TESCO - Accounting Practises and their impact on business

TESCO PLC Accounting practices report

Introduction

Tesco was founded in 1919 by a man named Jack Cohen from a market stall in East London. Tesco has since grown into 12 countries and employs over 530,000 people (Tesco Plc, n.d.) it is the largest UK retailer and ranks third world wide by annual sales behind Wal-Mart and Carrefour (Biesada, n.d.).

Although Tesco initially was a food retailer it has expanded its business to selling much more than food including finance, mobiles, clothing, furniture and electronics. Tesco as a retailer will be the main focus of this report.

The report will discuss various accounting techniques that Tesco undertakes to ensure the success of its business; these techniques will be analysed.

Budgeting Processes

Virtually all food and beverage organisations in the UK use budgets for planning and control (Abdel-Kader&Luther 2006, p.343). Budgets should be linked to the organisation’s mission and objectives (Atrill & McLaney, 2012p. 190) hence when contemplating Tesco’s mission statement which is to "create value for customers to earn their lifetime loyalty” an evaluation of the budgets alignment can take place.

Tesco’s drive to bring value to its customers, has been linked with setting budgets that are focused on cutting costs wherever possible and rewarding those who are loyal to the organisation by implementing a loyalty program named The Club Card. 

Furthermore, Tesco has been known to cut profit margins in order to reflect savings for its customers, (Vizard, 2013 p.3), in 2011 Tesco found that it was losing market share and responded by more price discounting and £5 rebates for every £40 spent which represented more than their actual margins (Grunys, 2012), this leads to illustrate that Tesco tends to re-forecast regularly, they are able to adapt to the fast moving environment by changing their budget and using information relevant at a certain time, however continuous change in the budget could be detrimental to their share price as cutting profit margins sporadically eludes to the fact that management encompasses poor forecasting skills.  

Tesco follows discretionary budgeting, therefore sets its budgets on previous years with some adjustments for any changes that may affect its budget. Tesco has been known to aspire for 3%-4% sales growth each year, however this was adjusted in 2008 to only 2% sales growth for the upcoming year due to the economic downturn at the time (The grocer, 2008).

Budgeting for a decrease in sales growth is preferable to sudden price cuts or rebates as those tend to hurt the operating profit margins pressuring the share price of the organisation and therefore leaving it at a competitive disadvantage.

• Budgeting with suppliers

Tesco engages in collaborative forecasting with some of its suppliers. This has proved essential to ensure no loss in sales or overstocking and that the supply chains are in coherence. One of Tesco’s suppliers the brewer Coors indicated that joint forecasts owned by both parties as well as one meeting to re-forecast demand if embarking on a promotion has led to 97% accuracy rate (Watson, 2005 p.8). This process leads to decreased levels of waste as the product is perishable hence cutting on costs and yet ensuring no loss in sales due to under stocking which hence maximises potential revenue. 

• Operational cost cutting

Tesco’s operational cost cutting in recent years due to the decline in the global economy resulted in what some describe as consumer unfriendly attitudes, the stores lacked effective maintenance, whilst customer service declined compounded by the horse meat scandal and fines for misleading pricing led to the organisation start ceding 30% of its market share to rivals (Katsenelson, 2013). HSBC in a note to their investors (December 2012) advised clients to decrease their Tesco shares and revalue the share down from 400p to 340p (Vizard, 2013).

The operational cost cutting could have placed Tesco in a vicious circle where losing consumers puts further pressure on profit margins resulting in further operational cost cutting and so forth.  

A reset in margins in such instances can aid the organisation to align itself back with its mission statement and it balanced scorecard mentioned later in the report.

In an interview with the CFO Laurie Mcllwee on Tesco’s corporate website (Tesco Plc, 2013) he states that the organisation aims to be more cash generative, hence investment spending is more disciplined, however the organisation recognises that failing in its core success area naming the UK operations is detrimental and therefore they have invested £1 billion to turn around the customer experience.

Costing processes & Working Capital

• Inventory 

Tesco is extremely efficient in cutting costs and apply it to managing their inventory effectively. Therefore Tesco is conscience of managing their working capital so as that their trade payables are higher than their receivables; in essence Tesco receives cash for a trolley load of groceries before paying for it (Atrill & McLaney, 2012 p. 437)

• Supply Chain costs

A key component of Tesco’s cost base is the sourcing of their inventory and delivering it to their outlets, the stages that encompass this process are as follows:

Procurement

Tesco’s ability to cut costs from its distributors is heavily attributed to its size and ability to exercise superior bargaining power, furthermore Tesco is able to leverage economies of scale in markets where it operates on a large scale such as the UK.

Storage

It is evident that Tesco holds low levels of inventory as their stock turnover ratio according to their annual reports is approximately 17 which is above industry average normally hovering around the 12 yet its below that of Sainsbury’s which is 21.8 (Bloomberg Business week, 2013). This suggests that although Tesco is performing above industry average and is therefore able to take advantage of its working capital and invest the cash in other areas of the business, there is still room for improvement in this area. If Sainsbury’s can have a significantly higher figure for stock turnover then Tesco may engage in benchmarking in order to realise better inventory turnover processes.

Transportation & logistics

This component of costs encompasses the inbound stock delivery to stores from warehouses as well as the outbound stock delivery directly to end users through Tesco’s home delivery scheme.

The key cost drivers in the transportation element would include fuel, depreciation of the delivery vans and labour. There is evidence that Tesco implements ABC costing for the outbound delivery of goods as it engages in levying the delivery charges on to its customers hence treating the activity as a cost driver. Geographical locations are taken into account and those who order delivery have to make a minimum purchase to enable Tesco to break-even on the process and make a profit. In a country where labour and petrol charges are high, this type of costing is essential, although competitors may try to compete on delivery charges, Tesco is comfortable in the knowledge that they own the largest operation and delivery depots in the UK hence it would not make sense for competitors to compete on the basis of delivery charges when Tesco can undercut them.

Direct & Indirect fixed cost

The direct fixed costs of running the retail outlet include leasing charges of the premises (if leased) otherwise an increment of the purchase price, utilities and labour.

In the sale and leaseback scheme mentioned earlier, Tesco capped the rental for 20 years which alleviates the risk of inflation and eases the budgeting for this cost. Furthermore, Tesco constantly seeks technological advances in order to cut its labour costs, such example would be the self checkout counters whereby no check out staff are needed but customers engage in registering the products and paying for them by themselves. Future technology is likely to impact these costs positively.

The indirect costs that Tesco is subjected to would include, head office salaries, machinery purchases and marketing expenses. These costs may be allocated on the size of each outlet or on the basis of sales revenue in order to reflect a fair burden on each store.

Management Accounting

• The shop

It is estimated that £1 in every £8 spent on retail in the UK is spent in Tesco (Phillips, 2007 p.143), therefore the organisation like many has a wealth of information that needs to be communicated internally and externally efficiently in order to asses effectively its marketing strategy as well as its costs and revenues.

Tesco uses a system named ‘The Shop’ it’s an extranet system that enables the organisation as well as some of its suppliers (although with limited access) understand the purchasing trends of its club card customers (a number representing 13 million homes). This system allows full tracking of the stores revenues by product, customer groups and geographical location (Phillips, 2007 p.144), the system also allows tracking of increased purchases when promotions take place which would allow management accountants to assess advertising budget’s returns. This system also allows for better capital allocation to stores when faced with capital rationing decision making.

Tesco’s closer integration and transparency with its suppliers through information gathering and dissipation encourages store management and line managers in owning their individual budgets as they are closely aligning them with the suppliers’ capabilities in delivering the product as well as the suppliers’ anticipated demand.

• Balanced Scorecard

Tesco’s balanced scorecard is very visible to employees and simple to understand ‘The wheel’ (Tesco Plc. n.d.) as it is referred to ensures that the core success factors for the organisation that ultimately result in maximising the shareholders’ wealth are communicated effectively.

In an aggressive, competitive environment the engagement of the employees in attaining the ultimate goals mentioned on the wheel are imperative hence its effective simplistic form. The wheel incorporates a fifth dimension naming the community in order to fulfil the recent demands by the general public by which large organisations are expected to engage in corporate social responsibility and be ‘kind’ to their surrounding community.

• KPIs

Tesco employs a number of KPIs to access its financial and operational performance.

Tesco like many organisations expresses its financial objectives in terms of target ROCE and  aims at increasing it year on year. The organisation also monitors closely the growth in underlying profit before tax as a main KPI in order to assess the health of its profitability growth plans (Tesco plc. 2013)

Tesco has relatively flat gearing ratios in the past 3 years, it maintained a ratio of around 38% which is a decline from 2009/2010 figures where it reflected 54% gearing ratio (Tesco plc, 2013). The organisation clearly views deleveraging to a 38% and maintaining this figure as a key performance indicator. Tesco’s sale and leaseback scheme as well as bond issuing mentioned later is clearly more strategically aligned with its ambition to deleverage. 

Capital decision making

• Acquisition T&S stores, UK

Planning permissions and governmental regulations can hinder expansion in the UK. Therefore Tesco’s decision to allocate capital in acquiring an already existing smaller grocer group has proved successful in succumbing to the difficulties of entering new locations.

Tesco’s knowledge of the British consumer’s spending habits and requirements is pivotal in its capital decision making, furthermore its satisfactory provision of lower prices to consumers than those offered by T&S solidified its case for the acquisition by the office of fair trading (office of fair trading, n.d.)

• Tesco’s International expansion – Acquisition of Fresh & Easy US stores

Although Tesco has enjoyed enormous success in the UK market, its international expansions have not always presented healthy decision making. 

Tesco invested an abundance of resources to enter the US market only to pull out with a $1.5 billion in losses (Sctweek, 2013 p.3) in 7 years. Although Tesco conducted market research for ready to eat meals which were the focus of their shops in the US, they failed to appreciate the challenges involved in changing the habits of the consumer that were a key success factor. Furthermore the timing of Tesco’s entry into the US in 2007 was disaster ridden as the US market embarked on a deep recession and consumers became more cost conscious hence preferring to cook raw foods as a cheaper option (Heffernan, 2013 p.257). It can be therefore concluded that Tesco failed to forecast the effects of a possible economic downturn on its US capital investment decision making processes.

• China

Tesco’s near failure in China has much to do with allocating capital at either end of the country on both coasts leaving a black hole in the middle hence difficulty in leveraging economies of scale due to transportation costs and lack of brand recognition. In essence their Chinese operations were far from consolidated and could have been in two different countries. Tesco yet again allocated capital for a merger with the largest Chinese grocery retailer who enjoys 200 stores across the country, this decision gives Tesco a 20% ownership of a much larger entity which is more likely to succeed and more importantly allows it to self finance moving forward (Katsenelson, 2013) implicating its cash flows positively in an economy that is cash strapped, hence alleviating any liquidity issues for the organisation.  

• Tesco’s Technology Investment

Tesco has recently announced £1 billion planned investment mainly in technology (Vizard, 2013). The organisation recognises the fast paced technological age and has invested in an app that enables customers to check the latest offers, furthermore the organisation’s first mover advantage (in home delivery) that has served the organisation a multitude of success is being upgraded through technology by offering same day delivery service. Coupled with the technological upgrades Tesco is investing in more distribution centres to serve its online shopping promises. Tesco has also invested in offering their own brand tablet which the organisation claims to be the highest selling tablet in their stores, outselling those of Apple’s IPad and Amazon kindles according to their Chief Philip Clarke (Vizard, 2013), the tablet is likely to impact the Tesco shopping experience in future. 

Capital Acquisition

Organisations primarily use debt or equity based products for financing capital and their capital structure debt equity ratio indicates the composition of the capital structure. High leveraging poses financial risk due to the high levels of interest on debt that need to be paid. Furthermore should an organisation file for bankruptcy a high number of debtors need to be paid prior to shareholders hence posing risk to shareholders who may not receive the value of their shares.

Currently Tesco has a gearing ratio of 38% where as one of its competitors, Sainsbury’s has a gearing ratio is 46%, furthermore Tesco has a market capitalisation of almost 4 times that of Sainsbury’s hence it is in healthy position to raise capital via debt issuance and bonds.

• Bonds

Tesco issued bonds in August 2013 secured by some of its UK stores in order to fulfil its expansion plans. The bonds were sold out of a special purpose vehicle (SPV) that will use the fund in order to purchase seven new stores, which then will be leased by Tesco subsidiaries (Euroweek, 2013 p.57).  Tesco’s ability to raise £493million is credit to its attractiveness as an investment to the bond markets and also is a reflection of its stability from a credit lending perspective.

The organisations leaseback agreement alleviates pressure off its cash flows whilst allowing it to expand in new locations. 

• Financing

Tesco engages in different methods when expanding globally, in some countries it creates a merger with a local player in home territory it engages in building its own stores and in other territories it engages in borrowing for its development, although on occasions with a local partner.

In Czech republic in 2008 Tesco and Multi Development (subsidiary of Multi Corporation) acquired financing by Hypo Real Estate Bank International AG in order to develop a new city centre anchored by Tesco (property magazine, 2008).

Tesco’s solid brand and experience makes it an attractive client for financing.

• Selling the real estate and leasing back 

In 2007, Tesco realised that in a cash strapped economy the opportunity cost of maintaining cash tied up in its real-estate holdings is far too high. Tesco needed the funds to upgrade other aspects of its operations, especially to maintain its technological progression; therefore Tesco sold 21 stores representing 3% of its total real estate holding to British Land, on a leaseback agreement, with a cap on rental increases (Sctweek, 2007), this is aligned with the organisation’s objective of becoming more cash generative

• Equity 

Tesco is a publicly listed company and trades in the London stock exchange and therefore has the capability of issuing shares in order to acquire capital, however since Tesco has a target earnings per share closely monitored and forms the basis of its KPIs it must ensure that no extra shares are issued that would jeopardise its EPS price. Furthermore the organisation is constantly under pressure to raise this figure by creating value for its shareholders.

Conclusion

Tesco’s aggressive presence in the UK market is the core of its success, it has let its operations be jeopardised by operational cost cutting and lack of capital investment during the economic downturn, whilst focusing on International expansions.

Some of Tesco’s international expansions have been extremely successful whilst others have failed to acquire the target return on investment, it can also be concluded that Tesco is more likely to succeed internationally if partnering with an experienced local entity. 

Tesco’s turn around in the past year when refocusing on its UK operations makes it an attractive investment with healthy cash flows. Understanding that the UK operations must not be compromised due to international expansions and that capital investment especially in technology needs to be made constantly will serve Tesco high returns in the long term.

Research Method

All of the research undertaken for this report has been secondary in nature. Tesco’s corporate website has contributed a vast amount of in depth knowledge which formed the basis of the report.

Further research and reading was undertaken on the industry as a whole and analysis was based on the author’s academic knowledge and research into the topics discussed.

References: 

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