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Determining Your Optimum Inventory Level To Boost Return On InvestmentBy David Brown, Edge Retail Academy |  January 18, 2017 (0 comments)

This is the second of a two-part series. To read Part One, click here.

Omaha, NE—In Part One of this series, we talked about The GAP Analysis, calculating your Optimum Inventory Level (OIL), Memo Stock and your Action Plan. To start Part Two of this series, I will next explain GMROI and how to calculate your OIL for each product category so you make the most of your sales.

Now that you understand how much inventory you need overall, i.e. across all categories, it is time to calculate the inventory requirements in each category. In order to understand how this works, you first need to understand GMROI (gross margin return on inventory). GMROI is a formula whereby Mark-up multiplied by Stock-turn equals GMROI.  For example, if your mark-up is 100% (which is a 50% gross margin) and your stock-turn is 0.8 then your GMROI is 80 (100 x 0.8). What this means in real terms is that for every $100 you have invested in inventory you are generating $80 of gross profit per annum. 

Here are some examples of how GMROI works in other retail sectors:

Retail Sector	Stock-turn	x	Mark-up %	=	GMROI
Music	5	x	30	=	150
Clothing	2	x	100	=	200
Groceries	12	x	14	=	168
Jewelry	1	x	110	=	110

 

Important: I am not recommending the Jewelry figures above. They are, however. typical of what we see when making these sorts of comparisons.

As you can see, it is the combination of both stock-turn and mark-up that is important.  Groceries have by far the best stock-turn and Jewelry has the best mark-up, but overall, Clothing has the best GROI with $200 of gross profit from every $100 invested in inventory. Here’s how GMROI works within a jewelry store:

Category	Stock-turn	x	Mark-up %	=	GMROI
Diamond Rings	0.5	x	90	=	45
Gold Chain	0.7	x	145	=	105
Watches	1.4	x	70	=	97
Silver Jewelry	1.1	x	150	=	165

Important: Again, these are not recommended figures, nor are we suggesting you throw out your diamond rings and replace them with silver because we also need to consider your Return on Effort (ROE).

So in practical terms, your GMROI is the only way to genuinely compare the performance of one category with another.  We often hear retailers complaining about mark-up and threatening to drop a product line that in reality has a better GMROI than other products with a higher mark-up.

So how does this help you calculate the OIL for an individual category? Well, following our example of ‘GAP’ Sales of $1.2m, let’s say 10% of your sales are currently coming from Diamond Rings and you want this to increase to 12% this year.  12% of $1.2m equals $144,000 of diamond ring sales. 

Let’s also say that you intend to increase your mark-up on Diamond Rings to 100% and achieve a stock-turn of 0.8 (meaning on average you expect them to take 15 months to sell).  The OIL calculation would look like this.  (Please note we can quickly, easily and affordably help you set up a Sales and Inventory Plan if required.)

Optimum Inventory	All Categories	Diamond Rings
Sales Budget (based on 12% of total)	$1.2m	$144,000
Budgeted Mark-up %	112%	100%
Budgeted Gross Profit (GP)	$633,963	$72,000
Budgeted Cost of Sales (COS) (Sales less GP)	$566,037	$72,000
Budgeted Stock-turn	1.2	0.8
Budgeted Inventory (COS ÷ by Stock-turn)	$471,698	$90,000
Current Inventory	$591,000	$77,000

So as you can see, in this example you would have $13,000 to invest in diamond rings.  But there is a little more to it because you are already arguably over stocked by $119,302 overall. But remember, another way to look at that is that you have enough inventory to do almost $1.8m in sales. I’d prefer to see you grow into your sales potential rather than shrink your inventory and therefore restrict future growth.  

Action Steps:

1. Decide what your business is going to look like in the next 12 months. For example, decide which categories you are going to build and which—if any--you want to reduce.
2. Take each category and determine what GMROI you expect (remember this is a combination of your mark-up and stock-turn in each category)
3. Using these figures, calculate your Optimum Inventory Level (OIL) in each Category.  Important: Do one at a time and start with the categories that can make the greatest amount of difference in the shortest amount of time.
4. If you are already over stocked in a category, decide whether you will increase your sales budget to match your inventory or reduce your inventory in that category.
5. If you are understocked in a category, look at othercategories that may be overstocked and work out how you can redeploy the investment where it’s needed.
6. Before buying, think about the price points and margin you want to achieve, the image you want to create, and the vendors you want to partner, and buy what checks off those goals.

This concludes the 2-part series of Determining your Optimum Inventory Level.  If you need help accomplishing any of these concepts for your store, please do not hesitate to reach out to The Edge Retail Academy.  877-569-8657, ext. 1  or  inquiries@edgeretailacademy.com