Cooperative Finance: Discounts Provoke Discussion!

Editor's note:

Recently, several readers wrote letters to the editor discussing financial matters.  These letters appear below, followed by a response from the authors of the finance column, Scott Beers and Margaret Lund.

 

"Profit" or "net savings":  who is out of step?

Dear Dave:

Enclosed is my renewal to Cooperative Grocer. At this stage in my life (age 78), neither the body nor the spirit is as nimble as it once was, but I still have strong attachments to the co-op movement. Berkeley Co-op is no more, so I must go to Palo Alto, Davis or Sacramento to shop co-op as we did so religiously for more than half a century.

Because financial statements played a big part in my career, I read them and your articles about them with interest. One bothersome terminoogy has been bugging me for several years and I was on the verge of a letter to the editor several times, but procrastination prevailed.

Is there a rationale for using the term "profit" rather than "net savings" or "net income?" In our day, because we thrived mostly on member business, we thought of the excess of income over expenses (obtained by offering our merchandise at market prices) as net income or savings to be returned to our members in the form of patronage refunds or to be placed in the Co-op's retained savings and used for financing the Co-op. I guess that "profit" connoted exploiting consumers and was "dirty capitalist" terminology and perhaps "politically incorrect."

Am I out of step with New Age Cooperation?

George Yasukochi, Berkeley, CA

Perhaps is is THEY who are out of step. Many co-ops under 30 cannot be trusted to know and learn from a history of consumer cooperatives based on member saless and competitive mass market prices. For short pieces on this history, see "Development Directions" in CG #18-19 (1989), and excerpts from What Happened to the Berkeley Co-op? in CG #32 (1992). For longer versions, see the publications catalogue of NCBA.  -- DG

 

Reporting discounts: reformat and refocus

Dear Editor:

I appreciated reading what Scott Beers and Margaret Lund had to say about member discounts in the March-April issue. Discounts have been a controversial subject for long time, and the debate about them can often become murky. So I was glad that Scott and Margaret presented such a quantifiable analysis.

Having consulted with a number of co-ops around the country, I found the article's statement that "Too often, discussion of (costs and benefits of discounts) is avoided until financial crisis forces examination. By then it is too late," to be all too true. There is a tendency on the part of co-ops to treat whatever discount structure they have as a given, without questioning its ramifications. In many cases, the structure was put in place years ago (and most likely without the kind of analysis that Scott and Margaret provide), and the current management labors with it as a burden. In effect, the discount structure retains a kind of a priori status that determines how many other financial variables (e.g., gross margin, wages, capital improvements, bottom line) will be dealt with.

I believe that one way to avoid putting off the discussion of discounts until it's too late is to simply change the way they are reported on the co-op financial statements. Typically, co-ops show their discounts as a reduction of sales, or at best as a reduction of gross margin. A simplified P/L might look like the following:

 

SCENARIO 1

                                                                    % of Gr. Sales

Gross Sales                        $1,500,000                100.0%

Member Labor Discount       $22,500                  1.50%

Member Discount                  $22,500                   1.50%

Net Sales                            $1,455,000                  97.0%

Cost of Goods                    $1,027,500                  68.5%

Gross Margin                       $427,500                    28.5%

Occupancy                                $60,000                4.0%

Personnel                                $285,000                19.0%

Operations                                $90,000                6.0%

Total Expenses                      $435,000                29.0%

P/L                                           ($7,500)                  -0.5%

 

In this case, the co-op is reporting a loss equal to .5% of its sales. Looking at a statement like this, it's not at all uncommon that board and management will start looking everywhere but at Member Discounts in order to plug the leak. In actuality, this statement hides the fact that the co-op is operating profitably, and that members received a premature distribution of the co-op's profits. That is, before the members received their Member Discounts (which amounted to 1.5% of sales) the co-op had a 1% profit. Unfortunately, this profit was given away every day at the register before it had a chance to accumulate.

In order to avoid this blind spoit, we always recommend to our clients that they use the following format for their P/Ls:

 

SCENARIO 2

                                                                    % of Gr. Sales

Gross Sales                        $1,500,000                100.0%

Cost of Goods                    $1,027,500                  68.5%

Gross Margin                       $472,500                    31.5%

Occupancy                                $60,000                4.0%

Personnel                                $307,500                20.5%

Operations                                $90,000                6.0%

Total Expenses                      $457,500                30.5%

P/L                                               $15,000              1.0%

Member Distribution            $22,500                    1.5%

Net P/L                                      ($7,500)            -0.5%

 

In this scenario there are two major changes.  First, Member Labor Discounts are folded into Personnel to reflect the fact that they are a labor cost. And second, Member Discounts are renamed Member Distribution to reflect that they are a distribution of profit. They are shown as coming after P/L. This makes what is actually happening much more evident. The co-op is being forced into a non-profitable situation by its policy of giving discounts to members regardless of the financial consequences to the co-op. If the board and management of this co-op regularly look at P/L's that were formatted in this manner, it is unlikely that they would continue to allow the Member Discount/Distribution to be exempt from scrutiny.

While re-formatting a co-op's financial statements is not in itself the solution to dealing with discount problems, it is a good first step on re-focusing board and management attention, and we believe it's a simple change that most co-ops can benefit from.

Paul Cultrera

for Up Your Margin, Albuquerque, NM

 

Careful management, not misguided arguments

Editor:

I'm writing about the article in the March/April issue on member discounts. Let me preface by stating that I have the highest regard for the many contributions made by Scott Beers and Margaret Lund to cooperatives. Most recently, I have appreciated their ongoing column in CG about cooperative finances. Their non-nonsense articles are always on important and timely topics and are unquestionably helpful to many readers. I am reluctant to be critical of their fine work. Nonetheless, I believe their most recent article about member discounts creates some unnecessary and false impressions.

In the example they use, Our Town Co-op provides a 10% discount to members once per month. They illustrate the inequities of this system -- it provides different members with different levels of benefits -- as well as the complexities of such a system when they analyze potential changes to the discount level. This is a very unfortunate example and makes the article irrelevant to most natural foods co-op readers, even those doing member discounts. Most co-ops that provide member discounts do so to all members with each purchase. Such a system, while not the intended interpretation of the (former fourth) co-op principle about equitably distributing surplus to all members, is nevertheless perfectly consistent with this principle and far superior to a once a month discount. Member discounts on all purchases do indeed result in distributions to all co-op members in proportion to their purchases.

The argument that a member discount violates the (former third) co-op principle that calls for a limited return to the members on their investment is unfortunately misguided. Indeed, any distribution proportionate to purchases will always be higher for members with larger purchases and can always be a large percentage when compared to a flat investment requirement. But this is a false comparison. The principle refers to the return paid to members on their investment, independent of purchases, just by virtue of having joined the co-op and invested in co-op shares. Patronage refunds and point of purchase discounts are no different when compared against investment. Limited return on investment is an important and poorly understood part of the co-op principles; this analysis is not a fair and accurate interpretation of it. (Note, both of the co-op principles referred to in the article, while no longer the third and fourth principles, are maintained in the 1995 revisions of the principles. They are two of several distinct elements of the new third principle called "member economic participation.")

While I very much appreciate the authors' desire to provide tangible alternatives, I am also concerned about their recommendation that Our Town Co-op change its member discount from 10% to 5%. Why perpetuate a system that is so inequitable and that flies in the face of one of the core beliefs of co-ops (that benefits should be distributed proportionate to use)? And, since it is more common for co-ops to provide discounts to members on all purchases, readers should be cautioned that a 5% discount on all purchases is not advisable. While discounts have their advantages, a 2% discount to all members (on all purchases) is a much more manageable and reasonable amount. (A 2% discount results in all members receiving about one week's worth of purchases from the co-op in discount annually.) While I know it is not the intention of the authors to recommend a 5% discount to co-ops discounting all member purchases, co-ops should be aware of this distinction.

Finally, while I cannot rationally make a case against patronage refunds, those on the front lines of co-op retailing know that discounts are popular. In a rational world, our members would understand that patronage rebates are the right way to go. But members have come to appreciate their point of purchase discounts. When carefully analyzed and managed, member discounts are a viable option for viable co-ops. Perhaps one of the biggest problems with patronage refunds is the tax law that requires that co-ops pay out at least 20% of rebates in cash (as illustrated in the article and accompanying sidebar) for reasons that do not apply to consumer co-ops. When faced with such a situation, most co-ops must choose between writing checks for very small amounts (indeed, in the example, Our Town Co-op would be writing a total of $400 in checks to at least 500 members) or paying the entire patronage rebate to members in cash. While the former results in a lot of paperwork for very little (perceived) member benefit, the latter is also troublesome. Most co-ops can ill afford such a cash drain, even one that may be popular with members. Member discounts should not be rejected out of hand; they can provide co-ops with a simple and equitable tool with which to reward members when managed and analyzed carefully and prudently.

Karen Zimbelman, Arcata, CA

See also Karen's article, "Member Discounts: Boon or Bane?" in CG #49, November-December 1993.
 

Beers and Lund respond:

Making sure you're there for your members tomorrow

We're very pleased with the stir of responses that our recent Cooperative Grocer column on discounts created. One of our main objectives in writing the column was to stimulate thoughtful discussion of the discount issue.

Respected co-op advocate and trainer Karen Zimbelman found our example of "our Town" Co-op, with its once-a-month discount structure, to be misleading. In our example, two members timing their monthly discounted purchases differently reaped very different financial gains. As Karen pointed out, under a program where the discount is allowed on every purchasee, the equity principle is not violated because each member gets the same savings on all of their purchases.

We used the once-a-month structure in our example for several reasons. First of all, while the "every day" discount system is certainly in use, the "limited day" discount system (once a week, month, or quarter) is also commonly in use and becoming more so. As Karen correctly points out, a 10% every day system or even a 5% every day system makes for a very dangerous drain on cash flow and is "not advisable."

In practice, however, we have found co-ops much more willing to retain the same percentage rate of discount and limit the frequency (10% but only once a month instead of every day) rather than reduce the overall discount rate. This appears to be true even when the lower every day discount would result in a larger average financial gain for the membership.

The second major reason for using a limited time discount example is that discounts fulfill very different functions for different people, often simultaneously. Some will argue that discounts are "due" to the members as owners, others will talk in terms of a "reward" for supporting the co-op, and others in terms of their marketing advantage. One of the things that Our Town Co-op found from their analysis is that members not only bought more than non-members in general, members bought more on their discount days than on their non-discount days. So even among the already committed, the discount played an important marketing function. That is one reason Our Town opted to retain its once-a-month system even though it continues a somewhat inequitable distribution of gain to members - because the marketing advantage of the discount resulted in a bigger pie of sales for everyone.

Another co-op could very well make a different decision. Our point was to encourage stores to think through their existing discount structure and consider options, calculating the cost of each, the advantages of each, and the reason for the structure -- are you trying to reward existing members? bring in new members? increase sales? To know if you are getting what you want from your discount structure, you really need to collect the kind of data we discussed in the last column, then analyze it together with several alternatives.

Karen also points out that since member discounts are based on purchases rather than equity amount, they are not technically a "return on investment." Therefore they do not violate the old fourth (now third) cooperative principle of limited return on investment. Technically this is true, but we do not find many potential members making this distinction. When asked to shell out $100 to join the co-op, member are asking themselves, "What do I get in return?" and are not noting the distinction between return based on investment versus return based on purchases. It would be nice if more members understood the difference, but in practice members compare the value of discounts and other benefits with the cost of membership and make a largely economic decision -- are the benefits (return) worth the cost (investment)?

In a perfect world our co-op members would also intuitively understand that patronage rebates are the "right way to go," but we agree with Karen that explaining why it is better to get your money at the end of the year rather than at the till is a hard sell. But then, commitment to education is still one of the co-op principles, right? We do not agree, however, with Karen's point that paying the required 20% of patronage rebates in cash is a "troublesome...cash drain." Rather, we must point out that member discounts are a daily cash drain of 100% that is more than troublesome. It approaches the self-destructive for some stores.

As a lender and as an accountant, we work with many different stores every year. More than a few are undercapitalized, are underinventoried, have inadequate physical plants, feature overworked and underpaid staff and are losing thousands of dolllars (of member money) every year. At the same time these same co-ops give away substantial sums they don't have in discounts to members. We are not against member discounts. But as we have said in this space before, the best thing you can do for your members is to make sure that you're there for them tomorrow. Sharing profit you don't have is not a way to make sure this happens.

Paul Cultrera wrote with the interesting idea of showing member discounts on an income statement after the profit/loss line. That way, if an operationally profitable store posts a loss due to discounts, the fact will be readily apparent. The in-your-face style of this approach is refreshing but it does pose some issues of its own. First, as discussed above, an important function of member discounts is a marketing one, and as a marketing expense discounts would more appropriately be above the profit/loss line rather than below. Second, the entries below the profit/loss line are generally reserved for items such as taxes, employee profit-sharing or patronage rebates, whose size is actually driven by the profit/loss figure. Member discounts, on the other hand, are a function of sales rather than profit and therefore logically belong above.

However, as Paul correctly points out, their traditional position as a component of the gross margin figure leads many co-ops to treat member discounts as an external factor beyond their influence -- like cost of goods -- rather than as a structurally controllable figure. Paul's system also might make a co-op's financial statements more easily comparable to non-co-op food stores that operate without member discounts. A good argument can be made either way.

Finally, long time co-op activist and shopper George Yasukochi wonders if we have to use the word "profit" at all. What about "net savings" or "net income?" he asks. The term "net savings" has often been used in the past, particularly among marketing and producer co-ops. For a co-op doing business only with members, this is an accurate description because any money the co-op had left over is rightly the savings due to members for using the co-op. With our consumer co-ops, however, a large percentage of sales is actually made to non-members. This makes the term "net savings" (to members) problematic because some of the money comes from non-members' purchases. However, the term "net income" is a perfectly accurate substitute for the more traditional business term "profit. If the word "profit" does not accurately capture what your co-op is after, "net income" might be what you want to aim for instead.

We appreciate the opportunity for dialogue on this important issue and look forward to more!

Scott Beers and Margaret Lund, Minneapolis, MN

See other articles from this issue: #064 May - June - 1996