Measuring Inventory Productivity, Cash Management Article

When I'm meeting with a potential client for the first time, I occasionally tell the story of the best year I ever had as a buyer. It was a year I ran a 2% decrease. Don't get me wrong, I ran plenty of increases over the years, but that was the year I did my best work. I was buying men's woven shirts, and boy, was it a knit shirt year! It was one of those "duck for cover" times, and my 2% decrease could have easily been a 10% or 15% drop instead. If only I'd been the knit shirt buyer!

It's easy to measure success on sales performance alone. It is the top line, after all, that every merchant looks at first on Monday mornings. And it's just as easy to get into the trap of thinking that as long as sales are running ahead that everything else will follow along. And most of the time, profitability and cash flow will follow directly from sales increase, but certainly not always. What happens when sales are off?

For almost every small retailer, inventory is the prime generator of revenue, profits, and cash flow. Inventory typically makes up 70% to 80% of a small retailer's financial assets. So it only follows that sales, profitability, and cash flow are directly linked to a small retailer's ability to manage inventory productively.

The key to any merchant's success is to turn inventory into cash, at the best possible markup, as quickly as you can, then buy more inventory and turn that into cash as quickly as you can, and so on and so forth. Now, that may be stating the obvious, but sometimes stating the obvious helps strips things back to their essentials.

Carrying unneeded inventory can decimate profitability and cash flow in a hurry. Not only does excess inventory tie up a lot of cash, but there are day-in and day-out costs associated with that inventory as well. From the expense of financing that inventory, to the costs of markdowns due to age and obsolescence, to the incremental payroll costs of moving it around, packing it up and putting it away to unpacking it and putting it back out, moving it from one spot to another, to the hidden costs of not being able to merchandise more productive inventory in its place, it all adds up, and hits the bottom line each month, each quarter, each year.

Inventory productivity at its simplest can be defined as the amount of sales and gross profit dollars an inventory investment generates over a given period of time, usually a year. And the most basic measures of inventory productivity are inventory turnover and gross margin return on investment (GMROI).

Inventory Turnover

Inventory turnover answers the most basic of questions; how many times was I able to turn my inventory into cash, buy more, and turn that into cash? It's not enough to know sales volume or inventory levels, it's critical to relate sales to inventory investment. A sales volume of $1,000,000 a year on an average inventory of $500,000 is one thing, but on an average inventory of $200,000 is quite another! It's the difference between turning your inventory over twice and turning it over five times.

The formula for calculating inventory turnover is pretty straight forward:

Sales (at retail value)
Average Inventory Value (at retail value)

Alternatively, if your system only carries inventory value at cost, you can calculate inventory turnover this way:

Cost of Goods Sold
Average Inventory Value (at cos)

Gross Margin Return on Investment (GMROI)

Gross margin return on investment answers the question: How many gross margin dollars did my inventory investment generate to pay for all of my other business expenses, such as payroll, rent, utilities, insurance, and so on?

Gross Margin Dollars
Average Inventory Value (at cost)

Or, stated as a percentage:

Gross Margin %
Average Inventory Value (at cost)

A couple of technical points regarding these formulas:

Both inventory turnover and GMROI are measures of the productivity of on-hand inventory, so the sales made from non on-hand inventory, such as special orders, needs to be excluded from the calculation.
Both inventory turnover and GMROI is stated as an annual turnover. However, the period being measured does not necessarily have to be a 12-month period. In certain situations, particularly for seasonal items, inventory turnover and GMROI may be measured for a period of a few months, with the result being "annualized" for comparison purposes.
Average inventory at cost is usually calculated by averaging the ending inventories for the prior 13 months. This represents the beginning and ending inventory values for the prior 12 months.
Inventory turn and GMROI are dynamic metrics, as sales and inventory levels fluctuate. While they are frequently calculated annually, to fully utilize them as dynamic merchandising tools it is necessary to measure them quarterly or even monthly, on a rolling basis.

And a few additional thoughts on inventory turnover and GMROI:

There is no magic bullet targets as to what your inventory turnover or GMROI should be. Every business is unique. While there may be industry ranges for both inventory turnover and GMROI, every small retailer is unique in their customer bases, merchandise assortments, and vendor structures. The key is to measure your productivity so you know where you are, then strive to improve that productivity.
Once you've measured your productivity to establish a baseline, and developed strategies for improving that productivity, you must remain focused on implementing and executing those strategies. Invariably, small retailers who don't remain focused on improving their inventory productivity usually find their productivity actually backsliding. There's no such thing as standing still. If you don't know that you're moving forward, you're most likely going backwards.
It's not just about reducing inventory, it's also about generating more sales with less inventory. Again, when small retailers focus on improving inventory productivity, they frequently focus on refining assortments and reducing inventories. But a funny thing usually happens in the process. They focus on where their sales and gross margin dollars are really coming from, they make sure they have the right merchandise, at the right prices, in the right places, at the right time, in the right quantities, and their sales increase!!

And a postscript. So, why was the year I ran a 2% decrease my best year ever? First of all, I saw it coming. It was pretty obvious in shopping the market before the season began that it just wasn't going to be a woven shirt year. Secondly, I had the benefit of a management that wasn't focused solely on the top line, they were focused on the bottom line as well. While they would have preferred that I ran an increase, they were more concerned about my department being profitable, and hitting my GMROI target.

So what did I do? Well, with two strikes against you, it doesn't make a lot of sense to swing for the fences. I bought very little up front, tested a number of different items in small quantities, but took few risks. I kept my assortments basic, to appeal to the widest range of customers, knowing that the fashion-forward crowd were headed straight for the knits anyways. I kept my inventories low, and avoided devastating markdowns.

And my GMROI, that most basic measure of retail profitability? My best ever.