Home » Self-Diagnosis Tool #4 – Inventory Management

Self-Diagnosis Tool #4 – Inventory Management

I used to like math. It lost me when it added the timber industry into the equation (logs and natural logs and all that calculus stuff). I got jaded because I could never figure out how to derive those trees into the answer the professor wanted.

I found, however, all that algebra I had to learn to get to calculus has actually been quite useful.

Today we’re going to put it to use to diagnose how well you are Managing your Inventory. Fortunately it is simple algebra, stuff your POS system might already do for you, and stuff you can easily program into an Excel spreadsheet once and not have to do it all the time.

Stick with me, because the numbers are fascinating.

First, here is the list of numbers we’re going to calculate:

  • Profit Margin
  • Turn Ratio
  • Gross Margin Return on Inventory (GMROI)
  • Accounts-Payable-to-Inventory Ratio
  • Current Ratio
  • Cash-to-Current Ratio

Here are the numbers we need to find from our reports to calculate the above numbers.

  • Gross Sales – This can be found on your year-end Profit & Loss Statement (also called an Income Statement)
  • Cost of Goods Sold (COGS) – This can be found on your year-end Profit & Loss Statement
  • Total Current Assets – This can be found on your year-end Balance Sheet
  • Total Current Liabilities – This can be found on your year-end Balance Sheet
  • Cash on Hand – This can be found on your year-end Balance Sheet
  • Accounts Payable – The money you owe to your vendors. This can be found on your year-end Balance Sheet
  • Current Inventory at Cost – This can be found on your year-end Balance Sheet
  • Average Inventory at Cost – You will likely have to calculate this unless your POS system has a report that will give you this number. Take your Current Inventory from each monthly Balance Sheet, add those twelve numbers together and divide by twelve.

Go get those numbers. I’ll wait.

PROFIT MARGIN

Profit Margin is your profit as a percentage of the retail price. The formula looks like this:

Profit Margin = (Gross Sales—COGS)/Gross Sales

Do this math and your results will likely be between 45% and 55%. That is a typical range for an indie retailer.

Obviously the higher the number, the better. If you are at or above the higher end of this range, good for you! There might be some room to push that margin a little higher, but for the most part, that area of your business is in good shape.

If your number is at the lower end of that range—and your rent/mortgage costs for your building are at 10% or higher of your Gross Sales—then we need to seriously look at how to raise that Profit Margin. Otherwise you won’t have enough money to properly pay for things like Payroll and Marketing.

I developed a simple, intuitive, easy way for any retailer to be able to raise their prices in the right way—one that doesn’t kill sales, but actually maximizes them. Most stores who adopt this pricing strategy see both increased Profit Margin and increased unit sales at the same time. Download the FREE Pricing for Profit eBook and see where and how to raise those margins.

TURN RATIO

Turn Ratio is simply a number that tells you how often you turn over your entire inventory in a calendar year. To do this calculation, you only need two numbers. The formula looks like this:

Turn Ratio = COGS/Average Inventory at Cost

The range for this number varies quite widely from 2.0 to 8.0. If you are a seasonal business such as a toy store, a garden center, or a gift shop in a summer tourist town, your number is often quite lower (2.0 to 5.0). If you are a store without a true season such as a pet store or baby goods store, your number will likely be higher (3.5 to 6.0). If you are a commodities store (i.e. grocery) your number will be much higher (5.0 to 8.0).

This is a tricky number to use by itself for diagnosing your business health. For instance, just being at the high end doesn’t necessarily mean you’re doing well. You might be losing potential sales because your inventory is too light. One misplaced order or one vendor who is out-of-stock could cripple your next month’s sales. Being at the lower end of your range isn’t necessarily bad, either, if you are able to get favorable terms from your vendors.

Often we’ll look at this number in conjunction with another number. For instance, if your Profit Margin is low, you can offset that by turning over your inventory faster (make it up with volume).

GROSS MARGIN RETURN ON INVENTORY

One number often used in conjunction with Turn Ratio is GMROI. GMROI tells you how much money you made for each dollar you invested in inventory. The formula is:

GMROI = (Gross Sales x Profit Margin)/Average Inventory at Cost

A typical indie retailer is likely going to have a GMROI between 200% and 400% meaning for every dollar you invested in inventory, you made $2 to $4 in return.

One reason we look at this in conjunction with Turn Ratio is because of Profit Margin. If your Profit Margin is really high, that lowers your Turn Ratio, but increases your GMROI. So if GMROI and Profit Margin are healthy, we know your Inventory is probably okay, even if your Turn Ratio is a little low. But if GMROI and Turn Ratio are both low, something needs to change.

There are only three ways to affect GMROI:

  • Increase Gross Sales (without decreasing prices – you might want to revisit Self-Diagnosis Tool #3 Customer Service)
  • Increase Profit Margin (see above)
  • Decrease Average Inventory at Cost (see “Dead Weight” below)

ACCOUNTS-PAYABLE-TO-INVENTORY RATIO

(Also called “Payables-to-Inventory Ratio”)

This is an interesting number to throw into the mix because it tells you how much of your inventory is already paid for, and how much is being financed by your vendors. The formula looks like this:

AP-to-Inventory Ratio = Accounts Payable/Current Inventory

A typical indie retailer will likely have an AP-to-Inventory Ratio between 20-35%. The higher this number, the more favorable the terms you are getting from your vendors. Being at the lower end of this ratio means either you have unfavorable terms (or no terms at all—common in certain food service industries) or too much dead weight in your inventory. If your vendors are all offering Net 30 or better terms and your Ratio is low, then it is definitely dead weight in your inventory.

One interesting phenomenon this number helps point out is when terms are incredibly favorable. For instance, some of my vendors would offer me December Dating. I could stock up heavily in January and not pay until December 1st. The upside was getting my large store stocked quickly and thoroughly. The downside is that my Average Inventory at Cost would be extremely high, putting me at the lower end of the range for both Turn Ratio and GMROI. But my AP-to-Inventory Ratio would be outstanding!

(Note: if your industry does not offer terms, you need a higher Profit Margin and Turn Ratio to offset this.)

CURRENT RATIO

This number comes straight off your Balance Sheet. The Ratio shows whether you have enough Current Assets to pay off all your Current Liabilities. The formula looks like this:

Current Ratio = Current Assets/Current Liabilities

Depending on when you do this calculation, your number will vary. If you are a 4th Quarter store and you run this number on January 1st, you’ll likely have a Current Ratio in the 2.5 to 3.5 range. other times of year it might be down around 1.5.

Most banks use that 1.5 as the bellweather mark. You need to be there or higher to be considered healthy.  Anything below 1.5 is too low because even the banks realize you won’t be able to liquidate everything in a pinch.

This number by itself is only part of the Inventory Management analysis.

(Note: if your Current Ratio is too low, you can look at a couple options to make it better. First, raise your prices and sell more goods to pay off those Liabilities. Your Current Assets include your inventory at cost, not at retail. Second, look into a long-term loan to pay off some of those Current Liabilities.)

CASH-TO-CURRENT LIABILITIES RATIO

Your Current Assets include two numbers—Cash and Inventory. This Ratio is similar to the previous one, but only looks at your Cash in relation to Current Liabilities. The formula looks like this:

Cash-to-Current Liabilities Ratio = Cash/Current Liabilities

Again, this number varies widely depending on time of year. If you just finished a successful Christmas season and are loaded with cash, your Ratio might in the 70-80% range. If you ran that same number on December 1st when your Inventory and Current Liabilities were at their highest, that number could be 10-20%.

Think of those two ranges as goals to shoot for depending on the time of year and your season. (Note: if you are in an industry without a “season” you’ll likely always be closer to the 20% mark and that’s okay.)

The key to this number is to look at it in conjunction with the Current Ratio. If your Current Ratio is good but your Cash-to-Current isn’t, then you have too much inventory. If your Current Ratio is bad, but your Cash-to-Current is good, then you don’t have enough inventory.

If both are bad, we have some serious work to do.

IDENTIFY THE “DEAD WEIGHT” AND THE “MUST-HAVES”

All of that math is done to help you understand whether your inventory is in balance or not. Retail is a balancing game. If you have too much inventory, you don’t have enough cash. Without cash you cannot pay your people to sell your excessive inventory. If you have too much cash, you might not have enough inventory to make the sales you need to continue your growth and keep your customers happy.

Most inventory problems happen when you are unable to manage the two ends of the inventory spectrum—the fastest and slowest moving products.

DEAD WEIGHT

Your “dead weight” in your inventory is the stuff that isn’t moving. You’ve paid for it, but it isn’t making you any money. It just sits on the shelf and sucks the life out of you. You have to find it and turn it into cash as quickly as possible.

Think of it this way …

If you spend $60 on a product and put it on your shelf, that space on your shelf has now cost you $60. That shelf space needs to make you money. Right now, however, it is costing you. The hope is that you’ll sell the product for $120 and make $60 for that shelf space, but the longer it sits, the more you stay in the red. Once you realize that item isn’t going to sell, mark it down to $60 and get back to even. Then find something else to put in its place that will sell and make you money.

You need a system for identifying these slow movers. I used the following criteria:

  • Didn’t sell through by Christmas
  • Hasn’t sold in 3 Months
  • Damaged box
  • Old style packaging
  • Don’t like it
  • Have a better version coming

That was the stuff I needed to move out. Every year in May and June my team and I would pull all these items off the shelf, mark them half-price, and then have a HUGE sale on the third Thursday in July. Turn it into cash.

Whatever system you choose to use, make sure you have one that identifies the dead weight and turns it into cash quickly.

MUST-HAVES

The other end of the inventory spectrum is the “must-haves”, the stuff you never want to be without.

  • If customers come in asking for the product by name, it is a must-have.
  • If your store is known for selling this item, it is a must-have.
  • If you sell more than one a week, it is a must-have.
  • If the item is something you always sell and the customer needs it right now, as in they’ll drive all over town until they have it, it is a must-have.

When cash flow is poor, this is where the inventory dollars need to go. Don’t worry about profit margin. Worry about keeping your core customers happy. If you are constantly saying “No, we don’t have it,” your customers will eventually stop asking.

There are several models for what percentage of your inventory should be changing to new product each year (or season). Rather than worry about percentages, let’s just put this into priorities. When you are looking to place orders, your priorities should be:

  1. Must-Haves
  2. New Products
  3. Everything Else

The vast majority of your customers are going to ask for two things:

  • Do you have a specific item?
  • What’s new?

Inventory Management is about making sure you have a positive answer for both of those questions.

DOS AND DON’TS

If you’ve made it this far, I’m going to leave you with some simple tips that will help you improve your cash flow.

Here is my Do List:

  • Do measure those numbers above. Together they tell a story. What gets measured and managed improves.
  • Do ask for Extended Terms from your vendors (but be sure to reward those vendors by paying those bills on time).
  • Do buy less but buy more often. Smaller orders placed more frequently will always improve cash flow. If a vendor has great terms at a trade show, see if they’ll take your huge order and split it into two or three ship dates to spread out your payments.

Here is my Don’t List:

  • Don’t buy anything you don’t want. Never pad an order with something you don’t fully believe in selling. It never works out well.
  • Don’t run out of the Must-Haves.
  • Don’t out-buy your terms. If it is Net 30, try to buy 30 days worth of product (not always possible, but incredibly effective when you do it right).

Whew! We’re at the end of this Self-Diagnosis Tool. Realistically, however, this is just the tip of the iceberg for Inventory Management. There are some more details in the FREE eBook Inventory Management for 4th Quarter Stores. (I also have one specifically for the Pet Store Industry.) I also recommend you look at Merchandising Made Easy. sometimes it is your displays that are turning good merchandise into dead weight.

-Phil Wrzesinski
www.PhilsForum.com

PS If the math is driving you crazy, find a high school kid getting all A’s in Calculus. Show him this. He’ll find the math to be incredibly easy and can set up your Excel Spreadsheet so that all you have to do is plug in the numbers.

PPS Sell off your seasonal merchandise. Don’t carry it over. Without going into all the details, you’re better off marking down your seasonal merchandise at the end of the season and turning it into cash than carrying it over into next year. The math says it is the right thing to do.

PPPS One last number I might look at is Shrinkage—the amount of inventory that disappears, unaccounted for. If you’re using a POS system, your shrinkage is the discrepancy between what your computer thinks you should have in inventory and what your physical inventory actually shows. Read those FREE eBooks on Inventory Management for more info on what causes shrinkage and how to control it.

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