Managing Inventory for Profit: The Big Picture
When asked for the secret of his success, a wise old merchant summed it up in four words: “Buy low, sell high”.
If you do business by buying or selling goods, gross profit margin and return on investment are the keys to success. Obviously, operating expenses must be managed carefully. But, in merchandising, whether it is at the wholesale distribution level or the retail level, profit is made above the line, by smart buying and selling. Smart merchandising requires a thorough grasp of your inventory and an intimate knowledge of your market.
How much should you invest in inventory?
You must know how much of a given product your customers want and when. If demand is cyclical or seasonal, you must plan inventory levels to match the cycle. Inventory should peak when demand is at its highest and shrink to match decline in demand. If you sell seasonal goods, your supplier is faced with the same challenge: to provide sufficient goods for the retailer to meet demand, plus some back-up stock to cover re-orders and be sold out by the end of the season. You must also anticipate the onset and decline of the selling season. You need to have goods on hand early enough to stimulate the interest of the customer, but not so early that you tie up precious inventory dollars long before the customer is ready to buy.
The Merchandising Challenge:
Some inventory items are offered in sizes and colors. A pair of shoes, offered in sizes 8 through 13, in half sizes and widths D and E becomes 22 stock keeping units (SKUs). A shirt, in sizes small (S), Medium (M), large (L) and extra large (XL), offered in three colors becomes 12 SKUs. Now, we must estimate how many of each size and color we will sell, over the cycle of the product, and determine whether re-orders will be available if we sell more than anticipated. If we purchase too many, if the selling season is poor or, if we guess incorrectly on the demand for a particular color, we will be left with stock that must be liquidated.
Our 22 pairs of shoes or our 12 shirts allow for just one unit of each size or colour. When that one item is sold, we’re stock-out. We must either re-order, incurring additional shipping costs or, forego sales because we do not have the appropriate stock. Obviously, we will need to order more of some units, based on experience and a demand curve, bulking up on sizes 9 through 11 in the shoes and sizes medium and large in the shirts.
The Seasonal Issue:
In the declining days of a seasonal business, the merchant begins to think about liquidating remaining stock. Seasonal “fashion” merchandise like the shirts may be out of fashion by the time the next season rolls around. The supplier may be able to fill in the shoe stock for next year’s season but, as our remaining stock sits on the shelves for the next nine months, we must provide space for it, insure it and replace the dollars we have invested so that we can purchase other merchandise.
Our return on investment in inventory depends on the number of items we sold at full price, the number of items we sold at an end-of-season marked-down price and the carrying cost of the units until the last of the original purchase is finally sold. Ideally, the merchandiser buys just enough to sell all units at full price; when they’re gone, they’re gone. In the real world, this rarely happens. This is why we have outlet stores.
The Human Factor:
Success in merchandising can also depend on the personality of the buyer. The enthusiastic buyer will overestimate the demand for a product, ordering in depth, in all available sizes and colours. The same merchandiser may be so emotionally attached to the product that they fail to recognize the magic moment when it’s time to “blow out” the inventory before the seasonal traffic level dies. At that point, regardless of how deep the discounts, there are no buyers.
Every seller needs to be enthusiastic about the quality, value, features and benefits of her products. At the same time, she must be utterly ruthless in dumping a product at the first sign of market weakness. The best merchandisers view a product as a dollar bill that is placed in harm’s way in order to earn a profit. If Product A is not selling, the consumer is sending a message. We need to be able to read the message and move our dollar bills into something the customer really wants.
If demand is relatively steady throughout the cycle, lucky you! If you are also fortunate enough to have suppliers who can deliver product reliably, on short demand, you can plan your inventory levels to match the supply cycle. If your supplier can replenish your stock in five business days, you need only stock enough units to fulfill five days’ sales, plus a little safety stock as a cushion. In this utopian situation, you could roll your inventory over fifty times a year. In this scenario, return on investment is text-book quality. Your investment in inventory is rolling over on a weekly basis. There are no markdowns of excess inventory so prices and margins remain constant. You are able to forecast and manage profit.
In the real world, if business were this simple, there would be a number of competitors looking for the same return. Competition leads to pressure on prices. Price pressure leads to weakened margins. Weakened margins lead to diminished return on inventory investment. If we do not match or beat our competitors’ prices, sales will diminish. Regardless of how good our replenishment cycle is, with reduced sales, it may take weeks or months for our inventory to turn over.
Optimum return on inventory investment depends on managing pricing, dealing with competition, always being able to deliver the product the customer wants and providing first-rate service.
In retail, pricing is an art. The consumer must believe she is getting excellent value for money, based on her standards. If she is shopping for a premium automobile or a piece of fine jewellery, to some extent, as long as she (or he) can afford it, the price is irrelevant. She just doesn’t want to find that her friend bought exactly the same item at a better price. If she is shopping for a loaf of bread, you can bet she knows which supermarket has the best price this weekend.
In between, the retailer’s price point on an individual item will be driven by the cost to place the item in stock, the gross margin he must realize to cover operating expenses and yield a return on investment and competition in the market place. Some items are more sensitive to price competition than others. Some high-profile products do not make profit sense based on the usual metrics but, they are a must-have for the retailer because they drive traffic.
Demand and price competition in these product leaders squeezes margins. Once in the door, however, the customer may be tempted to buy other products that are less price and margin sensitive. If the consumer perceives that she is getting good value from the subject of her visit, she may infer equal price and value in her other purchases.
Ready for more detail?
If some of these points resonated with you, read about some numerical examples that capture the impact on inventory return on investment caused by factors of pricing, inventory mix, gross profit engineering, markdowns and obsolescence.
Inventory Management by the Numbers:
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