The Merchandise Budget
We have referred to retail inventory as “the Beast” because it is the biggest number on the retail balance sheet. It is an asset where the retailer invests cash in the hope of earning a margin which, after covering expenses will provide an acceptable net return on investment.
That return on investment depends on the merchant’s control of operating expenses and the gross profit margin realized when each item is sold to the customer. Most retail operating expenses like rent, utilities and wages are predictable.
Inventory however, has many moving parts particularly if the business is influenced by seasonal demand, fashion trends or developments in technology. Snow shovels and winter coats and boots don’t sell in July. Lawn mowers and patio furniture don’t sell in January. Winter merchandise which hasn’t sold by the end of March won’t contribute anything to Gross profit until the snow flies again. In fact, many retailers begin discounting winter merchandise at the end of January in the hope of converting it into cash while there is at least some consumer demand. A warm fall can delay the sale of winter merchandise until November or December, contracting the season when merchandise can be moved at “full margin”.
Unsold seasonal merchandise is not only a drag on gross profit it must be stored during inactive months, to be integrated with new merchandise when the cycle repeats. Every dollar of unsold seasonal merchandise reduces the budget for new merchandise by a similar amount. If this rule is ignored, the result will be an increase in inventory investment which will require additional cash. This is one of the scenarios where inventory becomes the beast, limiting financial options and impairing profits, creating a management migraine for the retailer.
Forecasted sales, planned gross profit margin, the dollar value of existing inventory and the maximum inventory value the business can afford must all be taken into account in planning a merchandise budget.
Consider this example, taken from our downloadable Retail Forecasting Tool: https://1drv.ms/f/s!At3ACJvcVcqPy2J7-PInwHGKFLh0:
We begin the operating year with $120,000. in merchandise on hand, at cost. We are anticipating an increase in sales in the new year totalling $700.000. Based on our estimate realized markup, including sales discounts, we estimate we will require $392,650. in merchandise to generate that sales number. We believe one of the results of increasing sales will be a slight increase in the year end inventory in the amount of $122,000. Adding opening inventory plus estimated cost of sales, less the estimated inventory value at the end of the year results in $394,650. which is called our “Open to Buy” for the year.
Now, we estimate how much of the open-to-buy will be received during each month. To a certain extent, we can direct the supplier when to ship merchandise. At the same time, we must be flexible. It might better suit the supplier to ship early and give us longer payment terms. In the sales estimates in our merchandise budget, we have noted the percentage of total annual sales contributed by each month. We have used this percentage, applied to the total annual open-to-buy to allocate goods received in each month. It’s not perfect but, it’s logical.
Tracking opening inventory plus receipts at cost less cost of goods sold gives us a closing inventory value at the end of each month. Assuming our assumptions are reasonably accurate, we now have a model for inventory levels at the end of each month throughout the year. Assuming your point-of-sale system is maintaining a perpetual inventory, it should be easy to generate a report at the end of the month, showing the value of actual inventory on hand. Comparing this number with the merchandise budget will tell us how well we are managing inventory, relative to plan.
If our sales and cost of sales estimates are correct and we don’t exceed our open-to-buy for the year, we should finish the year with a manageable inventory number. Keep in mind that the year end inventory number is one that will provide enough free cash to operate the business, plus some borrowing if credit is available at reasonable cost.
If the business has a liquidity problem, as long as sales are consistent, the likely culprit is excess inventory. The only way to get the inventory number under control is to buy less or sell more. Excessive inventory can be mitigated by a “blow-out” sale where goods are quickly converted to cash by offering dramatically lowered prices. In doing so, we run the risk of training our customers to wait for the next big sale. The “blow-out” should only be undertaken with careful planning, focusing on slow-moving or obsolete merchandise and preferably held at a location separate from the existing business. The objective is to drive down inventory and generate cash while avoiding harm to the core business.
The best solution to excess inventory is to plan ahead, buy wisely, repeat-order as required and be disciplined. We can’t control the weather or our competition. We can manage risk and reduce our exposure by keeping inventory under control and adhering to our merchandise budget.