RETAIL GROSS PROFIT: A STAGE BY STAGE**ANALYSIS

RETAIL GROSS PROFIT: A STAGE BY STAGE
ANALYSIS
Paul T. McGurr, Ashland University
ABSTRACT
Retail gross profit percentage is not a single measurement but a series of measurements
based on the product's stage in the distribution channel. This paper performs a stage by
stage analysis of retail gross profit identifying the adjustments made to gross profit and
the parties responsible for the adjustments.
INTRODUCTION
Retail gross profit is the difference between the amount of the retail sale and the
acquisition cost of the item sold. In a few retail establishments, such as heavy equipment
or automobile dealers, specific identification can be used to easily determine both the cost
and the retail of each item sold. However, for most retailers the calculation of the
retailer's gross profit becomes more difficult.
Even those retailers with sophisticated point-of-sale (POS) systems cannot exactly
determine gross profit. There are too many events that impact gross profit that occur
outside the POS measurement vehicle which remove exactitude from even the best
system. Gross profit calculation in retail organizations must therefore be an estimation.
This fact is not often understood by accountants and managers without a retail
background. Manufacturers and others who are used to detail process costing or job
costing cannot understand the difficulties in retail gross profit estimation.
This difficulty is further masked because retailers use a simple, basic formula to calculate
retail gross profit during any accounting period:
Gross Profit = Retail Sales - Cost of Product Sold
Cost of Product Sold for an accounting period is also determined using another simple
formula:
Beginning Inventory + Purchases Ending Inventory = Cost of Product Sold (Cost of
Sales)
The amounts needed to determine gross profit are retail sales, which are readily available
from cash register or other readings; purchases, which are available from warehouse
shipment records or invoices received for product delivered directly to the store, and
inventory balances. The problem is in the determination of the inventory balance. The
ideal method is to take a physical inventory of the retail stock at the store and cost each
item at its original purchase price. This is impractical as retail physical inventories are

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expensive and disruptive to store operations. Specific identification of each item's cost
may be very time consuming Therefore, except for high dollar value, low quantity
inventories, retail physical inventories are usually not performed at the end of every
accounting period and the cost of products sold in the gross profit calculation must be
estimated.
Even when a retail physical inventory is performed there still remains a basic difficulty in
the determination of the inventory value. Merchandise at retail establishments are
normally accounted for at store level at their RETAIL value; Gross profit determination
using the above accounting formulae is based on the merchandise inventory COST value.
Even when retail physical inventories are performed an estimation process is required to
determine the proper ratio of cost to retail of the inventory counted. This dichotomy
between the retail store's operational need to keep track of its inventory at RETAIL and
the retail organization's accounting need to keep track of the amount of product sold at
COST is the source of many of the difficulties in the management of gross profit at a
retail store or a chain of stores.
The practical solution to these estimation problems is for the retail organization to set a
cost to retail ratio to be used to determine the cost of inventory maintained at retail
(cost/retail percentage), or to set a standard gross profit percentage to be used in the
determination of cost of sales and gross profit (gross profit percentage = 1- cost of sales
percentage). This estimation process is not easy. However, it is critical to the successful
operation of a retail organization. Inventory cost and gross profit estimation is further
complicated in that different functions of the retail organization calculate and analyze
these percentages at different stages in the gross profit calculation and each function's
view of the gross profit percentage differs in definition from that used by other functional
areas of the organization.
Table 1
Stages of Retail Gross Profit Determination:
STAGE
IMPACTED BY
RESPONSIBLE FUNCTION
Purchased Gross Profit Percentage Cost Adjustments
Purchasing
Bill Out Gross Profit Percentage
Retail Adjustments Merchandising
Expected Gross Profit Percentage
Other Adjustments Store Operations
Achieved Gross Profit Percentage


There are at least four distinct stages in a retail organization's gross profit percentage
determination. Each of these stages will be analyzed and examples will be provided of
the normal retail activities which occur and affect the calculated gross profit percentage.
Table 1 summarizes the four stages and lists the type of adjustments which impact the

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gross profit percentage calculated at each stage. The table also lists the corporate function
primarily responsible for the adjustments made at each stage.
Each retail organization accounts for gross profit differently depending on its industry
practices and the style and goals of the management of the organization. Further, items
described below may be treated as adjustments to store gross profit in one organization
while the same item may be considered a corporate general or administrative expense
adjustment by another organization. This may be true even if the two organizations are in
the same retail category. Examples provided will be discussed related to a specific
inventory item. Most retail organizations do not maintain item-by-item gross profit
calculations but combine individual items into product categories or departments when
analyzing gross profit and adjustments to gross profit.
PURCHASED GROSS PROFIT PERCENTAGE
A retailer makes the decision to carry a specific item in inventory based on many factors
including the normal cost of that item from the supplier. The retail price is then
determined by management using the product cost and a desired gross profit percentage
per item sold, along with non-monetary considerations such as competitive pressures and
merchandising concerns. The basis of successful retailing is to price the retail product so
that the gross profit achieved at the store level is sufficient to cover all the retail
organization's operating costs with enough left over to achieve a reasonable return on
investment.
When the original retail price is set, the retailer must recognize that adjustments will
occur that will cause the final achieved gross profit to differ from the original gross profit
used in the original pricing decision.
Cost Adjustments
The decision to carry a product in inventory and the determination of its retail selling
price is based on the item's normal purchase cost from the vendor. Often a single cost for
each product is found in the purchasing and accounting systems and is used to set a retail
price at the stores. However, vendors often make adjustments to the normal purchase
price paid. These changes and their accounting have a direct impact on the retailer's gross
profit.
Manufacturers and other vendors often allow a price reduction to a retailer if the retail
firm orders a minimum volume of a specific product or a product line from the vendor. A
manufacturer offers this incentive both to increase sales and to maximize production
runs. A wholesaler offers this incentive to manage inventories. "Tiered pricing" systems
offer varied discounts based on annualized purchase levels and serve to ensure that this
discount is received by the retailer over an entire year as long as the purchase volume
remains steady.

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Deal allowances are special reductions in manufacturer list price of an item offered over a
specific limited period of time. Manufacturers offer deal pricing as incentives for the
retailer to carry a large quantity of a particular product. Often manufacturer deals are tied
in to the manufacturer's advertising campaign for the discounted product. A deal
allowance is not contingent upon any performance required of the retailer.
A promotional allowance is a special reduction in manufacturer list price of an item
which is limited to a specific period of time and is contingent upon the retailer
completing a performance requirement related to the manufacturer's product. The
promotion may be as simple as a price reduction during the manufacturer's promotional
period or as demanding as the preparation of a special display of the product in the retail
store. A promotional allowance which is tied in to the advertising program of the retailer
is called an advertising allowance. The type of advertising to be provided is agreed upon
by the retailer and the manufacturer offering the allowance, sometimes in a joint
advertising campaign. The allowance itself may be calculated as a flat fee, a percentage
of the advertising cost, or as a discount based upon the volume of sales generated by the
retailer during the advertising period. Not all retailers apply advertising allowances to
gross profit. Some account for advertising allowances as a reduction of advertising
expense.
Incoming freight costs incurred in the receipt of product should be included in the normal
cost of the product. Incoming freight savings from back hauls by a corporate
transportation department are sometimes subtracted from product cost. Other
organizations credit such savings to the transportation department cost center. Outgoing
freight incurred in shipping product from a central warehouse to the retailer's retail outlet
is normally charged to a transportation department cost center.
Purchase discounts are percentage reductions (normally 1% or 2%) in the amount paid to
the vendor if payment is made in advance of the normal due date. There is some
argument whether purchase discounts are offered as an incentive to pay early and should
be considered financing income to the retailer or whether purchase discounts are a
method use by the vendor to offer product at a more competitive reduced cost. The
method used to account for purchase discounts is an example of how the accounting
treatment of a normal recurring event can directly impact gross profit.
BILL OUT GROSS PROFIT PERCENTAGE
After the above adjustments have been made and the adjusted acquisition cost of the
product is known, the determination can be made of the bill out gross profit. The term
"bill out gross profit" is often used to describe the gross profit of inventory billed to the
store from a corporate warehouse. However, at store level the gross profit of inventory
received from the warehouse must be averaged with the gross profit of inventory
purchased directly by the store (called "drop shipments", "store door" or "direct store
deliveries"). The term "bill out gross profit" will be used to describe the weighted average
combined gross profit of the product received by the store regardless of source (another
term in common retail usage is "incoming gross profit").

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This bill out gross profit percentage is the responsibility of the PURCHASING function.
Further adjustments to gross profit are initiated by other functional areas. Bill out gross
profit percentage is normally calculated on a store departmental level. The bill out gross
profit percentage will vary from merchandise department to department within an
organization due to different departmental competitive and marketing influences.
Incoming gross profit percentage will also vary from store to store depending on store
product mix.
Retail Adjustments
Once inventory is received at the store, the control emphasis shifts from the product cost
to the product retail price. Rarely does an individual store have control over the cost paid
for product. However, store operations and store merchandising do have significant
influence over the retail price ultimately received for the product.
From the time an item is received at a store with an assigned retail price, events occur
which cause the retail price of that item to change. These events must be monitored and
accounted for if the retail organization is to accurately determine the actual gross profit
achieved by the store. Often permanent changes are made to the retail price of an item.
Price changes are usually made in conjunction with a change in cost from the vendor.
Permanent changes in retail price are also made in response to competitive pressures.
Increases in retail prices result in windfall increases in gross profit when there is a large
quantity of product on hand that was purchased at the original lower cost.
Advertising markdowns are temporary reductions in the retail price of an item for a
specific period of time in conjunction with an advertising program. The advertising
program can take any number of forms - electronic, print, in-store POS notices, etc. At
the end of the advertising period, the retail price of the item is raised back to its normal
level. However, during the run of the advertisement the gross margin received is less than
the bill out gross margin.
Discounts are percentage reductions in retail price which are offered only to a specific
category of customer. Common discount categories include employees, senior citizens,
preferred readers, and baby club members. Discounts reduce the expected gross profit
earned below the bill out gross profit percentage.
Reductions in retail price made to stimulate sales of slow-moving or out-of-style
merchandise are called closeouts. Closeouts commonly occur at the end of a season (e.g.,
post-Christmas sales, swimsuit sales in September, etc.). The goal of a closeout discount
is to sell unwanted inventory and replace it with different, faster moving items.
Retail prices are sometimes reduced through retailers' in-store coupons or through
doubling manufacturers' coupons. The issuance of retailer in-store coupons is a marketing
technique which stimulates sales of specific items. The practice of doubling
manufacturers' coupons is often driven by competitive factors and is an incentive to
entice consumers into the store without guiding them to any specific products.

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Certain retail establishments, such as pharmacies, have differing retail prices for the same
product because of different reimbursement formulae used by third party carriers who
ultimately reimburses the retailer for the consumer's purchase. Such adjustments change
the gross profit percentage from the calculated bill out gross profit.
EXPECTED GROSS PROFIT PERCENTAGE
When all retail adjustments made at store level have been accounted for the actual retail
price and acquisition cost are known and the expected gross profit percentage can be
determined. After all activities initiated by corporate functions have been accounted for
the expected gross profit percentage is that for which the store is held responsible.
The retail adjustments which caused the difference between the bill out gross profit and
the expected gross profit percentage are primarily the responsibility of the
MERCHANDISING (including Advertising) function. Even when retail price changes
arising from vendor cost changes are initiated by the purchasing function, the decision as
to the date of their implementation is the responsibility of the merchandising function.
The retail adjustments initiated by the merchandising function are normally made to
increase sales or to open shelf space for other products.
Other Gross Profit Adjustments
The actual achieved gross profit percentage of an individual store rarely matches the
expected gross profit percentage even though this has been carefully planned and plotted
by corporate functions. Other events occur at the store and elsewhere in the organization
which have an impact on the final gross profit percentage achieved.
Appropriation of a store inventory item for a purpose normally considered an operating
expense is called store use. An extreme example of this is a car dealership providing the
sales manager with an automobile for her personal use. At other times an inventory item
must be discarded for no value or is sold for a reduced amount, due to damage to the item
or its packaging. Such usage cause unplanned reductions in gross profit.
Stores must sometimes discard inventory for no value or sell the items for a reduced
amount when the sale date is past the "sell by" date of a perishable product. The
discarding of an inventory item, for little or no value, due to the item being spoiled is
known as spoilage. Spoilage is different from outdated product only in that some
perishable products spoil before their "sell by" date due to improper handling or storage.
Obsolescence is the discarding of an inventory with no value received, due to the item
becoming unsaleable because the product has fallen into disuse. Items can become
obsolete because of technological improvements, because of changes in style or because
of changes in consumer tastes.
The intentional removal of inventory from the store without full payment of the retail
price is known as theft. There are three categories of theft from retail stores: 1) External -

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Shoplifting and other theft of product by customers, 2) Internal - Outright theft by
employees, consumption or other use without payment, and other unauthorized
discounting or removal of product without full payment, 3) Vendor - Theft by in-store
vendors through removal of inventory or by failure to deliver all product invoiced.
Retail pricing errors are the failure to collect the expected retail price of an item due to an
error in the pricing system. Errors can be caused by a cashier missing of the item retail
price, by an improper retail price sticker being placed on the product or by an input error
in the retail price programmed into a point-of-sale (POS) scanning system.
The above other gross profit adjustments are all instances where the amount of money
received when the inventory leaves the store differs from the expected retail price. Gross
profit adjustments also arise from errors in the accounting for the purchase or sale of an
inventory item.
Many of these gross profit adjustments cannot be identified at the time they occur. Their
total and the amount of their impact on gross profit is only known when a physical
inventory is taken and compared to the expected or book inventory. However, even when
a physical inventory is taken this final gross profit calculation is not clear cut because the
store physical inventory is normally taken at retail. The inventoried retail must be
adjusted to cost using a cost to retail percentage. The calculated physical inventory cost is
compared to the general ledger which has recorded cost of goods sold at the expected
gross profit percentage. The difference is usually called "shrinkage" when there is a
recorded loss and "pickup" when there is a recorded gain.
ACHIEVED GROSS PROFIT PERCENTAGE
After the inventory shrink or pickup has been recorded an achieved gross profit
percentage for the period between inventories can be determined. The achieved gross
profit is that which the stores actually received from the sale of the product regardless of
how the inventory was removed from the store (i.e., sold, discounted, stolen, etc.).
The difference between the expected gross profit and the achieved gross profit is
primarily the responsibility of the STORE OPERATIONS function. Except for
bookkeeping and other accounting errors, these adjustments to gross profit are caused by
action, inaction or lack of proper controls which are the responsibility of personnel in the
store operations function.
SUMMARY
The determination of a store's final achieved gross profit is the responsibility of not only
corporate management which sets overall profit guidelines but also of the
PURCHASING, MERCHANDISING and STORE OPERATIONS functions, each of
which has a specific impact on the final achieved gross profit. Store physical inventories
must be taken to accurately determine the achieved gross profit. However, due to the
costs of physical inventories and the difficulties in converting the physical retail

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inventory to accurate historic cost, estimations are almost always used in the gross profit
determination and the financial statement recording of a retail organization's gross profit.
Different methods are used by retail organizations to develop estimations. These
differences make it difficult to compare gross profit percentages of retail organizations.
Gross profit percentage comparison is further complicated because different retail
organizations include different cost centers and cost components in their accounting for
gross profit. For these reasons, analysts must take care when attempting to compare gross
profit percentages based on financial statement presentation alone.

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