Retail Inventory Optimization: How Standard Inventory Profitability Measures Can Mislead You
BusinessIf you own a small or medium retail store (or stores), typically 75% of your investment is in inventory. Additionally, with the exception of ancillary services and custom orders, almost all sales revenue and profits are generated from your inventory. Most importantly, excess inventory can suck up all of your cash and force you into insolvency and closing.
Therefore, one of your main goals is to maximize the performance of your inventory.
The industry standard measure of how well you’re doing is called “gross margin return on inventory investment,” or GMROI. GMROI is defined as:
(Sales – Cost of Goods Sold) / Average Inventory Value (at Cost)
GMROI can be calculated for the entire store, for individual items, for departments, and for any arbitrary group of items.
The higher the GMROI, the more money you make for every dollar invested in inventory.
Retail consultants usually give the following advice:
- Calculate the GMROI of your inventory items
- Identify the items with the lowest GMROI and those with the highest GMROI
- Look to replace items with the lowest GMROI, with items more similar to those with the highest GMROI
In principle, the above is very good advice. By focusing on the types of merchandise that generate the most profits, a retailer will be able to improve its cash flow and profits.
So it seems like all you have to do is install a POS and inventory management system that provides that kind of information (a word of warning: except for the very high end, most POS systems DO NOT track inventory average and therefore cannot calculate GMROIs or item-level inventory turns).
In practice, however, the solution is not as easy as the above suggests. This is because the GMROI of an item is greatly affected by the retailer’s own actions. In many cases, to improve GMROI, what the retailer has to do is change their processes, not their merchandise!
Put another way: no matter what you replace an item with, the GMROI will remain low, if the underlying cause of the low GMROI is one of these:
- Excessive inventory of slower moving items
- Buying too large lots at once
- Extreme sales
- Move items to slow-moving display locations
If you have the same average inventory of a slow moving item as a fast moving item, you will naturally have a lower GMROI. For example, we had a customer who always bought more than any item in a department, if his stock was reduced to 3 dozen of the item. For their best-selling products, that represented just one week’s sales. But for the slower moving, it would take more than a month to sell 3 dozen. Naturally, the GMROI of the slower moving items was much lower than the GMROI of the faster selling items. If you can reduce your storage level for a slow moving item, you will increase your GMROI. That’s because your average investment will be less. In general, you don’t have to replace merchandise with a low GMROI, if you can reduce your average inventory without reducing your sales.
You may be buying large quantities of an item because you are getting a volume discount, or because the supplier convinced you to stock it. For example, one of our retailers was tempted by a supplier’s volume discounts. You would buy quantities large enough to reach the discount level of stores much larger than yours. Unfortunately, those orders were so large that it would take more than 6 months to sell. As a result, their cash flow suffered greatly and the GMROI for those items was very low. The good news is that you don’t have to look for replacements for items with this problem. All you need to do is exercise cash flow discipline and order smaller amounts more often. GMROI will increase proportionally and you will find more cash.
You may be using an item as a “loss leader” by pricing it at cost, or even lower. However, the selling season may have been shorter or less pronounced than normal, and you ended up having to offer a drastic clearance sale on seasonal items. Either will cause the items to have a low measured GMROI. Again, the good news is that you don’t have to replace the merchandise. Just ignore the seemingly low GMROI – profitability is actually higher than your calculations indicate. If you are using the article as a loss leader, you should charge the losses to marketing. If you’ve offered a clearance sale on seasonal items, decide to be more conservative next time. The point is: if you manage the price of the item the same way you do the other items, your GMROI will be higher, and you may not have to replace it after all.
In any store, merchandise in some parts of the store moves faster simply because of its location. Island displays, eye-level shelves, the front of the store – merchandise in those areas will outsell merchandise in other areas. If an item is not in those high-traffic areas, expect your sales to be lower than if the item were displayed in the high-traffic areas. That will bring lower GMROI. Replacing those items is not likely to increase your sales, profits, or GMROI. Any replacement item that you place in a low-traffic area will still have lower sales than if it were in high-traffic areas. Unfortunately, the high traffic area of any store is limited. Therefore, you cannot place all of your merchandise in high traffic areas. The solution is to keep less stock of the items you place in low-traffic areas. By reducing average inventory in proportion to lower sales volume, you can free up cash and increase GMROI.
As you can see, there are many reasons why GMROI may be lower for some items than others. You should first try to identify why the GMROI is lower and try ways to display it. Ask how you can make your system calculate the “potential GMROI” of an item, which is what it will be after making all the adjustments suggested above. You should only replace items if your “potential GMROI” is still low.