November 2, 2017
Retailing by the Numbers — Part II
In the second of this two-part series, the author focuses on a number of inventory calculations that can improve your bottom line.
In the first of this two-part article, I discussed a number of business and accounting terms important to realizing profits. These numbers are your FFL’s report card, measurements of performance that tell you what needs to be done to ensure profitability. Without the information those numbers provide, you are simply wandering around Retail Land not knowing if you are doing well, just surviving or walking in red ink. Let’s take a look at a few more types of number-crunching you should be doing.
Average Inventory, Cost Method
Average inventory measures the total amount of inventory at cost value you keep in the company on average for a defined period of time (usually a year). Remember, this is an average, as opposed to a point-in-time inventory. The formula is:
End-of-month inventory for 12 consecutive months summed, divided by 12 = average inventory
Note: Some accountants prefer to add beginning-of-the-year inventory plus 12 end-of-month inventories and divide by 13. In either method, you’ll get an average dollar value of your inventory. This number becomes very important in the context of inventory turns (discussed below). If your average inventory is too high relative to your sales, you incur excessive inventory carrying costs and markdowns. Result: lowered profits.
Average Inventory, Retail Method
This also measures average inventory but is used by those retailers using the retail method of accounting, wherein inventories are valued in retail dollars as opposed to cost dollars. The formula is the same, but use the retail values rather than the cost values of the inventory.
Turns, Turnover or Turn Rate
The turn rate is perhaps one of the most important, miscalculated and misunderstood formulae in retailing. Turns measures the number of times during a fiscal year the average inventory is sold. In more graphic terms, it measures the velocity of the inventory flowing through your company or the average length of time inventory sits on the shelf before it’s sold. Turn rate can be measured in cost or retail terms. Retailers most often use the cost method. The formula is:
Cost of goods sold (COGS) for the year, divided by average inventory at cost (not point-in-time inventory) = turn rate
The resultant number may look like 2.3. Such a number means that you have sold your average inventory 2.3 times during the course of the year. Expressed differently, the turn rate measures the average number of months your inventory rested before selling. In this example, 2.3 times is equal to 5.2 months; 12 ÷ 2.3 = 5.2. A higher turn rate number is obviously better, since you need to invest less money in order to generate the same sales. A higher turn rate (lower average inventories) also keeps the merchandise fresher and with fewer markdowns due to obsolescence or damage.
Gross Margin Return on Investment (GMROI)
GMROI is a wonderful calculation that measures the profit productivity of your inventory relative to its sales, margins and inventory level over a defined period of time (usually a year). It expresses how many gross profit (not net profit) dollars you receive in return for every dollar invested in inventory. GMROI can be computed for an item, a group of items or for your entire inventory. The formula is:
Annual gross profit dollars divided by average inventory at cost = gross margin return on investment
The resultant number might look like 1.45, which means that for every dollar you invest in inventory, you receive back $1.45 in gross profit. A value of $2 is wonderful and a value of $1 is poor. Any GMROI number greater than $1.50 is significant. You can improve your GMROI by increasing sales, increasing margins, lowering average inventory (increasing turnover) or any combination of these.
The open-to-buy calculation measures the amount of money or units that can be purchased within a specific time period in order to achieve a certain planned level of inventory. The calculation is driven by a turn rate objective based upon a sales forecast, the current on-hand inventory and open orders for future delivery. In lay language, monthly OTB answers the question, “How much can I purchase, in each month, for any given category of merchandise, so I have enough to sell and not be overstocked, and if I want a certain turn rate?”
The OTB calculation requires two parts:
- The planning formula (creates the purchasing budget)
- The monitoring formula (tells us how we are adhering to the budget)
Both can be done in either cost or retail formats. The most common for the shooting industry is the cost formula. The planning formula is:
Planned sales in cost dollars (COGS), plus desired ending inventory* minus beginning inventory, minus open orders = OTB in cost dollars
(*Where planned ending inventory is generated by a desired turn rate. See note below.)
The monitoring formula is:
Beginning-of-month inventory at cost, plus month-to-date inventory receipts at cost, plus balance on order for the month at cost, minus month-to-date sales at cost (COGS), minus balance of month’s sales plan at cost = computed end of month inventory at cost. Compare to planned end-of-month inventory = positive or negative OTB for the month.
Note: Planned sales are by month. The planned end-of-month inventory is a function of the desired turn rate. For example, if you want four turns, each month’s ending inventory will be the sum of the next three months of planned sales; 12 months ÷ 4 turns = 3. Both the OTB planning and monitoring formulae are computed by month for six to 12 rolling advance months.
OTB reports can be set up on a Microsoft Excel spreadsheet or through OTB software from your software suppliers.
Weeks of Supply (WOS)
WOS measures the number of weeks it will take to sell completely out of specific merchandise based upon current on-hand inventory and projected sales per week. Projected weekly unit sales can be computed many different ways, such as prior month’s weekly average, prior weekly moving average, weighted average, same weeks last year looking forward or planned forward weekly sales. Weeks of supply can also be calculated in dollars or units. WOS calculations are most important when analyzing inventory or turn rates. The formula is:
Current on hand, divided by projected weekly sales (using one of the above methods) = weeks of supply
The weeks-of-supply calculation is similar to turn rate, e.g., 13 WOS = 4 turns (or 52 weeks ÷ 4 turns = 13 weeks of supply). Put another way, if your turn rate is only two, on average you carry a 26-week supply of everything; 52 ÷ 2 = 26. Such a low turn rate suggests far greater profits can be realized by the company.
The current ratio is a measure of business liquidity, inclusive of the inventory asset. Companies that have a high current ratio are considered to be more liquid and, therefore, healthier. The formula is:
Current assets, divided by current liabilities = current ratio
A ratio of 2:1 (twice as many current assets as current liabilities) is considered a good benchmark for a healthy company.
Of course, there are more ratios and formulae that can be included in this guideline, but I have included those that are the most significant and the most commonly used. Those included represent core knowledge the entrepreneur should master.
I urge the reader to analyze their business operations in terms beyond the simple totals of sales and expenses. If you run your business in both qualitative and quantitative terms, your success quotient will no doubt go up. Remember, good math equals good business!