Basics of Retail Math (Part 2)
To read Basics of Retail Math (Part 1), please click here.
Turnover of inventory, or turn, is the calculation of how many times you sell and replenish the merchandise in your store over the course of a year. To figure out your turn, divide your annual sales by your average inventory (at retail). For instance, if your sales are $400,000 for the year and your average retail is $100,000, your turn is 4. The more times you can turn over your inventory, the better it is because:
- You will have less older merchandise.
- You will have more opportunities to buy, which should lead to better buys.
- The inventory will be more up-to-date.
- Less money will be tied up in inventory.
- You’ll make more profit on your invested capital. (If you need $100,000 of inventory—tied up capital—to feed $400,000 worth of sales and profits, you’re obviously better off than if you need double that inventory for the same results.)
Stock to sales ratio is the monthly view of turnover. It is the amount of merchandise in the store at the beginning of a given month divided by the amount of sales of merchandise for the month. It provides you with a quick view on how well you manage the inventory. For instance, if you have inventory of $120,000 and $30,000 in sales for the month, then your stock to sales ratio is four to one. This means that it will take four months of selling at your current rate to sell through the average monthly inventory.
Knowing that there are twelve months in a year, this means you are turning your goods at the rate of three times a year (twelve months divided by a four stock-to-sales ratio). However, if your (realistic) goal is to achieve a stock-to-sales ratio of three to one, that is a turn of four— you are overstocking and need to find ways to operate on less inventory or to sell more!
Your ultimate goal should always be to develop the highest level of sales from the smallest possible inventory. But be careful what you wish for. If you try to push your turns too high, you may run out of merchandise that your customers want, and they may go elsewhere.
The number of turns for which you should aim varies by type of retailer. Thus, before you set your target, you should find out what is the industry norm. Actually, this is another reason to belong to the trade association most related to your type of retail store. Such organizations can give you the average guidelines for turn and stock to sales ratios for different seasons that should help you keep the right amount of inventory on hand, particularly through your first few years in business.
You should review your turnover ratio every week. The higher the turnover, the stronger the retail business will be. With a high turnover, you have less money invested in the inventory at any given time and a lower risk of carrying products your customers do not want to buy. You get higher sales from the same amount of space, have fresher goods in the store, and can always feature new items to tempt your customers.
There’s nothing more disappointing to a repeat customer than seeing nothing but the same old stuff. While turn rates are innately different between different categories of retail, within each category there are two basic, and quite different, strategies that you must decide upon when setting your turnover objectives:
1. High margin, high price, and low turnover
2. Low margin, low price, and high turnover
A low turnover item must give you a high margin in order to pay the rent for sitting on your shelf for a long time. In contrast, a high turnover item obviously has to pay less rent, and therefore can make a lower margin. Strategically, you can mix these two turnover concepts as long as one dominates the other so you are giving a clear message to the customers.
For instance, in your toy department, you may price Barbie at cost to create a high turn, but price her accessories higher to create more margin, expecting that customers who buy Barbie because of the price will pick up the other items because no little girl can exist without at least three new outfits for her doll!
Obviously, you want to turn all your merchandise as quickly as possible. The trick is to recognize that you may have to stock low turnover items as a service to your customers to induce them to come to your store and buy the more popular items.
For example, a well-known cosmetic company’s president was delving through his firm’s lipstick sales and discovered that, of the ninety six shades they marketed, four did 81% of the business, ten did 94% of the business, and fifteen did 98% of the business. His first thought was to discontinue all but the fast-selling four. Fortunately for him, wiser heads prevailed and the company kept fifteen shades and discontinued
the rest. “We’ll save so much inventory by eliminating eighty-one shades, we’ll increase our profits even if we lose the whole two percent of sales that are in the discontinued shades,” the president explained. “In any case, most of the women buying those shades will probably switch to the ones we’re keeping.” The result? Sales fell to about half. A large majority of women were buying the same fifteen shades, but they wanted to feel they had a huge choice. They were offended to think that the company was, in effect, deciding the shade for them. The president not only reinstated the missing shades, he increased their number to 125. The result? Sales grew to about 30% more than the original level—but women still almost exclusively bought the same fifteen shades!
Yes, providing a good selection is often part of pleasing your customers. But it has a cost. Slow Turn causes:
- Slow-moving merchandise to clog your shelves and make it harder for customers to find the goods they want
- Excessive accumulation of old styles, odd sizes, and extreme colors
- Increased expenses
- Deeper markdowns and the need to run them more often
The challenge is to balance the inventory level against the service level you want to provide your customers. As I said, it’s a balancing act. Too high a turn will produce too many out-of-stock situations and hence lost sales and disgruntled, often non-returning, customers. Too low a turnover could put you out of business.
Determining How Much Margin to Go After
Remember the retailer’s creed: Always strive to squeeze as much margin as possible. The more margin you can extract from one item, the more money you have to cut prices (and margins) on the products and deals that drive traffic through your store. However, when trying to raise margins, you must bear in mind what the consumer is willing to pay in your store environment. If you are a discount store, you cannot expect to make the same margin the department store down the street makes on the same item. In your store, your customers are only in the mood for bargains.
In general, margin decisions should be based on:
• Competitors’ retail. If an item is carried throughout your trading area and it’s an item you cannot do without, you must decide if you are going to be parity priced with everyone else or have the lowest price in town. Having the lowest price will hurt your overall margin, but it may increase turn and build customer traffic.
• Last year’s sales on this item or a similar product. Once you have a history of an item, you can determine how price-sensitive it is and if you have room to get more margin.
• Planned turnover of an item. If you expect sales to be limited and you’re carrying the item only as a convenience for the customers, take the extra margin. I always thought the president of the cosmetics company I referred to earlier should have up-priced all the colors that hardly sold and called them “premium shades”! Not only would he have improved his margins, but I bet he would have sold more of those shades. Cosmetics buyers are always looking for something “exclusive.”
• Wholesale costs. Be sure to shop around among wholesalers (if you are not dealing directly with the manufacturer) to see if you can reduce the price you are paying. Even a few pennies saved can accumulate into good margin gains at the end of the year. Most retailers make a pre-tax profit of between 2% and 8% of sales; only in rare cases do their pretax profits exceed 10%.
Let’s assume that your pre-tax profit is 5% of sales. Now, if you can cut the cost of your purchases so your margin increases by 2%, for example, by paying $6.00 for an item you sell for $10.00 instead of paying $6.25, that extra $0.25 drops to your bottom line. That means that your pre-tax profit increases from $0.50 to $0.75—a whopping 50% increase in your profits!
If you can make a 2.5% improvement on all the cost of all merchandise you sell, and your annual sales are $1,000,000, then your pre-tax profit would rise from $50,000 to $75,000. Not bad! Certainly worth pushing your suppliers to give you some price breaks. Because there are no additional expenses, that extra $0.25 drops to your bottom line and you make $0.50 for every $10.00 of merchandise you sell.
• Manufacturers suggested retail. Although this is only a guideline, it gives you a sense of the worth of products. If you are a discounter, this also allows you to prove to your customers how much you have cut your price.
• Handling and selling costs. Products can vary dramatically in what they cost to sell. Some products (like glassware) break easily so customers or sales people are likely to damage a certain percentage of the stock. Certain goods have a tendency to disappear because of shoplifting (electronics). Others are extremely heavy or awkward to move from the warehouse to the selling floor, so the freight and handling costs may be high. Some may be shipped from across the street while others may be coming from across the country, so transportation costs need to be considered. Some goods may come in pre-ticketed while others require a lot of handling and ticketing in the store, adding to your cost. Some goods tend to have a high return rate. All these costs need to be factored into the product’s retail price. A brittle, faddy, easily stolen article with a 60% margin may actually be less profitable than a solid “evergreen” product with a 40% margin.
• Nature of the goods. If you are dealing in fad- or fashion-oriented merchandise (which includes everything from fashions themselves to cosmetics to toys to novelties that come and go—remember the Pet Rock?), know what an item’s likely shelf life is. How will the manufacturer help with markdowns? These, too, are factors you need to consider when thinking through how to price merchandise and how much initial margin to achieve.
• Correlation among departments. For instance, infant clothing should not be selling higher than boys and girls clothing.
• Demand and supply of goods. If you have the exclusive distribution of a hot item, you can usually squeeze out additional margin. If there is a high demand but short supply, and you find there is little price resistance for an item, you can get additional margin there as well.