volume variace together with mix variace whe comparig o the level of all assortmet. 385 (11,4%) +285 (-10.3%) 290 (72,5%) 290 (0,0%) 225 (3,9%) 165 (17,8%) 575 (62,2%) Budget Mix Cost Actual Figure 1. Presetatio ad summary of Gross profit ad margi variace for aalysed example Formulas 3-6 calculates variaces. To calculate gross margi variaces we ca do multiple recalculatios as preseted i tables 2-7, but for the large assortmet it would be resource cosumig therefore already havig variaces it is easy to traslate it to gross margi variaces. Formulas were derived by the author of this article usig algebraic formulas derivatio method. As we kow volume variace has o margi impact therefore i all cases gross margi impact due to volume will be equal to zero. Gross margi Mix,, Cost variaces ca be calculated usig formulas 7-9. Var ( C CostVar ) VarGM % (7) S ( S Var ) CostVar CostVarGM % (8) S Var MixVar GM GM Var CostVar (9) GM% % BT% GM% GM% Var GM% - Gross margi variace for all assortmet or part of the assortmet expressed i gross margi poits; CostVarGM% - Gross margi cost variace for all assortmet or part of the assortmet expressed i gross margi poits; MixVarGM% - Gross margi mix variace for all assortmet or part of the assortmet expressed i gross margi poits; Var - Gross profit variace expressed i moey terms; CostVar- Gross profit cost variace expressed i moey terms; C - Actual total cost of all assortmet or part of the assortmet, ca be take from P&L report; 11

7 Gedimias Jagelavicius S - Actual total sales of all assortmet or part of the assortmet, ca be take from P&L report; GM % - Gross margi of all assortmet or part of the assortmet i Actual sceario, ca be take from P&L report; GMBT% - Gross margi of all assortmet or part of the assortmet i Base sceario, ca be take from P&L report. Merchadisig decisios impact all 4 types of variaces. Usual logic of merchadisig is to ivest i gross margi i order to icrease sales ad. Table 8 presets examples of offers used ad its impact o ad gross margi through variaces i situatio whe compay icrease spedig i the offers versus base sceario. If compay decrease spedig i the offers the impacts o variaces are opposite to those metioed i the table. Table 8. Merchadisig promotio offers impact o profit ad margi variace whe compay icrease ivestmet i the offers Promotio example Discout e.g. 40% off for particular product. Coupos e.g. is lower with preseted coupo. - Loyalty reward programs e.g. collect miles/poits ad redeem it for additioal product or services. Kids eat free Buy 1 & get 1 free or 3 for the of 2 Mix Cost Discout should icrease volume therefore volume variace will be positive with o impact to gross margi due to ature of volume variace. should icrease as cliets ted to choose our compay vs. competitio to obtai beefits therefore volume variace goig to be positive, o impact o gross margi. Discouted volume will icrease ad it ca caibalize sales of other so their volumes ca decrease. Impact to margi & profit is positive if promoted product margi is above average vs. the margi of total assortmet ad egative if promoted product margi is below average No mix variace as usually loyalty rewards are give o full assortmet Gross profit ad gross margi will decrease as discout impacts No chage to therefore o variace No impact to ad margi due to cost Cost var. is egative for & margi. Negative gross profit var. equals to cost of which ca be redeemed from collected poits. Gross margi variace equals cost of redeemed divided by reveue. Overall impact to Gross profit & margi Promotio is overall gross profit variace is positive - gross profit var. is more tha offset by sum of volume ad mix variaces. Overall Gross margi variace will be egative uless discouted remai with higher tha average gross margi eve after discoutig Offer is egative cost variace is more tha off-set by positive volume variace. Overall Gross margi variace will stay egative due to this offer. 12

8 Gedimias Jagelavicius Promotio example Free samplig Bous pack e.g. of 1 liter is the same as 0.75 l Loss leader sellig oe or few at loss or little profit i order to attract customers to buy other Moey refud offer e.g. buy at regular but you ca retur if you do t like them Mix Cost variace positive as customers are goig to buy more of those which they tried through samplig of Bous pack product will icrease ad it will result i positive variace variace is positive variace is positive as cautious customers are goig to try Mix is goig to be positive if sampled have higher tha average gross margi ad egative if sampled have lower tha average gross margi Mix is positive if bous pack product has higher tha average gross margi ad opposite if bous pack has lower gross margi comparig to total assortmet Mix depeds o volume icrease of with higher tha average gross margi vs. volume icrease of with lower tha average gross margi Mix variace is positive if with higher gross margi will be drive by this offer No chage to therefore o variace No chage to therefore o variace variace egative for both gross profit ad gross margi No variace Cost variace is egative for & margi. Negative gross profit variace equals cost of samples. Gross margi variace equals cost of samples divided by reveue. Negative cost var. for profit ad margi equals to icrease i product costs bous package vs. regular package cost multiplied by actual quatity sold No cost variace Gross profit cost var. is egative ad equals to the cost of retured which ca t be resold. Gross margi variace is cost of retured usalable divided by reveue. Overall impact to Gross profit & margi Offer is egative cost var. is more tha off-set by sum of volume ad mix var. Overall Gross margi variace will stay egative due to this offer. Offer is egative cost var. is more tha off-set by sum of volume ad mix variaces. Overall Gross margi var. will stay egative due to this offer. Promotio is variace is more tha off-set by sum of volume ad mix variaces. Overall Gross margi variace will be egative. Offer is egative cost variace is more tha off-set by sum of volume ad mix variaces. 13

9 Gedimias Jagelavicius 4. Gross margi maagemet framework Now we kow that ad margi eeds to be aalyzed by calculatig variaces which helps to idetify the reaso or driver for icrease or decrease i profit ad margi. To apply this theory i practice ad make it meaigful i maagig the compay we eed to take ito accout compay strategy ad merchadisig decisios which are made to drive sales. Combiig strategy ad merchadisig decisios with gross margi/profit variaces aalyzes allows to measure where do we go i terms of directio defied by strategy ad esures merchadisig decisios are aliged with strategy. Strategy will give us a aswer to questio - how compay does wat to develop. Let s say compay has a strategy to grow through itroducig ew. I this case our ad margi aalysis eeds to split all assortmet ito groups depedig o time of itroductio. After calculatig ad gross margi ivestmet or di-ivestmet for each group we kow exactly how much ad where do we ivest i each product group. Similarly compay ca have a strategy to grow through few strategic categories of product ad fiace the growth through icreases i o-sesitive. I this case we split assortmet ito groups based o strategic priorities ad measure ivestmet (di-ivestmet) for each group separately. Figure 2 presets example where we ca see that compay was drivig ew by ivestig i cost (improvemet of product quality or stroger merchadisig offer of the ew product impactig cost variace) ad at the same time icreasig s ad growig volume i this product group. Last year s were icreasig volume due to decrease i s ad at the same time compay was savig o cost of last year s. Overall result was deteriorated by which fiish life cycle volume was decliig eve with decreases ad declie of from these were ot off-set by ewly itroduced therefore overall ad margi of the compay declied. +40 (10.0%) 330 (82,5%) +10 (+3.5%) (85,0%) (-13.7%) 290 (72,5%) 285 (71,3%) Last year total Mix Cost Most ew Mix Cost Last Mix Cost year itrod. Prod. Actual total New s Last year s Fiishig life-cycle Figure 2. Example of aalyzes of strategic product groups & margi Merchadisig decisios drive sales ad growth of. It is very importat to measure success ad impact of each decisio therefore to have good quality of iformatio we ca split all assortmet of by type of promotio ad measure success of each offer. If discoutig decisio with X poits of margi ad Y dollars ivestmet i pricig results i greater volume ad mix variace the the offer is successful ad i this way we ca measure retur of each type of offer. For example retur o ivestmet of samplig offer described i table 8 ca be calculated by dividig overall icrease drive by samplig by cost variace of samplig offer. The gross margi maagemet framework aalyses assortmet by splittig it ito groups 14

10 Gedimias Jagelavicius depedig o compay strategy ad each promotio type withi assortmet is aalysed separately. Ivestmet or divestmet is measured by calculatig ad gross margi variaces (Figure 3). Group A (e.g. ew ) split ito 4 variaces Group B (e.g. last year itroduced ) split ito 4 variaces.. Group N (e.g. ed of the lifecycle) split ito 4 variaces Strategic groupig of assortmet Mix Cost 4 Gross Profit & Margi variaces Offers type 1 (e.g. discoutig)split ito 4 var. Offers type 2 (e.g. samplig) split ito 4 var.. Offers type N (e.g. 2 for of 1) split ito 4 var. Merchadisig promotioal offers Figure 3. Gross margi maagemet framework 5. Why is ot eough to measure oly variace Classical cost accoutig measures profit or cotributio variaces where variace is expressed i moey terms. The framework proposed by this article additioally measures margi variace. It is importat to uderstad ot oly but as well gross margi variace as gross margi variace gives additioal dimesio to uderstad behavior of customers. Figure 4 presets top level two-dimesioal customer behavior aalysis whe both dimesios ad gross margi variace are aalyzed. Goig deeper ito variaces we still eed to look at both profit variace ad margi variace, e.g. Figure 5 presets example of coclusios which ca be made whe aalyzig iter-relatio of gross margi mix variace with volume variace. Similarly whe aalyzig particular offer, e.g. discoutig we ca see what has happeed to variace i relatioship to quatity ad together quatity ad mix variace. Gross margi variace is the iput to aalyze offers impactig s such as discoutig if variace was egative meas compay ivested i the offer more tha i base sceario (e.g. last year) ad if quatity variace was positive meas customers liked the offer, if quatity ad mix variace was positive this discoutig offer did t caibalize other offers. + - Total Gross Profit variace Gross Margi ivestmet pays back i gross profit icrease Ivestmet was ot eough to growth or ot attractive to customers There is a space to icrease gross margi further Gross margi icrease was too high ad fired back impactig decrease i profit - + Total Gross Margi variace Figure 4. Two-dimesioal aalysis of merchadisig decisios 15

11 Gedimias Jagelavicius This article is limited with descriptio of few situatios whe aalyzig ad margi variace as it is impossible to list all the situatios ad preset big variety of coclusios which are possible to make by usig the proposed framework ad aalyzig big assortmet by busiess usig two dimesios ad gross margi combied with classical 4 variaces, cost, volume, mix. 6. Coclusios Both gross margi ad eed to be aalyzed whe evaluatig strategic ad merchadisig decisios of the compay. Compaies with large assortmet of have to rely o gross margi maagemet vs. maagemet whe plaig at a detailed level. Classical, cost, mix, volume variace is a tool to aalyze ad margi drivers. Profit ad margi variace formulas allow to make calculatios i shorter way without the eed of multiple recalculatios. Gross margi maagemet framework preseted i the article allows to evaluate strategic decisios ad calculate retur of differet merchadisig offers. + - Gross Profit ($) variace Customers geerally like offers but choose cheaper Customers pick cheaper offers ad overall customer propositio is ot attractive or too expesive Customers like our offers ad customer propositio is likely to pay-back Offers with higher tha average gross margi were supported but other offers lack support - + Gross Margi (%) Mix variace Figure 5. Customer behavior aalysis from volume ad mix variaces Refereces Bhimai, A., Horgre, Ch., Datar, S.M., Foster, G. (2008). Maagemet ad Cost accoutig, 4th editio. Pearso Educatio Limited. Cushma, L.M. (2011). A Practical Approach to Merchadisig Mathematics. Fairchild Books. Goldtratt, E.M., Eshkoli, I., Browleer, J. (2009). Is't It Obvious? North River Press Publishig Corp. Horgre, Ch., Datar, S.M., Raja, M. (2010). Cost Accoutig, 14th editio. Pretice Hall. Hurlbut, T. (2005). Gross Margi the Overlooked Metric. Ic Magazie, September. Shah, D. & Kumar, V. (2012). The Dark Side of Cross-Sellig. Harvard Busiess Review, December,