Finance & Accounting Marketing Dec 2, 2008

Dis­count­ed Dia­pers and Stock­piles of Soup

Man­ag­ing earn­ings through marketing

Based on the research of

Craig J. Chapman

Thomas J. Steenburgh

Listening: Interview with Craig Chapman

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What did Enron, World­Com, and Tyco all have in com­mon? Account­ing abus­es on a grand scale and mas­sive finan­cial decep­tion from the very high­est lev­els of man­age­ment. As investors lost bil­lions of dol­lars, the earn­ings man­age­ment game with its fuzzy math and earn­ings mag­ic came under fire, and stronger, sweep­ing leg­is­la­tion was enact­ed to reform Amer­i­can busi­ness practices.

While much has been made of the oppor­tunis­tic exer­cise of account­ing dis­cre­tion, a sec­ond type of earn­ings man­age­ment strat­e­gy has gone large­ly ignored: the oppor­tunis­tic struc­tur­ing of real trans­ac­tions. New research by Craig Chap­man of the Kel­logg School’s account­ing and infor­ma­tion man­age­ment depart­ment exam­ines the ways in which man­agers use retail-lev­el mar­ket­ing actions to influ­ence the tim­ing of con­sumer pur­chas­es in rela­tion to their firms’ fis­cal cal­en­dars and finan­cial performance.

In a new paper enti­tled An Inves­ti­ga­tion of Earn­ings Man­age­ment through Mar­ket­ing Actions, Chap­man and his col­league, Thomas Steen­burgh (Har­vard Busi­ness School), report evi­dence that soup mak­ers use tac­tics such as price dis­counts to improve earn­ings at the end of a report­ing peri­od. The authors under­score that the com­pa­nies do so 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.”

Pat­terns of Price Discounting

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. At the same time, Chrysler, Ford, and Gen­er­al Motors were all report­ing sig­nif­i­cant sales growth asso­ci­at­ed with offers of employ­ee dis­counts for all. In each case, 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 did more than take per­son­al advan­tage of the dis­counts. He decid­ed to explore how com­pa­nies might use such mar­ket­ing as an earn­ings man­age­ment strat­e­gy. He and Steen­burgh chose to focus on soup because, they report, it is eas­i­ly stock­piled and is pur­chased in greater quan­ti­ties when it is offered at a dis­count.” In addi­tion, Chap­man notes, there are mul­ti­ple man­u­fac­tur­ers with cross-sec­tion­al vari­a­tion in their fis­cal cal­en­dars, allow­ing us to con­trol for sea­son­al­i­ty effects.”

While steep dis­counts often cost the com­pa­ny, the prac­tices offer sav­ings oppor­tu­ni­ties for con­sumers and red flags for investors.Alter­na­tive prod­ucts had built-in dis­ad­van­tages. I believe the same thing hap­pens with cars, but you get rid of your car. And if you filled your fridge with beer, you’d prob­a­bly drink more; I’m not sure that’s the case with soup,” he con­tin­ues. You need some­thing that shows changes in demand. I chose an item with as few vari­ables as possible.”

For their data, the researchers relied on infor­ma­tion on the buy­ing pat­terns of house­holds in Sioux Falls, South Dako­ta, and Spring­field, Mis­souri, between 1985 and 1988 gath­ered by the ERIM mar­ket­ing test­ing ser­vice. Based on that data, they then col­lect­ed infor­ma­tion on soup mak­ers’ pro­mo­tions and finan­cial per­for­mances, in some cas­es from the com­pa­nies themselves.

Tac­ti­cal Tim­ing of Mar­ket Promotions

In con­trast to pri­or lit­er­a­ture sug­gest­ing that firms reduce mar­ket­ing expen­di­tures in order to boost report­ed earn­ings, Chap­man and Steen­burgh found that soup man­u­fac­tur­ers rough­ly dou­ble the fre­quen­cy of all mar­ket­ing pro­mo­tions (price dis­counts, fea­ture adver­tise­ments, and aisle dis­plays) at the fis­cal year-end, and that the firms engage in sim­i­lar behav­ior fol­low­ing peri­ods of poor finan­cial per­for­mance. The authors observed that firms gen­er­al­ly offer deep­er and more fre­quent dis­counts to man­age earn­ings upwards dur­ing these periods.

Chap­man and Steen­burgh point out that the use of such mar­ket­ing prac­tices effec­tive­ly enables firms to arti­fi­cial­ly inflate their report­ed rev­enues, but since the extra prod­ucts have been sent to end con­sumers, the firms escape scruti­ny from the Unit­ed States Secu­ri­ties and Exchange Commission.

We esti­mate that soup man­u­fac­tur­ers use price reduc­tion to legal­ly boost sales rev­enue and quar­ter­ly earn­ings by almost 20 per­cent,” they report. Nev­er­the­less, there is a price to pay, as we esti­mate that quar­ter­ly EPS falls by 23.5 per­cent in the sub­se­quent report­ing peri­od, result­ing in a net loss of 3.5 per­cent of the quar­ter­ly EPS to the manufacturer.”

Chap­man sums up the sit­u­a­tion when he observes, They’re pro­mot­ing a prod­uct and sell­ing it at a low­er price today that they might have sold at a high­er price tomor­row. The process involves extra costs.”

When the study was com­plet­ed, Chap­man found plen­ty of anec­do­tal evi­dence to sup­port its results. You mean the can can’ effect,” the exec­u­tive of a New Eng­land truck­ing com­pa­ny told him, explain­ing that super­mar­ket chains com­plained that his trucks were not strong enough because they were over­loaded at the end of every quarter.

Chap­man sug­gests that the effect applies to a host of durable prod­ucts that are eas­i­ly stored and have a high con­tri­bu­tion mar­gin along with suf­fi­cient­ly high price elasticity.

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 says. It’s a basic tool of business.”

Brand Man­agers Overruled

The study also revealed that deci­sions to use mar­ket­ing as a tool of earn­ings man­age­ment are made at high lev­els in the exec­u­tive suite. We observe that firms switch their pro­mo­tion­al slots from small­er rev­enue brands to larg­er brands in peri­ods when we pre­dict them to have incen­tives to man­age earn­ings upwards,” Chap­man and Steen­burgh report. Since it is high­ly unlike­ly that a brand man­ag­er would vol­un­tar­i­ly give up pro­mo­tion­al sup­port, this change is con­sis­tent with the actions being direct­ed by par­ties high­er in the orga­ni­za­tion than brand man­agers.” Chapman’s con­ver­sa­tions with brand man­agers have con­firmed that fact. They com­plain about how their head offices keep inter­fer­ing with their plan­ning process with short-term plans,” he says.

The results of this study have far-reach­ing impli­ca­tions. They will not only ben­e­fit prac­ti­tion­ers nego­ti­at­ing with sup­pli­ers and those respon­si­ble for set­ting price and pro­mo­tion strat­e­gy in response to com­peti­tor actions, but also those who design incen­tive-based com­pen­sa­tion and reg­u­la­tors who are mon­i­tor­ing report­ing of fis­cal peri­od-end­ing promotion.

While earn­ings man­age­ment strate­gies involv­ing steep dis­counts often cost their users, the prac­tices offer sav­ings oppor­tu­ni­ties for con­sumers and red flags for investors. “ can save sig­nif­i­cant amounts of mon­ey by tim­ing their pur­chas­es,” Chap­man advis­es. 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.”

Featured Faculty

Craig J. Chapman

Member of the Department of Accounting Information and Management faculty until 2017

About the Writer

Peter Gwynne

About the Research

Craig J. Chapman and Thomas J. Steenburgh, 2011. An Investigation of Earnings Management through Marketing Actions, January, 57(1): 72-92.

Read the original

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