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David Brown: Go Figure

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Part 4 of 5: David Brown helps you calculate return on investment.

 

LET’S RECAP WHAT we have covered in the previous three articles: Step 1 – The GAP Analysis (INSTORE, January); Step 2 – The Gross Profit GAP (February); Step 3 – The Sales GAP (February); Step 4 – The Inventory GAP, Part 1 (March). 

If you are serious about achieving your future wealth and retirement goals then please complete these steps before continuing with Step 4, Part 2. 

Now that you understand how much inventory you need overall, it is time to calculate the inventory requirements in each category. 

In order to understand how this works, you first need to understand Gross Margin Return on Investment (GMROI). 

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GMROI is a formula whereby markup is multiplied by stock turn to give you an indicator of how your store is performing. For example, if your markup is 100 percent 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 year.  

Here’s how GMROI works in other sectors: 

IMPORTANT: The jewelry figures above are typical of what we see when making these sorts of comparisons.  

As you can see, it is the combination of both stock turn and markup that is important. Groceries have by far the best stock turn and jewelry has the best markup but overall, clothing has the best GMROI with $200 of gross profit from every $100 invested in inventory. 

Here’s how GMROI works within a jewelry store: 

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IMPORTANT: 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. 

In real terms, your GMROI is the only way to genuinely compare the performance of one category with another. Often retailers complain about markup and threaten to drop a product line that in reality has a better GMROI than other products with a higher markup.  

So how does this help you calculate the Optimum Inventory Level for an individual category? Well, following our example of GAP sales of $1,062,265, let’s say 10 percent of your sales are coming from diamond rings and you want this to increase to 12 percent. (12 percent of $1,062,265 = $127,472 in diamond ring sales.)

Let’s also say that you intend to increase your markup on diamond rings to 100 percent and achieve a stock turn of 0.8 (meaning you expect them to take on average 15 months to sell). The OIL calculation would look like the chart below: 

So as you can see, in this example you would have $11,125 to invest in diamond rings … but alas there is a little more to it than that because you are already arguably overstocked by $173,450.  

ACTION STEPS

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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 ones you are going to reduce (if any). 

2. Take each category and determine what GMROI you expect (remember this is a combination of your markup and stockturn 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 overstocked in a category, decide whether you will increase your sales budget to match your inventory or reduce your inventory. 

5. If you are under stocked in a category, look at other categories that may be overstocked and work out how you can redeploy the investment where it’s needed. 

6. Before rushing out and buying blindly, think carefully about the price points and margin you want to achieve, the image you want to create and the vendors you want to partner.

Next we will explain how to break your annual budgets into monthly targets so you can measure, monitor and modify your results and strategies. 
Congratulations on successfully completing Step 4, Part 2.

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