A Case For Changing The Way We Account For Promotions And Discounting
By Michael Jorgensen, Executive Vice Chairman, NCASEF
7-Eleven’s system of promos and discounts certainly needs some rethinking. While researching my most recent audit using the new Inventory Walk Report, I reviewed the nonalcoholic beverage category by item. Drilling down to the by-item report I noticed that there was an abundance of discounts and markdowns. On just the first 10 of 31 pages, the discounts equated to approximately $57,000, which based on the total purchases reflects that 18 percent of my inventory in this category alone is discounted.
Now this being an audit, I thought about my inventory shortage and how we pay for shortage at full retail value multiplied by VIP (Variable Inventory Percent), not the full retail value minus discount. VIP is calculated using the previous 12 months’ purchases at cost divided by the previous 12 months’ purchases at retail. Special Items Purchases, consigned merchandise, write-offs, and product markdowns are excluded from Purchases at cost as well as Purchases at retail. It seems that in this one category I’m paying 18 percent more on shortage due to the amount of discounting occurring at the POS register ONLY when items are sold.
So I’m effectively bringing products into the store at retail that is unrealized because of the amount of promotional activity and discounting we now have. When inventory is unaccounted for, whatever the reason, I’m effectively paying a higher cost for the missing inventory since the product retails for a higher retail than I will ever realize selling that product for in my store.
For example, let’s say my VIP is 63 percent. I have one-liter water with an actual cost of $0.71, a retail of $1.89, and a discount of $1.00, bringing the actual retail to the customer to $0.89. If one bottle is unaccounted for at the audit, the cost I will have to pay back for the missing bottle is $1.19 (retail price of inventory on the floor by VIP). The difference in cost between the actual cost ($0.71) and the VIP cost is $0.48. I’m paying $1.19 per one-liter for any short at the time of my audit. Yet on promo (100 percent of these are sold on promo), the most I will sell that item for is $0.89.
Let’s try another example, using a category that franchisees have been consistently asking to be changed to markup—the food category. The actual cost of a pizza slice is $0.53 and the retail when delivered is $1.49. 93 percent of my pizza sales go out the door discounted, going out at 2 for $2 or as part of a discounted whole pie (an even larger discount). If one slice is unaccounted for as part of the audit, the cost I will pay for that slice shortage is $0.94, this is $0.41 cents more than the actual cost.
This works for many products across the store, especially as promotional activity and discounting increase. Take apple fritters, for instance. An apple fritter costs $0.80, is invoiced at a retail of $1.89, and sells on promo at the POS register for only $1.00. The markdown is $0.89 for each fritter. It’s a great deal for our customer, but if there is a discrepancy upon my audit, I’m paying back $1.19 for shrinkage and at inventory, a difference of $0.39 between VIP cost and actual cost. This is especially illuminating when you consider that 100 percent of the water and fritters are sold on promo, as is 93 percent of the pizza slices.
This accounting complication first occurred to me with the introduction of mini tacos which originally were retailed at $0.50 each and sold at 4/$1. This made no sense as close to 100 percent were being sold as a bundle (you can’t go to McDonald’s and get just one chicken nugget). In this scenario if one mini taco was unaccounted for we are paying $0.50 on inventory variation when the most we will realistically realize is $0.25 as a sale.
Cigarettes, which account for a large part of our sales and inventory, also need to be considered. Roughly thirty percent of my cigarette sales are cartons and a large percentage are also sold as 2 and 3 pack promotions, yet they are being added to my retail inventory at the higher pack price. If a pack of cigarettes is unaccounted for, I am paying the shortage back at the full pack price times VIP. The likelihood of realizing the full value of everything you bring into your store is minimized by the promotional activity and discounting. It appears that on inventory shortages we all pay back a higher cost because of this.
The considerations extend beyond inventory variation as well, to the interest we are paying on inventory. The portion of interest we pay for our inventory is based on our retail inventory on hand times VIP. We are paying interest on that inventory based on the retail price that the inventory was brought into our stores. Over 7,300 franchised stores and hundreds of items being sold on promo or discounted, inventory variation and the difference in interest we are paying on our inventory adds up to a ginormous number.
Promotional activity and discounting are crucial to our business and determine our ability to maintain or grow our customer counts and sales, but the accounting must be revisited. To get to the price to compete in the marketplace for customers, we are compelled to buy into the promotions and discounts. 7-Eleven uses its bargaining position to negotiate with vendors and the way they account for the discounts and funding compels franchisees to participate in the promos. Customers are happy, the vendors are happy, and 7-Eleven is happy, but franchisees end up paying more in inventory variation and more in interest on the inventory they carry than they should.
In most other businesses, shrink is in the cost of sales. In our system it is not part of the cost of sales, it is after the fact and the cost is borne by franchisees. It doesn’t matter if it is a paper shortage, something set up incorrectly in the ISP, or theft. With all the promotional activity and discounting and the accounting billbacks, and scanbacks, the more convoluted it gets for us to even be able to track down our proper credits. 7-Eleven does not disclose inventory variation numbers because it is a franchisee expense.
To finish where I started, based on our current accounting, if I have a retail inventory shortage of $1,000 and my VIP is 63 percent I will pay back $630. But assuming my non-alcoholic beverages markdowns of 18 percent extends to all categories of inventory across the entire store the retail value of the missing inventory will only be $820. Multiply this by VIP and it reduces the inventory variation at cost to $517 reducing what I must pay back on the shortage by $113.
7-Eleven needs to revisit the way promotional pricing and discounting are accounted for because times have changed. The way we are doing accounting might not work the way it used to. I realize that there are many benefits to our business to participate in promotions and discounting, from driving traffic and customer retention to signing customers up for 7-Rewards, but franchisees shouldn’t bear the burdens of higher interest costs or an inflated cost of inventory shortage based on SEIs accounting.