Did Tesco Get Hooked on Drugs?

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\"Under-the-tableThat’s a strange question, and the answer is even stranger: “yes,” at least figuratively speaking.

It all has to do with vendor allowances and the revenue bump they give retailers. These allowances are intended to incentivize retailers to better promote or better display a manufacturer’s product, and there’s generally a lot of money left over for retailers after that’s done.

For a long time, supermarket insiders have cloaked vendor allowances in secrecy, privately referring to them as the “drug” supermarkets just can’t kick. The metaphorical drugs caused supermarkets to become almost entirely dependent on them for profitability, despite the fact that they fostered grotesque retailer inefficiencies in the long run.

Now a day of reckoning may be at hand, because Tesco has blurted out the dark truth. Tesco, a huge UK supermarket chain, is being battered by newly disclosed accounting irregularities that were used to puff up financial reports by hundreds of millions of dollars.

Tesco stated: “[Irregularities] are principally due to the accelerated recognition of commercial income and delayed accrual of costs. Work is ongoing to establish whether this was due to error or an aggressive accounting policy.” Commercial income, by another name, means vendor allowances.

Overstating the Case

Tesco is the victim of its own overstated accounting, a far too common practice in the food industry.

How grave is Tesco’s problem? The chain has acknowledged that its profits over the past two years were overstated by $412 million, about half of which occurred in the first half of 2014 (with the balance over the preceding 18 months). Clearly, the problem accelerated at a fast clip.

In the wake of the scandal, roughly 10 top-level executives were shown the door, including Board Chairman; Richard Broadbent.

To get an insight on what these vendor allowances are all about and how they became fertile ground for cooking the books, let’s take a look in the rearview mirror.

Making Allowances

Vendor allowances are by no means unique to supermarkets. They flourish in various trade channels, from department stores to consumer electronics stores. But allowances are uniquely important to supermarkets because they operate on such thin profit margins. The revenue boosts they represent are essential to profitability. It’s a Faustian dilemma: Many supermarket chains would be completely unprofitable and out of business if it weren\’t for vendor allowances.

So what are these allowances, and how did they come about?

They date to Nixon-era wage and price controls in the 70s which were designed to curb inflation. At the time, manufacturers saw compromising controls coming, so they sharply increased the price of goods. At the same time, they told retailers not to worry because they would receive allowances to offset the increases. The manufacturers cagily rationalized this as a means of building in increased list prices with the arrogant intent that retailers could be eventually weaned off the allowances. That was not to happen.

The first allowances were promotional, referred to as “street money,” which are fees paid to retailers by manufacturers to offset retailers’ cost of running cents-off advertisements. The result was the advent of the notorious “tombstone” newspaper supermarket ads that simply listed a product name and its price in a couple lines of type. Sometimes several dozen of these bare-bones ads would be heaped onto a page. They had all the personality and attraction of a phone book. Basically, retailers ran them so they could send manufacturers tear sheets, proving compliance with allowance requirements. The real intent was to perform on the cheap, banking the excess funds to meet their bottom line.

It wasn’t long before allowances proliferated. Some were offered by manufacturers, others demanded by retailers from manufacturers who wanted to do business with them.

In the long litany of allowances and similar practices, we find deals (short-term vendor sales), slotting fees (money charged by retailers to “slot” product into a warehouse or store), incentive rebates (fees paid as incentives to retailers to reach sales goals), off-invoice deductions (unilateral retailer markdowns of invoices), returns (rebates for goods deemed unsalable by retailers) and even more.

Unintended Consequences

Some of these allowances led to highly inefficient practices on the part of retailers chasing these funds. Deals, for instance, gave rise to forward buying, which is retailers’ practice of buying vast amounts of product on deal with the aim of bridging to the next deal. This caused retailers to build excessively huge warehouses to store the proceeds of forward buying. Huge capital costs resulted. Odder still, regional deals sparked a form of diverting: trucking product from one part of the country where it was on deal to another part where it wasn’t.

The most insidious type of allowance is incentive rebates, which brings us full circle to what happened at Tesco. These rebates are premised on the idea that if a retailer agrees to sell a certain amount of product in excess of what was previously sold, say, a year earlier, a substantial fee would be paid. Generally, manufacturers pay these fees in quarterly increments as sales goals are achieved.

Here’s the problem. Let’s say a retailer is experiencing sales and profit declines and is looking for a way to make the books look better. What could be better than to book the entire annual rebate in advance? At the same time, why not push costs forward to the next quarter? And that’s just what Tesco did.

Tesco is a company in deep financial trouble. In the first half of this year, Tesco’s operating profit declined by 41%, driven to those depths by increasing competition from discounters on its home turf, plus costs associated with retreating from several countries into which it imprudently expanded. As we have reported, Tesco withdrew from the US not long ago.

Failing and Flailing

In the US, there are two companies that fell victim to early booking of incentive rebates, the very same problem Tesco now faces.

One is grocery wholesaler Fleming Cos., which failed outright. Fleming veered into the realm of dubious legality by demanding “side letters” from vendors’ sales reps specifying that incentive rebates would be paid even if sales performance fell short. The problem was that the actual contracts demanded performance. When the practice was uncovered and halted by vendors, Fleming’s fictitious revenue prebooking led to quick collapse. Ahold of the Netherlands, which at one time owned many different supermarket chains along with a foodservice company in the US, nearly failed because of allowance prebooking. Ahold squeaked out survival by jettisoning foodservice and reducing US supermarket holdings to two major banners – Giant and Stop & Shop. Ahold’s former CEO and CFO went on trial in Holland because of the accounting scandal. Both received suspended prison terms, but paid sizable fines and vanished from the business.

All this raises the issue of what can be done about deals and the harm they cause. Like most counterproductive practices, there is incentive among all parties to leave them in place. In the US, about 8% of many retailers’ profit (that’s about all of it) can be attributed to vendor allowances. Moreover, retailers particularly skilled in wringing allowances from manufacturers have an advantage over less-skilled competitors. In a vicious circle, manufacturers like allowances because they are key to “trade loading,” that is, moving product out of their warehouses to retailers’, generating attractive sales numbers, which lead to big bonuses.

The Reformation

Increasingly, though, manufacturers are realizing that the practice of allowances must change. Right now, Procter & Gamble is divesting minor brands along with their less promising brands. Many of these brands were kept afloat by trade loading. Retailers, pushed by discount chains, also realize that selling product to customers at an unfair price offers no future. A shorthand way to judge whether a retailer is earnest about a customer-centric strategy is to see how their private label is doing. The proportion of private label sold by a retailer that’s also a “buyer” is low because private label offers no vendor-alliance opportunities. Conversely, a retailer that sells a lot of private label must be in the selling business. That situation comes about because a private label is owned by a retailer. Retailers can’t pay themselves allowances; allowances transfer funds from branded-goods manufacturers to retailers.

A good example of consumer-centric retailing can be found at Kroger, the largest and most successful supermarket chain in the US. It now generates 25.2% of all sales from private label. Its mid-tier Kroger store brand is the best-selling single brand of any type at the chain, and these numbers are the highest of any supermarket retailer in the US.

Since P&G is the nation’s largest consumer packaged goods manufacturer and Kroger its largest supermarket retailer, could rationality return and supermarkets get off drugs?

Maybe that will happen since the key to success for retailers of all types is simply to offer product consumers really want at a fair price. But legacy retailers that have been long dependent on manufacturer funds will have a tough row to hoe to get there.



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