FREDERICK E, WEBSTER, JR,, JAMES A, LARGAY III, & CLYDE P, STICKNEY Persistent inflation in the American economy has led accounting rule makers to require large firms to report the effects of inflation on certain of their financial statement data. At present, these adjusted data are to be presented as supplementary disclosures under Statement of Financial Accounting Standards No. 33, "Financial Reporting and Changing Prices." One major result will be significant changes in cost estimates and asset valuations. The changes in financial accounting requirements are likely to be reflected almost immediately in managerial accounting procedures, with specific implications for marketing decisions in such areas as new product introduction, pricing strategy, and the valuation of individual customers and market segments. The authors describe the new accounting data briefly and, using examples, illustrate the implications for marketing managers.

THE IMPACT OF INFLATION ACCOUNTING ON MARKETING DECISIONS I

NFLATION has become a persistent and increasingly important fact of economic life in the United States in recent years. The Consumer Price Index (CPI) compiled by the U.S. Bureau of Labor Statistics increased approximately 25% in the five-year penod from 1967 to 1972, roughly 5% per year. From 1972 to 1977, the CPI increased by almost 50%, an average annual rate Frederick E. Webster, Jr. is Associate Dean and E. B. Osborn Professor of Marketing, James A. Largay III is Professor of Accounting, Lehigh University, and Clyde P. Stickney is Professor of Accounting, The Amos Tuck School of Business Administration, Dartmouth College. The authors express their appreciation for support from the Tuck Associates Program. Professor Largay also wishes to acknowledge the financial support of Coopers & Lybrand; he was Coopers and Lybrand Visiting Associate Professor of Accounting at The Amos Tuck School when this article was written. Journal of Marketing Vol. 44{FaU 1980), 9-17.

approaching 10%. The annual rate of inflation in 1978 was more than 9% (Bureau of Economic Statistics, Inc. 1979) and is reported to have been approximately 13% in 1979. Press reports for the first quarter of 1980 suggest that inflation was running in excess of an annual rate of 18%. Significant price inflation, once regarded as a minor economic problem that appeared from time to time in an overheated economy, now appears to be a chronic phenomenon that must be accounted for in economic and financial decision making. The Financial Accounting Standards Board, the accounting rule-making body, issued a pronouncement in September 1979 requiring supplemental disclosures of the effects of inflation on the financial statements of most large publicly held firms beginning with the 1979 annual reports (FASB 1979). Those 1979 annual reports leave little doubt that these changes in financial reporting requirements will have a direct impact on the manage-

The Impact of Inflation Accounting of Marketing Decisions /

9

rial assessment of specific products, markets, and businesses as well as on marketing decisions relating to pricing, service, promotion, and distribution. To give just one example, in tbe 1979 Annual Report of tbe General Electric Company (1980), Reginald H. Jones, Chairman of tbe Board and Cbief Executive Officer, noted: Severe inflation distorts the finaticial reporting of business, giving the illusion of soaring profits when, in fact, real profits—profits stripped of their inflatiotiary increments—have failed to keep pace with the rising costs of replacing buildings, machinery and equipment, maintaining inventories, and supporting research and development.

A management made cognizant of tbe impact of inflation on reported sales and income figures undoubtedly will begin to evaluate decisions relating to products, customer selection, pricing, service, credit and accounts receivable, promotion, distribution, and inventory policies in the new iigbt sbed by tbese inflationadjusted figures. Tbe purpose of our article is to show, through the use of examples, how inflation-adjusted accounting is bkely to influence marketing decision making. We suggest that tbe major impact will probably be a heightened emphasis on measures of asset utililization. Marketing managers are likely to find tbeir performance being evaluated by measures of retum-onassets-employed (including inventories and accounts receivable as well as plant and equipment) by product, customer, sales territory, and market segment, rather than the more traditional measures of sales volume, market share, and profit margin contribution.' Tbougb tbese cbanges will not occur ovemigbt, and it may be too early to measure tbe full impact of tbe new FASB requirements (which are still regarded as "experimental"), tbe potential significance of their impact can already be seen.

The Problem of Historical Costs Conventional financial statements report all activities in terms of tbe nominal number of dollars expended at tbe time assets were acquired, or "acquisition cost." Tbus, a piece of equipment purchased for $10,000 in 1975 would be carried at $10,000 on tbe balance sbeet in 'The assumption that asset utilization will become more important in the evaluation of marketing managers' performance is supported by interviews with more than 20 CEO's and other memhers of top management conducted in 1979 and 1980 by the senior author, in connection with a research project supported by the Amos Tuck School of Business Administration. Dartmouth College, and the Marketing Science Institute. Although that research is not the basis for this article, it does support an important assumption made here—viz. ihat these new financial reporting requirements will significantly alter managerial accounting practice and the way top management views products, customers, sales territories, and market segments.

10 / Journal of Marketing, Fall 1980

1980, minus accumulated depreciation calculated on tbe $10,000 base. Likewise, inventories and tbe cost of goods sold would be stated in terms of tbe prices paid for tbose goods. Historical cost accounting fails to recognize two important, but different, effects of inflation. First, no recognition is given to the fact that the dollar does not represent a constant, or stable, measuring unit over time. The purchasing power of tbe 1975 dollar, as measured perbaps by the CPI, is not the same as tbe purchasing power of tbe 1980 dollar. Yet accountants add bistorical cost amounts for inventories and otber assets as tbougb the measuring units were the same. Such procedures are just as illogical as adding the number of dollars in a U.S. bank account to tbe number of pounds in a London bank account to obtain total casb. The measuring units are just not the same. Tbe second deficiency of bistorical cost accounting is tbat, prior to sale, no recognition is given to cbanges in tbe prices of tbe specific assets held by a firm." Whereas tbe concern witb tbe stability of the measuring unit is witb changes in tbe general purcbasing power of the dollar, tbe concern in tbis second case is witb changes in the specific prices of particular assets. In a period of rising prices, traditional accounting practice tends to overstate the profitability of most enterprises by understating the current cost of replacing inventory items sold and plant and equipment used. Tbe Commerce Department bas estimated tbat tbe result bas been an overstatement of corporate profits by 30 to 40%, an amount that could equal $50 billion or more in tbe United States annually {Business Week 1979).

The Required Supplemental Disclosures Developing an understanding of the disclosures required under Statement 33. tbe new pronouncement of tbe Financial Accounting Standards Board, is perbaps done most easily witb an example."* Table 1 lists the data used in the illustration. A firm begins its first year of operations. 1980, with $400 in cash and contributed capital. On January 1, 1980. the CPI is assumed to be 200. Tbe firm immediately acquires two widgets for $100 each and a piece of equipment for $100. During tbe first six months of 1980, general price inflation is 5%. Tbus. tbe CPI increases from 200 to 210. On July 1, 1980. one widget is sold for $240 and tbe widget is replaced at the new higher replacement cost of $115. Otber expenses paid on July 1, 1980, total $100. Dur-

"Some minor exceptions arise in the case of "iower-of-cost-or-market" adjustments to inventories and marketable equity securities. •'Readers wishing to pursue these accounting issues and techniques in more depth are referred to: Vancii (1976): Sterling (1975); Stickney (1977); and Largay and Livingstone (1976).

TABLE 1 Data for Inflation Accounting Illustration Balance Sheet as of Jan. 1, 1980 Cash: $400 Contributed Date: January 1, 1980 CP! 200- (5% increase} Cost of One Widget $100 Cost of Equipment $100 Transactions 1. Buy 2 widgets at $100 eacb, $200 2. Purchase equipment (5 yr. life) for $100

ing tbe second six months of 1980, general price inflation is 10% (tbe CPI increases from 210 to 231). Financial statements prepared according to several inflation accounting metbods are illustrated in Table 2. Historical Cost/Nominal Dollar Accounting Column 1 of Table 2 sbows tbe results for 1980 as tbey would be reported in the conventional financial statements. Sales is stated at the nominal dollars received when tbe widget was sold. Cost of goods sold, inventory, depreciation, and equipment are reported at tbe nominal dollars expended wben tbe inventory and equipment were acquired. Tbe reported net income of $20 fails to reflect either cbanges in tbe general purcbasing power of the dollar or changes in tbe specific prices of the inventory and equipment. Historical Cost/Constant Dollar Accounting Column 2 of Table 2 shows income statement and balance sbeet amounts restated to dollars of constant general purcbasing power. Historical cost valuations are still used. However, bistorical cost amounts are restated to dollars of constant purcbasing power at the end of 1980. For example, the purchasing power received wben the inventory item was sold for $240 on July 1. 1980. is equivalent to receiving $264 dollars of December 31, 1980, purcbasing power. Likewise, tbe sacrifice in purchasing power wben tbe widget was purchased for $100 on January 1, 1980. is equivalent to sacrificing $115.50 in purcbasing power on December 31, 1980. Tbus, an equivalent measuring unit underlies tbe amounts in column 2. (Note tbat tbese restated amounts do not represent the cunent replacement cost of the specific assets. The specific prices of these assets could have changed in an entirely different direction and pattern than prices in general.) One new element in column 2 is the purchasing power gain or loss on monetary items. A firm tbat holds

Capital: $400 June 30, 1980 210 - (10% increase} $115 $110 1. Sell 1 widget for $240; replace widget at $115 2. Pay otber expenses of $100

December 31, 1980 231 $140 $120 Close books and prepare statements

cash or claims to cash during a period of inflation loses general purchasing power. A firm tbat borrows from otbers during inflation gains general purchasing power. The purcbasing power gain or loss is a measure of the increase or decrease in general purchasing power during a period due to being in a net lending position (purcbasing power loss) or net borrowing position (purchasing power gain). In the illustration, the firm held $100 of cash during tbe first six montbs of the year while the general purchasing power of the dollar decreased 5%. It tberefore lost $5 of general purchasing power. This represents a loss of $5.50 measured in dollars of December 31, 1980, purchasing power. Tbe firm also held $125 during tbe last six montbs of tbe year. Witb 10% inflation during tbis six-month period, an additional loss in purcbasing power of $12.50 is realized. Tbe aritbmetic is sbown in note d to Table 2. Tbe purcbasing power gain or loss on net monetary items is not reported in tbe conventional financial statements. It is a unique element in tbe income statement under constant dollar accounting. Current Cost/Nominal Dollar Accounting Wbereas column 2 restates bistorical cost amounts for changes in tbe general price level, column 3 reports amounts in terms of tbe current replacement cost of specific assets.** Matcbed against sales are tbe current

•^Controversy persists within the accounting profession as to the appropriate concept of replacement cost. Some argue that the current cost of replacing the specific assets held by the firm is most relevant. For example, the replacement cost of a 30-year-old steel mill is the current cost of acquiring or constructing a steel mill with identical physical and operating characteristics. Others argue that the current cost of replacing existing assets with assets serving the same function ii more appropriate. For example, the replacement cost of a 30-year-old steel mill that produces 100,000 tons of steel per year is the cunenl cost of acquiring a new steel mill with the same output, or productive capacity. The current cost of Ihe new steel mill would be adjusted downward to reflect the used condition of the asset owned but would not be adjusted to reflect the technological superiority of the new steel mill.

The Impact of Inflation Accounting of Marketing Decisions / 11

TABLE 2 Illustration of Financial i Statements Reflecting Inflation Accounting (1) Historical Cost/ Nominal Dollars

Balance Sheet Casb Inventory Equipment Ace. Depre Total Assets

.

115.5^ 23.1'' 110.0'

248.6 15.4

100 (20)

100

264.0 126.5"" 24.2" 110.0

3

65'^ 16'

20

101

125 215

125.0 242.0^

280

115.5^ (23.1)

92.4 459.4 462.09 (2.6) 459.4

3.6^ (18.0) 39.0 125 280

125 120 (24)

96

260.7 3.3 11.0°

15' 2'

400 20 420

Contributed Capital Retained Earnings Total Equity

237

(18.0)'^ (2.6)

80 420

14) Current Cost/ Constant Dollars

240 115

1

220 20

(3) Current Cost/ Nominal Dollars

264.0

240 100 20 100

I I I

Income Statement Sales Cost of Goods Sold Depreciation Other Expenses . Operating Income Realized Holding Gains: Goods Sold Depre. Assets Used Unrealized Holding Gains: Inventory Depre. Assets Purchasing Power Loss . . . Net Income

(2) Historical Cost/ Dollars Constant

120 (24)

501 400 101

501

96 501 462 39 501

Minimum required disclosures are shown in boldface type. ^100 X (231/200) ''100 X (231/200) ==100 X (231/210) "[100 X (10/200) ^100 X (231/200) '100 X (231/200) 9400 X (231/200) ''110/5 - 22 '115- 100 - 15

X + = -

115.5 115.5; 115.5/5 = 23 1 110 (231/210)1 + 125 x 21/210) - 5.50 + 12.50 - 18 115 X (231/210) = .M2 115.5 462

cost of replacing tbe widget sold and tbe services of equipment used.^ Hence neitber revenues nor current costs are measured in end-of-year constant dollars, but in dollars of various vintages witbin the current year. Operatitig income (sales minus expenses measured at current replacement cost) reports tbe firm's ability to maintain its operating capacity. If sales revenue is not large enougb to replace goods or services used up, tbe firm will have to cut back its level of operations unless outside financing is secured. that the use of a LIFO rather than a FIFO cost-flow assumption for inventories in historical cost accounting generates a cost of goods sold which typically approximates the current cost of units sold (also see footnote 7). To a lesser extent, the use of accelerated rather than straightline depreciation in historical cost accounting provides an analogous result in the case of depreciation expense.

12 / Journal of Marketing, Fall 1980

'22- 2 0 - 2 •^280 - 215 - 65 ' 9 6 - 80 = 16 X (231/210) - 126.5 "22 ;< (231/210) - 24.2 °126 5 - 115.5 - 11 P24.2 - 23.1 - 1.1 •^280 - 242 - 38 ^96- 92.4 - 3.6

Current cost income statements also include a new element—r^o/Zzet/ and unrealized holding gains and losses. A bolding gain or loss arises from holding an asset wbile its replacement cost increases. Tbe widget purcbased on January 1. 1980, for $100 was beld during tbe first six montbs of the year wbile its replacement cost increased to $115. Wben tbe widget is sold on this date, tbe firm realizes a bolding gain of $15 ( = $115 $100). Likewise, a holding gain of $40 ( = $140- $100) would be reported on tbe other widget acquired in January 1, 1980, and a bolding gain of $25 ( = $ 1 4 0 $115) would be reported on tbe widget acquired on July 1, 1980. Tbe latter two bolding gains would be characterized as "unrealized" ($65 = $40 -I- $25) because the widgets bave not yet been sold. Whether bolding gains constitute an increase in tbe

The FASB does not require the supplemental disclosure of all the information in columns 2, 3, and 4 at the present time. Tbe Board encourages experimentation, recognizing the need for an educational effort to inform statement users of the usefulness of the information. The minimum disclosures required are sbown in boldface in Table 2. For companies having fiscal years ending on or after December 25, 1979. tbe boldface information from column 2 must be disclosed; firms may delay presenting tbe boldface information in columns 3 and 4 for one year. In addition, a summary of selected bistorical, constant dollar, and current cost information for the most recent five years must be disclosed but the first year of current cost data need not be reported for fiscal years ending prior to December 25, 1980.

ble), small changes in profit margins become especially meaningful. The slow growth that characterizes many consumer and industrial markets has caused distributors and end users to stretcb out their payments for goods received, putting further pressures on tbe marketer's financial situation. Longer term prospects for market growtb are clouded by substantial demographic shifts, including a slower rate of population growtb and a significant increase in tbe average age of the population. As corporate managements attempt to cope with and plan for the combined forces of inflation, tight money supply, high interest rates, and low rates of growth in the economy in general and in specific markets, they will need new criteria to evaluate marketing performance. Commonly used measures such as gross margin, return on sales, and cbanges in market sbare all bave a sbortcoming—tbey do not take into account the financial resources committed to a particular product, customer, sales territory, or market segment. This sbortcoming can be corrected by using sucb measures of performance as return on investment, return on equity, and return on assets employed. At tbe same time, management must be prepared to incorporate tbe new in flat ion-adjusted accounting information into tbese additional measures of performance. Costs must be redefined to take into account cbanges in prices of plant, equipment, raw materials, working capital, and tbe labor tbat bave gone into inventories of finisbed goods and work in process. Tbe effect will almost always be to reduce profit estimates below levels indicated by traditional accounting metbods. Attractiveness of particular products, customers, sales territories, market segments, and even total businesses may be cbanged accordingly. Tbe amount of tbe profit decrease will depend, in general terms, on tbe amount of capital (plant, equipment, and working capital) committed to a particular marketing unit (product, customer, territory, etc.) and specific price changes of factors such as raw materials and energy used by that marketing unit. Marketing units tbat look like real ''winners" on the basis of traditional accounting methods and measures such as gross margin and return on sales can quickly become "losers" when inflation-adjusted costs and capital requirements are considered.

New Criteria of Marketing Effectiveness

Measuring Marketing Performance

Tbese specific developments in accounting standards are occurring against a background of more general management concern about tbe financial impact of marketing decisions. Witb tbe prime lending rate reacbing 20% in tbe spring of 1980 and most firms paying I to 2% over tbat for tbeir sbort-term borrowing to finance current operations (especially inventories and accounts receiva-

Marketing projects and activities, and marketing line managers such as field sales managers, sales promotion managers, product managers, and market managers are characteristically evaluated by measures of sales volume, market share, and gross margin contribution. In tbe words of one cbief executive officer interviewed a short time ago, "We bave said to tbe marketing people.

value of a firm is a subject of considerable controversy. Proponents argue tbat firms that purcbase assets early in anticipation of increases in replacement costs are better off tban firms tbat delay purchases and must pay tbe higher replacement costs. Opponents argue tbat firms cannot use such holding gains as the basis for dividend payments without impairing the ability to replace those assets used or sold. The balance sbeet on a current cost basis reports assets at their current replacement cost at year end. Current Cost/Constant Dollar Accounting Observe tbat although column 3 reports amounts in terms of current replacement cost, the current cost amounts are measured in terms of dollars of varying general purchasing power. Sales and expenses are measured in terms of dollars of midyear purcbasing power. The amounts shown for various assets are measured in terms of dollars of end-of-tbe-year purcbasing power. Column 4 presents all amounts in column 3 restated to an end-of-year constant dollar basis. Perbaps the most interesting disclosures in column 4 are the holding gains. Because the reported amounts indicate the extent to which changes in prices of a firm's specific assets exceeded the cbange in tbe general price level, they are referred to as real holding gains. Also sbown in column 4 is the purchasing power loss on net monetary items. Required Supplemental Disclosures

The Impact of Inflation Accounting of Marketing Decisions / 13

you get the sales volume and the contribution margin and we'll worry about how to finance it." When top management complains about marketing and sales managers' lack of "a profit orientation," they usually are asking for more concern for contribution margin (defined as revenue minus cost of goods sold and marketing expenses), more control over direct marketing expenses ("increased productivity"), and less concern with gross sales volume per se. Only in the recent past has top management gone the next step and expressed concern with the total level of asset commitment to specific products and markets. Though the concern for profit versus sales seems very straightforward in the abstract, it is a major management issue in practice. Marketing people are in fact under severe pressure to produce sales volume, to meet sales quotas, and to capture and hold market share. These are the typical measures of operating performance used to evaluate marketing people. A manager is usually given a budget to work with at the beginning of the operating period (after a process of budget planning and review that results in allocation of marketing dollars to territories, products, and markets), and is then charged with responsibility for maximizing the sales volume, and perhaps contribution dollars, within that budget constraint. In recent years, guided by the logic of the product portfolio approach^ and by better understanding of the financial aspects of business strategy, top managements and corporate planners have begun to use estimates of return on investment, in its various forms, to evaluate marketing projects and activities and to allocate financial resources among them. These more sophisticated measures of marketing performance treat products, customers, market segments, and sales territories as competing uses of scarce financial resources. Each requires a certain commitment of plant and equipment, working capital, and marketing expenditures. When these resource commitments are factored into the calculation of profitability, simple measures of sales volume and profit margin contribution are evaluated in a new light. The emphasis is shifted to the rate of profit per dollar invested in each marketing activity. Top management is called upon to make subjective judgments and to assess tradeoffs between business growth requiring additional investment for future profitability and positive cash flow from limited investments in the short term. Inflation accounting adds yet another dimension to the increasingly sophisticated assessment of the financial implications of marketing decisions. The performance of marketing managers in the future is certain to be

approaches are described and evaluated by Abell and Hammond (1979).

14 / Journal of Marketing, Fall 1980

increasingly evaluated in terms of asset utilization by measures of return on assets employed for product, market segment, sales territory, and other marketing control units, adjusted to reflect the current level of general or specific prices.

Implications for Marketing Management Virtually all areas of marketing decision making— market segmentation, product strategy, pricing strategy, distribution, salesforce management, advertising, and sales promotion—will be influenced by the new inflation accounting data. In general, the greatest impact will be in those products and markets requiring heavy capital investments in fixed assets and working capital. In particular, old plant will imply high replacement cost (and high depreciation). High current inventory costs will increase the measure of capital required when LIFO (last-in, first-out) is used and will decrease operating income under FIFO (first-in, first-out).^ Inflation accounting will produce evidence of the need for larger and probably more frequent increases in selling prices than would be indicated by traditional accounting methods. With operating income as the key measure of profit, maintaining the desired level of profitability will require increases in selling prices, to the extent permitted by competitive pressures, to offset the higher current costs reflected under inflation accounting. As return on assets becomes a more significant measure of marketing performance, marketing managers will feel the pressure to improve their performance by increasing the ratio of operating income to sales as well as by increasing the ratio of sales to assets, the "asset turnover" ratio. The reason is seen in the simple relationship: Return on _ Operating Income _ Operating Income Assets Assets Sales

Sales Assets

Note that inflation accounting is likely to exert a "double whammy" on retum-on-asset (or retum-oninvestment) calculations. First, maintaining present selling prices in the face of higher current cost depreciation and cost of goods sold will reduce operating income (which excludes holding gains), the numerator. Second, the growing replacement cost of assets increases the denominator. The result are sharp declines in measured return on investment.

^In a period of rising prices, LIFO leads to a lower inventory cost on the balance sheet than FIFO but will generate a cost of goods sold figure in the income statement which closely approximates current replacement cost. In contrast, FIFO results in balance sheet values for inventory that are close to current cost but cost of goods sold amounts that reflect older (and lower) costs.

Illustration of How Inflation-Adjusted Accounting Data Can Influence the Evaluation of Performance of Marketing Units To indicate how the relative desirability of marketing units can be changed by the new accounting information, we analyze three hypothetical marketing units. The illustrations focus on the potentially dramatic differences between historical cost and current cost accounting data. We believe that most firms will discard constant dollar information in favor of current cost data. The rates of general inflation used in constant dollar accounting provide insights into interest rates and into the implications of net monetary positions. Yet they rarely measure the effect of changing prices on a particular marketing decision, marketing unit, or business firm. We now tum to the numerical illustrations presented in Table 3. Comments on the Performance Measurements The examples show how the move to new measures of performance such as return on assets can change the performance ranking. Consider first the historical data alone. Marketing unit C has top ranking under the more traditional gross margin/sales ratio with a whopping

50%! Yet because of its relative capital intensity, it drops to third when return on assets is computed. Marketing unit B is preferred on the basis of historical return on assets. Notice how the use of current cost data can affect the traditional gross margin/sales ratios. Unit B comes out well at 25% although it drops below unit A when the operating income/sales ratio is computed. In terms of current cost return on assets, unit A comes out best, even though the current cost data have reduced its return on assets from 20 to 4.29%. Purchasing Power Gain or Loss on Monetary Items We believe that the most useful piece of infonnation generated by constant dollar accounting is the purchasing power gain or loss on monetary items. It provides a rough measure of the direct effect of inflation on the value of net monetary items owned or owed by firms. In Table 3, marketing unit A requires a net monetary asset position of $400,000 which will be responsible for a $40,000 loss in purchasing power during a year of 10% inflation. If this $40,000 purchasing power loss is used to reduce A's operating income, its current cost return on assets falls to 4.06% [ - ($750,000 -- $40,000)/ $17,500,000], below that of unit B.

TABLE 3 Comparison of Current Cost and Historical Cost Information in Performance Evaluation sf Marketing Units

Sales Cost of Goods Sold: Variable Costs Depreciation of Plant and Equipment

Marketing Unit A Hist. Cost Current Cost

Marketing UnitE Hist. Cost Current Cost

Marketing Unit C Hist. Cost Current Cost

$8,000,000

$8,000,000

$5 ,000 000

$5,000 000

$3,000,000

$3,000,000

$4,000,000 $ 4,500,000

$?,non 000

$2,250 000

$1,000,000

$1,100,000

1,000,000

1,750,000

1,000 000

1,500 000

500,000

1,410,000

$5,000,000

$6,250,000

$3 ,000 000

$3,750 000

$1,500,000

$2,510,000

Gross Margin Marketing Expenses

$3,000,000 1,000,000

$1,750,000 1,000,000

$? oon 000 1,000 000

$1,250 ono 1,000 000

$1,500,000 500,000

$ 490,000 500,000

Operating Income

$2,000,000

$ 750,000

$1 ,000 000

$ 250 000

$1,000,000

($ 10,000)

Gross Margin/Sales Operating Income/Sales . . . . Capital Requirements (Investment in Assets) . . . . Return on Assets ( = Operating Income/ Capital Requirements) . . . . Identifiable Net Monetary Assets (Liabilities) General Inflation Rate Purchasing Power Gain (Loss) on Monetary Items .

37.5% 25%

21.88% 9.38%

$10,000,000 $17,500,000 20%

4.29%

40% 20%

25%

$4 000 000

$6,000 000

5%

25%

4.17%

50% 33.33%

13.33% Loss

$5,000,000 $18,000,000 16.67%

Loss

$400 ,000 10%

10°/

($200 ,000) 10%

($40, 000)

—

$20, 000

-0-

The Impact of Inflation Accounting of Marketing Decisions / 15

Furthermore, the purchasing power gain on monetary items accruing to marketing unit C converts its current cost loss situation to one of marginal profitability. Managerial Reaction to Conflicting Performance Measurements Although alternative measures of performance often provide conflicting signals, the problem is exacerbated by the current cost information. The outputs of historical cost accounting systems are based on completed transactions and are generally verifiable. In contrast, current cost infonnation is a subjective answer to a "what if" question, //plant, equipment, merchandise displays and so forth are replaced soon, what would their cost be? What is reasonable depreciation on their estimated current cost? And so forth. The marketing manager who faces performance evaluation with current cost information must be cognizant of several factors. 1. Current cost estimates are not unique and are subject to assumptions about timing of resource replacements and whether specific assets or productive capacity are to be replaced. 2. If management has no plans to replace assets in the short term, estimated replacement costs may be irrelevant. 3. For a going concern with contemplated resource replacements during a period of rising prices, current cost estimates are much better indicators of the economic value of resources than their historical costs. 4. Return on assets measurements which incorporate current cost data provide management with a good sense of the ability of a given marketing unit to support the capital committed to it over the intermediate to long term. 5. Constant dollar infonnation is not likely to be particularly relevant in marketing decisions unless a particular marketing unit regularly requires a substantial net monetary asset or liability position. In such cases, management should consider calculating the purchasing power gain or loss on monetary items. Significant discussion (some would say "controversy") is continuing in the accounting profession about the desirability of various methods for estimating current replacement costs, changes in prices, and so on. Concern has been expressed that inflation-adjusted figures, because they involve more "subjectivity" than historical costs, can be more easily manipulated by the managers whose performance is being evaluated. Tliough this is clearly a legitimate concern, it must be recognized as a separate issue relating to behavioral implica-

16 / Journal of Marketing, Fall 1980

tions of accounting data and procedures, not the central concern in thinking about the impact of inflation. To a significant degree, of course, all measures of cost and asset commitment are based on subjective judgment and negotiated understandings among all parties influenced by these estimates. Some managers are better than others in using accounting data, of whatever kind, to their own advantage. Our modest objective has been to help marketing managers understand how inflation-adjusted data will differ from those based on historical cost. We are confident that those managers who have read this article will hold a significant advantage in the new business environment over those who have not!

Summary We have outlined alternative approaches to accounting for the effects of inflation and have sketched the wide range of ramifications for the marketing decision maker. The following conclusions summarize the major points. 1. Persistent inflation causes firm profits to be overstated by traditional, generally accepted accounting principles. 2. Large publicly held firms are now being required to disclose a combination of constant dollar and current replacement cost adjustments to historical cost accounting data. 3. Corporate managements are likely to make increased use of inflation-adjusted financial data in their decision making as these data become the generally accepted measures of performance used by investors and stockholders in evaluating management. 4. Marketing managers will be evaluated by a more complex set of measurements with emphasis on those relating to asset utilization. 5. Virtually all areas of marketing decision making will be influenced but the most affected are likely to be pricing and distribution. To respond to these pressures positively, marketing managers will need a better understanding of accounting and financial management than that of their predecessors. The characteristic marketing manager's emphasis in analysis and action on sales volume, gross margin, and market share must be replaced by a more general management focus on bottom-line profitability and return on investment. Top management will think increasingly in terms of total resource allocation across products and markets, assessing the total product portfolio in terms of complex tradeoffs between business growth opportunities in markets requiring additional investment for future profitability versus cash generation now in markets with limited or negative investment. Heightened awareness of the impact of inflation on measures of

use of the sophisticated measurements, analytical techniques, and strategic planning approaches that are available to help cope with the new pressures and complexities.

corporate fmancial performance will undoubtedly sharpen management concern for this dilemma. Marketing management must adopt new attitudes, what might be called "a general management orientation," as well as make

REFERENCES Abell. Derek F. and John S. Hammond (1979). Strategic Market Planning. Englewood Cliffs, New Jersey: Prentice-Hall, Inc. Bureau of Economic Statistics. Inc. (1979), Handhook of Basic Economic Statistics. 33 (July). 99-103. Business Week (\919), "Inflation Accounting" (October 15), 68. Financial Accounting Standards Board (1979), "Financial Reporting and Changing Prices." Statement of Financial Accounting Standards No. 33 (September). General Electric Company (1980), "1979 Annual Report," Annual Report Issue of The General Electric Investor, 5. Largay III, James A. and J. Leslie Livingstone (1976), Accounting

/V1/1RKETING /1SOCMTION

for Changing Prices, New York: Wiley/Hamilton. Sterling. Robert R. (1975). "Relevant Financial Reporting in an Age of Price Changes." Journal of Accountancy, (February), 42-51. Stickney. Clyde P. (1977). "Adjustments for Changing Prices," in Handbook of Modern Accounting, 2nd edition, Sidney Davidson and Roman L. Weil, eds.. New York: McGraw-Hill. Vancii. Richard F. (1976). "Inflation Accounting—The Great Controversy," Harvard Business Review, (March-April).

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•L. The Impact of Inflation Accounting of Marketing Decisions / 17