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OBJECTIVE

The objective of our analysis was to measure the costs incurred and revenues accrued by a group of retailers in granting revolving credit to their Arizona customers during fiscal 1970 and to determine whether the service charges accrued during the period were sufficient to cover the costs. Our study did not attempt to measure the profits or losses by retailers on credit sales.

RETAILERS PARTICIPATING IN THE STUDY

The Arizona retail operations of eight retailers were included in our study. The participating retailers were:

- Babbitt Brothers Trading Company
- The Broadway
- Diamond's
- Goldwater's
- Levy's
- Montgomery Ward & Co., Inc.
- J. C. Penney Company, Inc.
- Sears, Roebuck and Co.

SUMMARY OF FINDINGS

Total revolving credit costs for the participant group of retailers were 8.90% of revolving credit sales; service charge revenue was 6.53% of such sales. In total, costs exceeded revenues by 2,37% of sales. All of the eight participating retailers incurred deficiencies of credit costs over service charge revenues. A comparison of the relative deficiencies of the retailers shows that the deficiency of revenues over costs for the three smallest retailers was twice that of the larger retailers expressed as a percent of revolving credit sales. The results are discussed in greater detail in the Study Results section.

APPROACH TO REVENUE AND COST DETERMINATION

This section describes our approach to selecting and treating revenues and costs for this analysis.

Revolving charge accounts are the focus of this analysis, These are legally termed "retail charge account agreements" and include all open-ended accounts on which the customer agrees to pay for charge purchases by making instalment payments on outstanding balances. The customer also agrees to pay a service charge computed periodically based on the outstanding balances in his account. closed-end contracts, regular 30-day accounts, and third-party credit cards are not part of this analysis.

96-687 O - 73 - 8

TOUCHE ROSS & CO.

- 3

All cost and activity data were furnished by the participants. We performed selective test checks which included reconciling the data supplied by the participants to their books of account and other quality control techniques that were appropriate under the circumstances. We did not, however, perform an audit of the data supplied to us. Our quality control techniques are described more fully in the Methodology section of this report.

STUDY RESULTS

Exhibit I presents our breakdown of total sales by the participating retailers to their Arizona customers during the twelve-month period measured. As the exhibit shows, the total Arizona retail store sales for the group were about $250 million and their total Arizona credit sales were about $125 million or 50% of total sales. Total revolving credit sales are about $105 million or over 80% of credit sales and nearly 42% of total sales for the period. Based on a survey of Arizona retailers performed by the Arizona Retailers Association, we estimate that this $105 million represents over 90% of statewide retail store revolving credit sales.

Exhibits II and III present our analysis of the revenues accrued and costs incurred in providing revolving credit to Arizona customers by our sample group; Exhibit II expresses total costs and revenues for each retailer in dollars; Exhibit III expresses them as percents of net revolving credit sales, excluding service charge revenues.

As Exhibits II and III show, all retailers incur deficiencies of revenues over costs; the aggregate deficiency for the eightparticipant group is slightly less than $2.5 million, which is about 2.4% of revolving credit sales. The significance of this deficiency is that the overall profit margin on revolving credit sales is 2.4 percentage points less than for cash sales.

A comparison of the relative deficiencies of the survey members shows that the three participants with less than $10 million in revolving credit sales had the highest deficiency of costs over revenues as a percent of revolving credit sales. The composite deficiency as a percent of revolving credit sales of the smaller retailers was more than twice that of the composite of the other five members as can be seen from Exhibit IV. The deficiency of these three participants is 4.26% of their revolving credit sales; the deficiency of the five larger participants is 2.11% of revolving credit sales.

There are substantial variations in service charge and cost levels from store to store. The variability in service charges results from differences in the method of assessing service charges, differences in balance payment requirements, and differences in the amount of receivables outstanding. Differences in cost levels are the result of variations in the scale of operations and other operational factors.

METHODOLOGY

The results presented in this study are summaries of information taken from actual operating data for the eight participating retailers for the fiscal year 1970. A specific year's operating data was reviewed for each participant so that costs assigned to revolving credit for each retailer could be directly related to the retailer's actual financial experience. The following steps describe the procedures we used to gather the cost and revenue data for the study:

Step one

Data was collected by the sample members according to detailed specifications and procedures which we designed. These specifications included the requirement to complete a questionnaire and reconcile the survey questionnaire to the participant's books of account.

Step two

After the survey members completed step one, we visited each retailer and performed the following tests to check the validity of the data collected.

We observed the physical operations and compared
them to the cost data prepared for reasonableness.
We reviewed the accounting system with management
to ascertain that proper accounts were used to
prepare the data.
We reconciled the cost and revenue data with the
books of account, which, in all cases but one, had
been audited by certified public accountants.

Step three

Cost allocations were performed using consistent techniques and procedures.

Step four

Cost ratios and relationships were compared among selected sample members and to available national cost of credit data to detect, question, and resolve out-of-pattern situations. We also consulted annual reports and, where appropriate, home office personnel of the survey members.

TOUCHE ROSS & Co.

- 5

Step five

The credit costs selected for this analysis include the cost of capital required to finance the revolving credit account balances. There are several methods that could be used to measure this cost of capital; these methods fall within the following general categories:

Assume receivable financing costs are
limited to the costs associated with
borrowed funds only.

Assume receivables are financed at a
rate which recognizes the cost of
funds invested by stockholders as well
as borrowed funds,

We reviewed various alternative approaches in each of the above categories and adopted an approach in the second category which measures the cost of funds provided by stockholders as well as funds provided by lenders. The approach we used (described below) is, in our opinion, the most appropriate for this analysis.

Five of the eight companies involved in the study have financing subsidiaries for the express purpose of providing the capital for receivable financing. The revolving credit sales of these five companies comprise almost 80% of the total sample revolving credit sales and 87% of total accounts receivable balances. Because of this widespread practice, we have adopted the financing subsidiary as the basis for measuring the economic cost of capital. One of the participants with a financing subsidiary started it during fiscal 1970; therefore, we excluded that retailer from the financing subsidiary cost of capital computations.

Each financing subsidiary received funds from two sources: debt (generally short-term) borrowed from outside and invested capital from the parent company. For each financing subsidiary analyzed, we computed the weighted average cost of capital by calculating the cost of the debt portion and the cost of the parent's invested portion. We then weighted these two costs in proportion to total funds stemming from each source. The debt cost used was the estimated interest cost incurred for short-term debt and the estimated rate paid for similarly rated debt instruments during 1970 for long-term debt. The cost of the parent investment was the parent's overall weighted average cost of capital, including stockholders'' equity and long-term debt. The total cost of capital for all financing subsidiaries analyzed yielded an overall weighted average cost of 8.9%, weighted by each retailer's average accounts receivable balances.

There are three retailers that did not have financing subsidiaries at all. of these, two are widely held public corporations enabling us to measure parent cost of capital; in each of these two cases, the weighted cost of capital was substantially greater than 8.9%. We were unable to measure cost of capital for the remaining company which was privately held; however, the sales of this retailer accounted for less than 1% of revolving credit sales for the sample.

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