Discounted diapers and stockpiles of soup
Craig Chapman explores the implications of managing earnings through marketing
What do Enron, WorldCom and Tyco have in common?
They are all guilty of accounting abuses on a grand scale and massive financial deception from the highest levels of management. As these firms' investors lost billions, the earnings management game, with its fuzzy math and accounting magic, came under fire. Stronger, sweeping legislation was also enacted to reform American business practices.
But another earnings management strategy has gone largely ignored: the opportunistic structuring of real transactions. Research by Kellogg Senior Lecturer Craig Chapman examines how retail-level marketing actions influence the timing of consumer purchases in relation to firms' fiscal calendars. With Thomas Steenburgh of the Harvard Business School, Chapman writes that soupmakers use tactics such as price discounts to improve earnings at the end of a reporting period, despite the fact that "the resulting gains come at the expense of long-term profits and may not be in the strategic interest of the firm."
Chapman came across the phenomenon while buying supplies for his infant son. "I began to notice a regular pattern of price discounting on diapers and baby formula," he recalls. "I found myself stockpiling product and making purchases only when items were offered at special prices. It appeared that price reductions close to the end of the fiscal period were boosting sales in the current period that might adversely affect sales levels in the future."
Chapman and Steenburgh found that soup manufacturers roughly double the frequency of all marketing promotions (price discounts, feature advertisements and aisle displays) at fiscal year-end and following periods of poor financial performance. Firms generally offer deeper and more frequent discounts to push earnings upward during these periods. This is at odds with earlier research showing that firms reduce marketing expenditures in order to boost reported earnings.
"We estimate that soup manufacturers use price reduction to legally boost sales revenue and quarterly earnings by almost 20 percent," the researchers report. Such practices effectively enable firms to artificially inflate their reported revenues. But since the extra products have been sent to end consumers, the firms escape scrutiny from the U.S. Securities and Exchange Commission.
"Nevertheless," Chapman and Steenburgh write, "there is a price to pay." The pair estimate that quarterly earnings per share fall by 23.5 percent in the subsequent reporting period, resulting in a net loss of 3.5 percent of the quarterly earnings per share to the manufacturer.
"The more I've presented the paper, the more it's clear that everybody — from software companies to cars to contractors — is doing this to make their financial targets," Chapman said. "It's a basic tool of business. They're promoting a product and selling it at a lower price today that they might have sold at a higher price tomorrow."
Also telling is that these decisions are made at high levels in the executive suite. Firms switch promotions from smaller to larger revenue brands to push earnings upward in certain periods. This is consistent with high-level action, since lower-level brand managers wouldn't voluntarily give up promotional support. Brand managers "complain about how their head offices keep interfering with their planning process with short-term plans," Chapman said.
He added that consumers can save significant amounts of money by timing their purchases.
"Investors, meanwhile, should be aware that when they see firms reporting increases in their top line revenues and decreased margins, they should watch carefully for subsequent deterioration in performance," he said. — Peter Gwynne