Retail Inventory Management: Living with the Beast

A small retail business, generating less than one million in annual sales, faces a number of existential challenges:

  • Competition from other retailers.
  • Competition from online stores.
  • Restless consumers demanding more choice, cutting-edge products and lower prices.
  • Increasing per-square-foot operating costs.
  • Increasingly complex labour legislation and rising payroll costs.
  • Rising cost of borrowing to finance inventory.
  • Losses through inventory shrinkage (a euphemism for theft) or obsolescence.

Survival and prosperity in the retail trade has never been easy.  Apart from cyclical economic factors, a buyer and seller of goods must always have the exact product, in the exact quantity, at the right moment and at the right price to satisfy the consumer, the moment she crosses the threshold. There are many examples of retailers who have been apparently successful over decades, only to falter and fail in the space of a few months.  Of all the possible reasons for retail failure, inventory is by far one of the greatest culprits.

Inventory represents cash – the universal key to profits and prosperity.  Cash tied up in slow-moving inventory represents cash that is not otherwise earning a profit.  Cash tied up in inventory represents funds that must be borrowed to pay rent and wages.  Cash tied up in inventory represents a lack of advertising power which drives sales and moves inventory. 

The two main symptoms of an Inventory crisis are too much inventory or the wrong inventory.  When all of the firm’s liquidity is tied up in inventory, there is a cash flow crisis.  When a large proportion of the inventory is slow-moving or obsolete, sales are lost or mark-downs must be taken.  Either way, the production of cash is anemic.

It is said, and I have never heard it refuted, that 80% of sales are produced by 20% of the inventory.  When we think of the unproductive retail space and the carrying costs of 80% of the retailer’s investment, the consequences are life-threatening.  When the risks are fully understood, the odds of failure should be enough to discourage any would-be retailer.  If you are thinking about staking your life savings or your pension on a post-retirement retail venture, you would be wise to put aside fantasies of that little shop with the bell over the door. 

If your personal investments are earning between 5 and 10 percent annually, you would be best advised to leave your money where it is.  The chances of your bettering the return on investment from a managed fund by launching a retail venture are slim at best.  Don’t assume that retailer on Main Street, who has been there for years, is “doing well”.  Often, we see what we want to see.  The only real test of success in business is a consistent return on investment.  If the business relies on trading goods to generate a profit, the retailer needs to be a highly skilled, well-equipped and well-financed business person.

Fortunately, we do business in an era where technology is increasingly accessible and affordable for the small retailer.  Point-of-sales systems and the analytics they generate give the small retailer insight into what is selling, in what quantities and the gross profit generated by each sale.  The smart retailer still has to do her homework but now, the data is available to make informed inventory management decisions.

In a related series of articles, we’ll talk about four key analytics in managing a sustainable retail enterprise: the Annual Operating Budget, the Sales and Cost of Sales Forecast, the Merchandise Budget and the Cash Flow Forecast.  Of these four elements of retail management, the Cash Flow Forecast is the most critical.  In another article in the Small Business Toolkit, we use the analogy or an aircraft running out of fuel in mid-flight, to describe a cash flow crisis.  In both events, the outcome is not pretty.

For the keen student of retail analytics, we have published an Excel workbook!At3ACJvcVcqPy2J7-PInwHGKFLh0 containing five spreadsheets (look for the tabs at the bottom of the sheet):

Operating Budget: 

Monthly and Annual Sales, Cost of Sales, Operating Costs and Net Profit

Sales and Cost of Sales Forecast: 

Monthly and Annual Estimated Sales, Cost of Sales and Gross Profit

Merchandise Budget:

Monthly Opening inventory, Purchases, Cost of Merchandise Sold and Closing Inventory

Cash Flow Forecast:

Monthly Opening Cash on Hand, Cash Receipts and Disbursements Borrowing or Loan Repayment and closing Cash on Hand

Operating Loan: 

Tracks planned monthly borrowing of funds to bridge normal cyclical cash fluctuations throughout the year, with the objective of reducing the loan to zero at least once in the annual cycle.

These five spreadsheets are linked.  When one variable changes, all related factors change.  When the cost of sales in one category of merchandise is changed, the impact is reflected in Gross Profit, Net Profit, Merchandise Budget, Cash Flow Forecast and Operating Loan.  To illustrate, if the Cost of Sales Percentage increases, more units of merchandise must be purchased to produce forecasted sales.  Purchasing more merchandise increases the Merchandise Budget, increases the demand for cash in the Cash Flow Forecast and may call for borrowing if cash is tight, which affects the Operating Loan balance.

Feel free to download the Retail Forecasting Tool, plug in your own numbers and see how it works.  A tutorial on the Retail Forecasting Tool is located here

Dave Hands


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