BY NOW YOU SHOULD have completed a GAP analysis (see INSTORE, February 2008, page 79) that will meet your future wealth and retirement requirements and have calculated your gross profit GAP and sales GAP.
So let’s move ahead:
Step 4: The Inventory Gap
In this step, we are finally ready to answer the big question: “How much inventory do I need to achieve my sales budget?” This figure is also known as the optimum inventory level (OIL).
A good way to think of OIL is: Enough inventory to give your customers the best possible choice, to give you the best possible return on your investment and to allow for sustainable growth.
The objective here is to help you understand and calculate your own OIL. This is a fairly complex but highly important process, so we’ll break into small steps.
The first is to take into account your business circumstances, such as:
- Is your business growing, static or declining?
- Are you intending to include new product ranges in your buying plan to boost certain areas of your business?
- Are you planning to drop certain product lines that no longer fit your business model or market position?
Categories which may show a below average gross margin return on investment (GMROI) but deliver a high return on effort. (We’ll come back to this last bit later.)
Once you’ve 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 ratio ßof 2.0 – meaning $200 of gross profit per annum from every $100 invested in inventory. This should be the basis for calculating your OIL if you are striving for best practice.
However, because most stores achieve 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 $100,000, you should be achieving between $250,000 and $300,000 of retail sales.
Looked at another way, using our example of GAP sales of $1,062,265, the OIL would be between $354,088 ($1,062,265 ÷ 3 = $354,088) and $424,906 ($1,062,265 ÷ 2.5 = $424,906).
$1,062,265 3 $354,088
$1,062,265 2.5 $424,906
GAP SALES BUDGET – 1,062,265
STOCK TO SALE RATIO – 3
OPTIMUM INVENTORY LEVEL – $354,088
GAP SALES BUDGET – 1,062,265
STOCK TO SALE RATIO – 2.5
OPTIMUM INVENTORY LEVEL – $424,906
IMPORTANT: Score less than this, 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 — the lack of sales is.
Action Steps
- Note any changes to your business circumstances as outlined.
- Calculate your OIL as explained.
- Calculate your inventory GAP by comparing your OIL with your current inventory level.
- Based on your inventory GAP, determine if your strategy moving forward will be to increase sales, reduce inventory or both.
Next month, we will explain GMROI and how to calculate your OIL for each product category.