When I first meet a potential customer, I occasionally tell the story of the best year I’ve had as a buyer. It was a year in which I had a 2% decrease. Don’t get me wrong, I made a lot of increases over the years, but that was the year I did my best work. I was shopping for men’s knit shirts, and boy, was it a knit shirt year? It was one of those “duck for cover” times, and my 2% decline could easily have been a 10% or 15% drop. If only I had been the knitted shirt buyer!
It’s easy to measure the success of retail sales solely by sales performance. After all, it is the top line, the number that every trader looks at first on Monday mornings. And it’s so easy to fall into the trap of thinking that as long as sales go on, everything else will go on. Most of the time, profitability and cash flow will stem directly from increased sales, but certainly not always. And what happens when the sales are off?
For almost all small retailers, inventory is the main generator of income, profit, and cash flow. Inventory typically represents 70% to 80% of a small retailer’s financial assets. So it only follows that sales, profitability, and cash flow are directly tied to a small retailer’s ability to productively manage their inventory.
The key to any merchant’s success is converting their inventory to cash, at the best possible profit margin, as quickly as they can, then buying more inventory and converting it to cash as quickly as they can, and so on. Now that may be stating the obvious, but sometimes stating the obvious helps make things essential again.
Carrying unnecessary inventory can quickly decimate profitability and cash flow. Not only does excess inventory tie up a large amount of cash, but there are also day-to-day costs associated with that inventory. From the expense of financing that inventory, to the downgrading costs due to aging and obsolescence, to the incremental payroll costs of moving it, packing it, and putting it away to unpack and put it back, moving it from one place. to another, to the hidden costs of not being able to market a more productive inventory instead, it all adds up and reaches the bottom line every month, every quarter, every year.
Retail inventory productivity in its simplest form can be defined as the amount of sales and dollars of gross profit that an inventory investment generates over a set period of time, typically one year. And the most basic measures of inventory productivity are inventory turnover and gross margin return on investment (GMROI).
Retail inventory turnover
Inventory rotation answers the most basic questions; How many times was I able to convert my inventory to cash, buy more, and convert that to cash? It is not enough to know the sales volume or inventory levels, it is essential to relate sales to inventory investment. A sales volume of $ 1,000,000 a year on an average inventory of $ 500,000 is one thing, but on an average inventory of $ 200,000 it is quite another. It’s the difference between turning your inventory over twice and doing it five times.
The formula for calculating inventory turnover is pretty straightforward:
Sales (at retail value) / Average inventory value (at retail value)
Alternatively, if your system only drives inventory value to cost, you can calculate inventory turnover like this:
Cost of Goods Sold / Average Inventory Value (at Cost)
Retail Gross Margin Return on Investment (GMROI)
The return on investment gross margin answers the question: How many dollars of gross margin did my inventory investment generate to pay for all my other business expenses, such as payroll, rent, utilities, insurance, etc.?
Gross margin dollars / average inventory value (at cost)
However, expressed as a percentage:
% Of gross margin / average inventory value (at cost)
A couple of technical points regarding these formulas:
Both inventory turnover and GMROI are measures of on-hand inventory productivity, so sales made from unavailable inventory, such as special orders, should be excluded from the calculation. Both inventory turnover and GMROI are expressed as annual turnover. However, the period being measured does not necessarily have to be a 12-month period. In certain situations, particularly for seasonal items, inventory turnover and GMROI can be measured over a period of a few months, with the result “annualized” for comparison purposes.
Average inventory at cost is generally calculated by averaging the ending inventories from the previous 13 months. This represents the beginning and ending inventory values for the previous 12 months. Inventory turnover and GMROI are dynamic metrics, as inventory and sales levels fluctuate. While they are often calculated annually, fully utilizing them as dynamic marketing tools requires measuring them quarterly or even monthly, on an ongoing basis.
And some additional thoughts on inventory turnover and GMROI:
There are no magic goals as to what your inventory turnover or GMROI should be. Every business is unique. While there may be industry ranges for both inventory turnover and GMROI, each small retailer is unique in its customer bases, merchandise assortment, and supplier structures. The key is to measure your productivity so you know where you are and then work to improve that productivity.
Once you’ve measured your productivity to establish a baseline and developed strategies to improve that productivity, you need to stay focused on implementing and executing those strategies. Invariably, small retailers that do not remain focused on improving their inventory productivity generally find that their productivity actually regresses. There is no such thing as standing still. If you don’t know that you are moving forward, you are most likely backing up.
It’s not just about reducing inventory, it’s also about generating more sales with less inventory. Again, when small retailers focus on improving inventory productivity, they often focus on refining assortments and reducing inventories. But something funny usually happens in the process. They focus on where their sales and gross margin dollars really come from, make sure they have the right merchandise, at the right prices, in the right places, at the right time, in the right quantities, and their sales go up!
And a postscript. So why was the year I ran a 2% decline my best year? First of all, I saw it coming. It was pretty obvious when shopping at the market before the season started that it just wasn’t going to be a year of knit shirts. Second, I had the benefit of management that didn’t just focus on the top line, but also focused on the bottom line. While they would have preferred me to execute a raise, they were more concerned with the profitability of my department and achieving my goal of GMROI.
So what did I do? Well, with two strikes against you, it doesn’t make much sense to jump over the fences. I bought very little in advance, tried several different items in small quantities, but took little risk. I kept my assortments basic to appeal to the widest range of customers, knowing that the cutting edge crowd was heading straight for fabrics anyway. I kept my inventories low and avoided devastating sales.
What about my GMROI, the most basic measure of retail profitability? The best of my life.