October 31, 2017
Retailing by the Numbers — Part I
Doing your math homework will keep you in the black.
The act of retailing is not altogether that hard. Sign a lease, buy some fixtures, load the store with merchandise and wait on the customers. While buying and selling is relatively easy, making a profit consistent with your investment is difficult at a minimum.
In order to realize those elusive profits, a lot of pieces must come together, all at the same time. This includes having the right products on a timely basis, merchandise presentation, informed staff, quality customer service, acceptable inventory velocity and controlled expenses, just to name a few. The last piece of that puzzle is information about your retailing performance. It’s your report card, the measurement of performance that tells you what needs to be done to ensure profitability.
I often speak of financial and operational measurements (reports), how they are computed and what they mean. In the absence of such information, the firearms proprietor is wandering around in Retail Land not knowing if they are doing well, just surviving or walking in red ink. This article and the one to follow are about the math of retailing and the basic information that all businesses should review on a regular basis — compute, compare and react. This is retailing by the numbers and a more secure way to seek out business profits; good math equals good business. I will discuss each formula, what it measures, why it’s important and what the numeric answer means. Consider retaining this article and its upcoming second part for future reference.
Net Profit Before Taxes
Net profit measures the dollar profits from the operations of the business. It can be calculated for any period, such as a month, quarter or year. In simple terms, it measures the dollar productivity of the assets employed by the company. The formula is:
Sales, minus cost of goods sold (COGS), minus all expenses = net profit before taxes
Net profit is expressed in dollars, while return on sales (below) expresses net profit relative to one’s sales as a percent.
Cost of Goods Sold (COGS)
COGS represents the cost value of the merchandise sold in order to generate sales. It measures only the dollar value of inventory actually sold during a defined period of time (e.g., a year), rather than the total of all inventory purchased for the same period. The formula is:
Beginning inventory at cost, plus purchases at cost, minus ending inventory at cost = cost of goods sold
The lower the cost of goods sold, the higher your profits will be. Note that COGS is not affected by markdowns, which only influence sales and margins.
Return on Sales
The return on sales measures your profits (usually over a year) expressed as a percentage of your gross sales. It is a shortcut method of viewing the profitability of a business. The formula is:
Net profit before taxes, divided by annual sales = return on sales
The resultant number will be expressed as a decimal value such as .05, which converts to five percent. Thus, if profits were $20,000 and sales were $400,000, the return on sales would be five percent; 20,000 ÷ 400,000 = .05. Retailers doing poorly might return two percent on sales, while more profitable operations might return 10 percent. An acceptable range is five to seven percent.
Return on Equity
Return on equity is sometimes called ROE or ROI (return on investment). It measures your annual profitability relative to your dollar investment to generate that profit. Usually ROE is expressed as a percentage. The formula is:
Net profit divided by net equity (paid-in capital plus retained earnings) or where net equity is total assets minus total liabilities = return on equity
In truth, profit as an absolute number tells only half the story. To judge profitability, it must be measured against the dollar investment ownership has made in the company. If your annual income (profit) was $50,000 and your investment in the company (original paid-in capital plus retained earnings) is $800,000, then your return on equity (ROE) is only 6.2 percent; 50,000 ÷ $800,000 = 6.2 percent.
Mark-on (not to be confused with mark-up) measures the initial cost/retail relationship for specific items or groups of items. The mark-on value expresses the hoped-for profit margin for any given item (as opposed to the final profit margin for that same item). The formula is:
Intended retail price, minus cost of the item, divided by the intended retail price = mark-on
The resultant number will be expressed as a decimal value such as .40, which converts to 40 percent. If an item costs $3 and you plan to sell it for $5, your mark-on is 40 percent; (5 – 3) ÷ 5 = .40.
Note: Mark-on as used here is expressed in retail terms (because we divided by the retail price). Some businesses (such as manufactures) may express their mark-on in cost terms (by dividing by the cost rather than the retail of the item). For example, if an item costs $10 and sells for $20, in retail we say there is a 50-percent mark-on; (20 – 10) ÷ 20 = .50. Non-retailers may say there is a 100-percent mark-on; (20 – 10) ÷ 10 = 1.00.
Also called “gross margin.” Unlike the mark-on calculation, mark-up measures the final cost/sales relationship for specific items or groups of items. In this case, the markup expresses the actual (not hoped-for) profit margin for any given item. The formula is:
Intended retail price, minus markdowns, minus the cost of the item, divided by actual selling price (not the intended selling price) = markup
The resultant number will be expressed as a decimal value such as .25, which converts to 25 percent. If an item costs $3 and you plan to sell it for $5 but had to discount it by $1, then your markup or gross margin for that item is only 25 percent; (5 – 1) – 3 ÷ 4 = .25. In order to support profits, the collective gross margin on sales must exceed total expenses by the amount of desired profits. If you desire to realize profits of seven percent on sales and your expenses are equal to 65 percent of sales, then your margins must be maintained at 28 percent; (100 – 7) – 65 = 28.
That concludes Part I of “Retailing by the Numbers.” In Part II, I’ll cover a number of inventory calculations that important to maintain profitability.