Business Calcium Blog

Basics of Retail Math (Part 3)


To read Basics of Retail Math (Part 1), please click here.
To read Basics of Retail Math (Part 2), please click here.

How to Increase Your Margin
Obviously, the question here becomes, “How do I increase my margin?” An additional question must be, “How do I increase my margin while still keeping my customers happy and therefore my sales rising?”

Relax. There are several different tactics you can use to help increase your margin while at the same time not changing the customer’s experience in the store.

A. Import Merchandise

It sounds complicated at first glance. However, importing merchandise can take on several different phases as your store grows. You may want to start off small, dealing with an importer using his label on the products. Once you reach a certain volume, however, you may be able to bring in your own private label products at considerably lower cost. In addition to saving money, here are some reasons to look into importing:

1. No middle man. If you are dealing with an importer directly or eventually importing your own products, you have eliminated the wholesaler or distributor from whom you were buying the goods. Thus, you have added their margin to your own.

2. Control. Once you establish a personal relationship with the overseas manufacturer, you may better control the quality, quantity, and timeliness of the merchandise you are buying.

3. Exclusivity. By importing a product featuring your name (and, possibly, your specifications), you can display an item that no competitor carries. That means you can sell it for whatever the market will bear without having to worry too much about what your competitors are doing.

4. Competitive Retail. You can bring in a high quality, private label item to compete effectively with a higher-priced, branded product carried by your competitors. In this way, you may be able to enhance your low price reputation while still maintaining a comfortable margin.

B. Cash Discounts

Vendors are generally forced to extend credit. However, because cash is king to them, they often encourage you to pay before the due date by offering you a cash discount for early payment or a payment in advance of a specific date. Among the more common cash discounts are:

1. 3/10 EOM. A discount of 3% if the invoice is paid within ten days from the end of the month.

2. 2/10 Net 30. A discount of 2% if the invoice is paid within ten days from the date it is issued. Ten is the number of days the rate is available. Thirty is the number of days within which the invoice must be paid.

3. 3/10 ROG. A discount of 3% if the invoice is paid within ten days of receipt of goods.
C. Delivery Terms

Delivery terms indicate when and where the title of the merchandise passes from the seller to the buyer. That is the time and place at which your risk of ownership begins. From that time and place, you own the goods and you pay for insurance and transportation. Therefore, you can save money by delaying the point at which you actually take possession of the merchandise. Two common delivery terms are:

1. FOB Factory. Your store owns the goods as soon as the carrier picks the shipment up at the factory. That means you pay the freight from there.

2. FOB Warehouse or Store. In this case, because the seller owns the goods until they arrive at your location, the seller pays freight, insurance, etc.
D. Dating

Dating extends the time by which you have to pay for merchandise. As the saying goes, “Time is money.” Dating is valuable for two reasons. The first reason is the interest you save on the money that you keep under your control for longer. This value depends on the prevailing rate at which you can borrow money. For instance, if interest rates are 12% per annum (as they were some years ago), then adding an additional month before you have to pay is worth 1% of the money you owe. If interest rates are 6%, that translates into a half percent gain each month. Always ask for additional dating.

The second reason, and often the more determinant one, is that you are likely to find that, like most retailers, you are chronically short of cash. This is not necessarily unhealthy (although it is uncomfortable) because there is a good reason for it.

If your business is growing (as you hope and intend that it will), you need more inventory. Even if your turn is a very impressive six times a year, in the short run you are still putting out more cash than you are collecting—six times a year turn means you have to buy two months of extra inventory to service your growth. Typically, you have to pay for the extra inventory in one month. Of course, you’ll get your money back in time, plus the profit on the extra volume, but you’ll be strapped until then. Dating helps overcome this problem. Fortunately, it also helps your supplier because you can buy, display, and sell more of his merchandise. Dating is always helpful, but there are occasion when you have a particularly strong argument to ask for it. Two such occasions are:

1. Opening a new store. The goods will be sitting in a store with no chance of selling or turning until the store opens, usually for thirty days.

2. Shipping to a warehouse instead of a store. The store loses the turnaround time it takes to get goods out of the warehouse. Goods could sit in a warehouse for thirty days or more before moving to the store.
E. Markdowns

As the name implies, to mark something down means to reduce the original retail price. Markdowns are taken for three rather different sets of reasons:

1. To speed the sale of slow moving products; to clear your inventory of odd sizes, colors, and styles, and to encourage the sale of soiled or damaged goods

2. To maintain price competition with other stores

3. To create the excitement of a special sale (the “happiest” of the three reasons because, while you’ll still lower your margins, you’ll boost your sales)
F. Other Retail Practices Used to Change Prices

Since the price you charge your customers will always affect your bottom line, you can never overestimate or underestimate the importance of price.

Here are some other retail practices sometimes used to change prices:

Additional Mark-Up. As the name implies, this practice changes the price upward. It is mostly used in one of the following occasions:

– A special sale is run at a marked down price, then the price is marked up to its previous level after the sale.

– A vendor increases the price on the next shipment of a certain item. Because the competition will be forced to increase their prices, those items already in your store are marked up.

Mark Up Cancellation. When you introduce a new item into your store, you may initially mark it up in order to establish a high price. Then, once that value is established, you may cancel the additional mark up and reduce the merchandise for a special sale. To some extent, you may be able to use the extra margin you earn when you first bring the item in (and it’s still new and exciting enough to attract customers in spite of its higher price) to help finance the lower margin sale you run subsequently.


Open to Buy

The purpose of an Open to Buy, or OTB, system is to tell you exactly how much merchandise you must purchase to satisfy the amount of inventory you have budgeted for a specified period of time, usually one month.

The simplified way of looking at OTB is:

- Planned end-of-month (EOM) inventory for March $100,000

- Plus planned sales for March +$40,000

- Plus planned Markdowns for March +$ 2,000

- Minus merchandise on order and due to arrive in March –$15,000

- Minus BOM (beginning of month) inventory for March –$90,000

- Open to Buy $37,000

Before you ever commit to buying product, you must have your OTB plan in front of you. That way, you’ll know when you need (and can afford) to buy new merchandise. You may not have the money to bring it in during March, but with your plan in front of you, you’ll be able to see that there is room during the first week of April. Without your OTB plan, you may inadvertently overextend yourself. You may be the best buyer in the world, but if you do not have the money to pay for goods, you won’t last long in retailing.

The only way to stay on top of this crucial facet of the business is to have a plan. The first step in developing this plan is to project your sales by month for the first year. Of course, this is a moving target, so you need to re-project them, or make sure your prior projection is still on target, at the start of every month.

The second step in your planning is to establish the turn of your inventory so you know how much inventory you will need at the start of each month to feed your projected sales. Once you know your sales and turn, you can quickly calculate your OTB to see how much to purchase each month. If, during the year, you are trending up or down in sales, OTB can easily be adjusted to meet those specific needs. Like all of the retail math tools we’re discussing here, look at this OTB as a tool for success, not something that will get in your way.


Retail Method of Inventory, Or Stopping Shrinkage

Shortages, also called shrinkage of inventory or just shrinkage, can cause a store to go out of business. Fast. That is why it is important to have procedures in place to keep track of everything happening in the store, from receipt of goods to final sale. There are two definitions of inventory:

1. Physical inventory. This is the counting of the stock that is actually on hand.

2. Book inventory. This is the record of what should be on hand. To derive the book inventory, begin with the starting inventory (either from store opening or the results of last year’s physical inventory). Add all purchases, all returns that are in saleable condition, and any makegoods the vendor may have provided for substandard merchandise. Subtract all sales and the amount of any markdowns that were below the price you paid for the goods.

Shrinkage, or overage, is the difference between the physical inventory and the book inventory. The only cause for an overage is a booking error that should be avoided by double-checking everything. Some shrinkage is inevitable, and you need to plan for it. It represents the loss of merchandise for reasons that cannot be precisely specified. Those reasons include:

• Vendor mistakes or fraud. Sometime, containers don’t include the full count of goods.

• Employee theft. This includes outright theft for profit (e.g., letting a few cases “fall off the back of a truck”), pilfering merchandise for personal use (taking home a box of detergent), and using store merchandise for legitimate reasons but without paying for it (a store clerk who needs a pencil opens a pack of a dozen and tosses the rest).

• External theft. The most frequent method of external theft is shoplifting. More rarely, theft from your warehouses may occur.

• Clerical mistakes and bookkeeping errors.

• Unrecorded markdowns and allowances. These result in the quantity of product sold for the dollar volume recorded actually being greater than the recorded amount. For example, if you mark down a $10.00 item to $5.00 but fail to note the markdown on your books, selling $100.00 worth of that item will sell twenty items but only show ten as having sold. The missing ten items will show up as inventory shrinkage.

• Unrecorded breakage.


How to Minimize Shrinkage

Some shrinkage may be unavoidable, but a majority of the loss is preventable. Whether the issue is sloppy record-keeping or neighborhood hooligans taking a “five-finger discount,” take the following steps to minimize shortages:

• Record merchandise as soon as it arrives.

• Properly mark, price, and identify merchandise before moving it to the selling floor.

• Record all price changes.

• Record each transaction.

• Change records before transferring goods or returning them to the vendor.

• Take precaution against theft, as discussed in the following sections.

Shrinkage from all causes has become a bigger problem than ever, particularly for first-time retail business owners for whom paperwork can easily become an overwhelming chore. In fact, the problem has become so prevalent that a 2% loss in shrinkage is a standard of the industry today. As discussed earlier, a positive change in the cost of goods has a huge impact on your bottom line. Unfortunately, shrinkage has exactly the same effect—in reverse! In addition to keeping careful records, there are several things you can do to curb shrinkage.

Employee Theft

Your employees should be the last people to steal from you. After all, you’re the one signing their checks! Unfortunately, the opposite is true: most employees steal from their employers.

The incidence of employee theft is high in retailing. Employees have greater access to a wide range of consumer goods that they either desire for themselves or know they can resell on the black market. Moreover, employees often view what they take as trivial and don’t consider it stealing. “So, I ate a muffin without paying for it; I was hungry.”

The office employee’s equivalent is taking home some ballpoint pens and pads of paper. However, trivial or not, these thefts add up, and their financial impact goes way beyond the items stolen because it reduces your store’s productivity, lowers turnover, inhibits hiring, and makes your store less viable.

In addition to casual pilfering, you may well face planned thievery, the willful theft of merchandise, supplies, or cash. Conspiracy with shoplifters or delivery persons is also common.


Shoplifting is a major problem, especially of smaller, easily hidden items in general merchandise retailers, and of expensive items in larger stores. While most shoplifters simply try to slip some easily hidden items into their pockets or bags, some shoplifters are more sophisticated.

To give you some idea of how tricky they can be, one of their favorite tricks works like this: The criminal legally purchases an expensive article of clothing or an electronic device, takes it out of the store,

removes the tags, leaves the item outside, and returns to the store with the tags and the receipt. Back inside, the thief picks out an identical item, takes it to the dressing room or some quiet corner of the store, and removes the tags. Next, he or she takes the item, without the tags, to the return desk, hands it and the receipt and tags from the legitimately purchased item to the harried clerk, and receives a refund. Unless a store security person actually catches the thief removing the tags, it’s hard to prove that the second item is not the first one. Even if each item is numbered sequentially so the serial number on the item does not match the receipt (something the clerk at the return desk is unlikely to notice) it is difficult to use that as proof of a scam when the thief can claim that the serial number was incorrectly recorded on the item. Some thieves even have the gall to go to another store in the same chain and return the first item, claiming they lost the tags. Others sell the items to a fence.

Strengthening Store Security

A secure store is a store that is experiencing less shrinkage than its competitors. Security may be costly, but so is shrinkage. Often the mere appearance of security, to both your customers and your employees, is enough to do the trick. Here are some timely tips for strengthening your store’s security:

1. Equip the store with a security alarm system hooked up to a central service company. Give each employee his or her own code so you can monitor who comes and goes.

2. Use locked trash dumpsters to decrease the risk of merchandise being thrown into the dumpster and retrieved later.

3. Do not permit personnel to park near loading docks or exit doors. A longer walk to stash or transport items can be a real deterrent to employee theft.

4. Strictly enforce inventory control and tracking procedures.

5. Follow up on all references when hiring any new employee.

6. Implement an anonymous tip program that motivates employees to report theft, drug abuse, and other business abuses by both coworkers and outsiders.

7. Keep a close tab on customers who spend a lot of time in your store. The closer you watch, the less likely a shoplifter is to target your store.

8. Place observation cameras at strategic locations. As long as the red lights blink, they can be fake cameras. One fast-food chain I know has three dummy cameras that appear to be hidden but are easily observed by employees when they are peering down at the cash register. They are inexpensive because they don’t work! However, the store also has one real camera that is very well hidden. Employees who decide to raid the cash register naturally turn away from the three cameras they think are observing them, shielding their misdeeds with their bodies.

What they don’t realize is that they have turned directly to face the working, well-hidden camera. They are surprised when, a week or two later, they are laid off without explanation. The company never actually accuses them of stealing; if it did, it would have to reveal the presence of the hidden camera, and then the game would be over.

Parting Words

Knowledge is the key to success. Knowing the numbers before you start your retailing adventure is vital to your success. Certainly there is a lot to learn, but know this: Understanding the basics will help you fine tune the rest and, in the meantime, will keep you alive and well, the latest addition to the thriving retail industry.

To read Basics of Retail Math (Part 1), please click here.
To read Basics of Retail Math (Part 2), please click here.

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