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A Formula To Determine Your Optimum Inventory Level, Part One |  January 04, 2017 (0 comments)

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Omaha, NE--The first thing to understand when it comes to determining your Optimum Inventory Level (OIL) is that it doesn't start with inventory.  There are three other steps required first to ensure your OIL is calculated accurately rather than based on guesswork and hope.

It starts by understanding that your retail business is simply a ‘tool’ to help you achieve your living and wealth needs both now and in the future--what we refer to as the GAP analysis.  The GAP is not an acronym, it is a metaphor do describe the difference--the gap--between where you stand financially now compared to where you need to be.

Only once careful consideration has been given to the first three steps, can you answer the question “how much inventory do I need to achieve my sales budget?”

Also referred to as the ‘Bottom Up’ budget, there are four steps to the ‘Gap’ Process.  These are:

  1. The ‘GAP Analysis’ (see below)
  2. The Gross Profit ‘GAP’
  3. The Sales ‘GAP’
  4. The Inventory ‘GAP’

The ‘GAP Analysis’ also consists of four steps:

  1. Retirement / Exit Planning (including Succession planning)
  2. Personal Exertion – your own market salary
  3. Return on Investment (this is different to GROI)
  4. Other Operating Expenses

I know the idea of basing your sales budget on all of these factors can be a little daunting or downright overwhelming, but it truly is the only way to determine a meaningful OIL. So assuming you at least have a good grasp of what your own ‘GAP Analysis’ would reveal, and based on that, you have been able to calculate your ‘Gross Profit GAP’ and ‘Sales GAP’, we are ready to continuing with Step 4 and to answer the question, “how much inventory do I need to achieve my sales budget;” i.e. your optimum inventory level.

A definition of OIL is: The right amount of inventory to give your customers the best possible choice while giving you the best possible return on your investment without affecting future sustainable sales growth.

The objective here is to help you understand and calculate your own OIL, however because this is a complex and highly important process it will be broken into smaller steps. When calculating your OIL it is important to take into account other business circumstances such as:

  1. Is your business growing, static or declining?
  2. Are you intending to include new product ranges in your ‘buying plan’ to boost certain areas of your business?
  3. Are you planning to drop certain product lines that no longer fit your business model or market position?
  4. Categories which may show a below average gross margin return on investment (GMROI) but deliver a high return on effort (ROE).
  5. What percentage of your total sales volume comes from custom work, special orders and repairs?  Because you don’t need inventory for these income lines.
  6. How quickly can you replace your fast sellers, etc?

A quick word on memo stock: when it comes to inventory management, as distinct to financial management, we don’t care who owns the product, e.g. you, in the case of asset inventory or your vendors, in the case of memo, we only care about the performance of it.  In other words, if it doesn’t sell, it doesn’t matter that someone else owns it, it’s no good and it’s taking the place of something else that could be turning for you.  So expect the same performance from memo as you would from your own asset inventory.

Having taken these factors into account, you are now ready to calculate your OIL, but do so understanding that GMROI is not an exact science but rather a ‘rule of thumb.’ Also, remember that it is difficult to sell what you don’t stock. In other words, investment precedes dividend.  You don’t get interest from your bank until you deposit some money and so it is with retailing.

Arguably, it is possible to achieve a GMROI of 200 i.e. $200 of gross profit per annum from every $100 invested in inventory.  This should therefore be the basis for calculating your OIL if you are striving for ‘best practice’. However, because most stores are achieving well below this, a more realistic ‘Rule of Thumb’ for a growing retail business is that every $1.00 of well chosen, well managed inventory will produce between $2.50 and $3.00 of retail sales per annum (excluding repairs, custom designs and special orders). 

That means, if your inventory level is $400,000, you should be achieving between $1 million and $1.2 million in retail sales.  Looked at another way, if your ‘GAP’ sales budget is $1.5 million and you do 20% of your sales from repairs, custom designs and special orders, your sales of finished product would be $1.2 million and the OIL would be between $400,000 ($1.2m ÷ 3) and $480,000 ($1.2m ÷ 2.5).

      GAP Sales Budget

       Stock to Sales Ratio

       Optimum Inventory Level

           $1,200,000

                     3

                  $400,000

           $1,200,000

                   2.5

                  $480,000

Important: Anything less than this level of performance and you are underperforming, which means you either need to address the lack of sales compared to the inventory you are carrying, or you need to address the excess inventory.  Our preference is that you consider both before deciding on a strategy because often the inventory is not the real problem, a lack of sales is!

Action Steps:

  1. Note any changes to your business circumstances as outlined
  2. Calculate your Optimum Inventory Level (OIL) as explained
  3. Calculate your ‘Inventory GAP’ by comparing your OIL with your current inventory level
  4. Based on your ‘Inventory GAP’ determine if your strategy moving forward will be to increase sales, reduce inventory or both

This concludes Part One of this series. Part Two will continue in an upcoming edition of The Centurion Newsletter. If you need help accomplishing this for your store, please do not hesitate to reach out to The Edge Retail Academy.  877-569-8657, ext. 1, or inquiries@edgeretailacademy.com.

Native New Zealander David Brown has over 15 years experience in consulting, training, and public speaking. In 1996 David began offering his own unique brand of specialized training and management services to retailers throughout Australia and New Zealand where, following an early introduction to the jewelry sector, he bought a half share in a jewelry store in Australia, and increased its sales and net profit threefold in just three years. HIs retail clients now include two of the major Australian jewelry buying groups, a major chain jeweler in Australia, and a New Zealand jewelry group who between them have a combined membership of 430 retail outlets. Brown conducts regular retail seminars, supplying vital industry benchmarking and trend analysis in addition to consulting with a number of the members on an individual basis. He is an expert in the areas of inventory management, sales growth strategies, retail systems and staff management and, with the development of powerful industry- specific software, Brown can business owners with information and strategies to significantly improve sales, profit margins, control, and ultimately peace of mind. He can be reached at (702) 456-4886 or david@edgeretailacademy.com.

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