"You know, for several years the business seemed to come so easily and we were growing so fast, I guess we sort of lost track of some of the fundamentals. Sales were up, the company was profitable; we re-invested our cash in more merchandise to keep the business growing. Then when sales leveled off, wham! Where had all the cash gone?"

If you're a small retailer, it's easy to focus on sales, and assume that if you are running increases that everything else will take care of itself. Take care of the customer and he will take care of you. But in the end, the true measure of where a small retailer stands is cash flow.

For small retailers, inventory truly is the coin of the realm. It's not uncommon for 80% to 90% of a their assets to be invested in inventory. This makes small retailers unique from many other small businesses. Holding too much inventory, or the wrong inventory, ties up valuable cash, while not having enough inventory in key items or categories deprives a small retailer of desperately needed gross profit dollars. It's the retail double whammy!

And yet, many small retailers, especially those still in the start-up phase, do not possess well-developed inventory management expertise. They invariably have a passionate commitment to the merchandise they are carrying and a keen understanding of their customer's needs and expectations. They keep a close eye on cash coming in and going out. But too frequently they do not possess the skills and background to manage the largest asset on their balance sheet, their inventory.

Effective inventory management can be defined in its simplest forms as having the right products in the right place at the right time in the right quantities. It combines merchandising, operations, logistics, vendor management, in-depth quantitative analysis and a commitment to detailed planning.

Key Concepts

Here are several key concepts that lead to effective inventory management and inventory productivity:

  1. To manage it, you must measure it. The two basic measures of inventory productivity are inventory turnover and gross margin return on inventory investment (GMROI). While there are no magic bullets when it comes to target inventory turnover or GMROI targets for any given small business, because every small business is unique in its own way, the key is to know where you stand and then to continually challenge yourself to improve your inventory productivity.
  2. Inventory levels need to be directly related to anticipated sales volume. The answer to the question, "How much inventory do I need?" starts with another question, "How much do I expect to sell?" There may be other factors that impact your inventory levels, such as vendor lead times and the quantities necessary for building merchandise displays, but at its most basic, inventory turnover is a measure of the relationship between inventory levels and sales volume.
  3. Think of inventory in terms of time. When I ask a potential client how much inventory they have on hand, most have the dollar value of their inventory right at their fingertips. But few are able to tell me how many weeks or months of sales that represents. If you have $1,000,000 in inventory at retail value on hand and expect to sell $1,000,000 at retail value in the next three months, you are in a far different inventory position than if you only expect to sell $500,000 at retail in that time. Measure your inventory levels in terms of time, "How many months (or weeks) of forward sales do I have on hand?"
  4. Remember the old Fram oil filter commercial? "Pay me now or pay me later." Sales and inventory planning is a lot like that. Detailed sales and inventory planning may seem tedious and time consuming, but when you're running low in a key item and can't get your next shipment in before you run out altogether, you'll wonder why you didn't take the time to plan ahead when it could have made a difference. And when you're taking your clearance markdowns, remember that excessive markdowns are frequently a function of inadequate sales and inventory planning months earlier.
  5. A good retail assortment is a lot like a great sports team, built around several superstars, supported and complemented by highly skilled roll players, who come together to form a whole that is far greater than the sum of its parts. Not every item or category is going to contribute like a superstar, but every item or category must contribute value to the overall assortment in order to generate positive cash flow.
  6. Dead inventory is a problem for most every small retailer at one time or another. When you find you have a build up of dead inventory the key to protecting your profitability is to act quickly, be clear headed in your assessment of what it will take to clear it out, and take your medicine. Typical retail inventories lose between 20% and 50% of their market value per year. Time is of the essence; it will likely require a larger markdown later to sell off the inventory than it will now. Turn it into cash now.

As time goes along, this column will regularly return to the issue of effective inventory management, explore these concepts and focus on specific things small retailers can do to increase the productivity of their inventory and increase cash flow.