What Gets Measured Gets Done – Metrics and their Impact on Your Business – Part 2

In my previous article (What Gets Measured Gets Done – Metrics and their Impact on Your Business – Part 1) I talked about the importance of measuring sales performance in a store in order to be able to assess what is working and what is not working and should be improved. In business and specifically in retail, you cannot improve what you cannot measure because how are you going to know if the things you are doing are having any impact on sales and profits if you cannot measure changes in sales and profits? Maybe you can improve profits by reducing expenses. And, maybe, you can improve profitability and sales by improving staff productivity, as we talked about in Part 1 of this series on metrics. Or, maybe it is just selling more to the same customer – more items or higher price product as we also learned previously. What about your inventory? Is there anything that can be done that relates to inventory levels that will help improve performance? How is inventory performing? Is it possible that sales and profitability are low because inventory is not turning as often as it should, or because there is a lot more inventory than is needed to support the sales plan or, is it the opposite: there is not enough inventory and you are therefore losing sales because customers can’t find the size or styles they like?

Both sets of measures, Sales Performance and Inventory (Merchandising) Performance Metrics, are key to running a successful business. Instead of just saying “we need to increase sales” or “we need to cut expenses” and not know how and where to start, through metrics you can now say exactly “how” you are going to achieve your goals of increasing sales and reducing expenses and track if you are really doing it.

The metrics that we are going to examine are the inventory or merchandise performance metrics which are also part of overall Key Performance Indicators (KPIs) and they include Inventory Turnover, Gross Margin Return On Inventory Investment (GMROII) and Stock-to-Sales Ratio.

Inventory Turnover (also called Stock Turn)

In my new book The Complete Idiot’s Guide To Starting & Running A Retail Store (Alpha, April 2008) , I describe inventory turnover as: “…the number of times you are able to sell and replace your inventory in a period of time. This is a number that you should review every six months. In general, the higher the turnover, the stronger your retail business will be. If you achieve a high turnover, you will have less money invested in inventory at any given time and face a lower risk of carrying items that your customer does not want to buy.”

To understand the positive impact of a high turnover, imagine what it would be like to have a store where you had items that as soon as you put them out on the floor they sold right away and you were able to pay your suppliers and business expenses with the money collected from your sales. Wouldn’t this be a profitable model? Is it too good to be true? Well, it is for most retailers, but not for all. Wal-Mart is a good example of a retailer that follows this model with many of its products, for example, its Pampers diapers category. With this item, Wal-Mart is able to achieve an inventory turnover as high as 160 (that means that a Pampers diaper is in the store for about two days!) and also with similar items that are in very high and predictable demand making them extremely profitable to Wal-Mart. Of course, not all products at Wal-Mart sell as well and as fast as these high stock turnover items, but overall Wal-Mart has one the highest inventory turnover rates in retail approaching 9 stock turns this year.

As a specialty retailer, you might have a few items in stock that might turn faster than others (items that your customers need to buy regularly and replace frequently), but the majority of your inventory will not turn as frequently as in the case of Wal-Mart and although your goal will always be to get as close as possible to paying your suppliers with your customers’ money, there are more important reasons why you should strive to achieve high stock turnover rates. “If you achieve a high turnover …you will also get higher sales from the same amount of space, have fresher product in your store, and always be showing something new to tempt your customer.” If you are familiar with the new fashion clothing store chains H&M (Sweden), Forever XXI (US) and Mango (Spain), you should know that they mastered the art of high inventory turnover in order to always have the latest, the newest, and the hottest fashions. Instead of receiving 12 deliveries a year with 24 – 48 items of a style like most clothing retailers, they receive up to 104 and more deliveries per year often with only 6 – 12 items of a style. Their business model is what is known as “Fast Fashion”: buy it now or it’s gone! Their inventory turnover is very high, as high as 16 times, because their goal is to have clothes, shoes and accessories on the floor that are never more than four weeks old and that is how they entice their loyal and eager customer who are looking for something new to visit them as often as possible. How do these chains succeed? Their styles reflect the latest trends and they are mostly copies of top designer styles which attract a lot of young consumers wanting to own ‘hot’ clothes and shoes for less, a LOT less! Also, all their products come from China and other very low cost clothing and shoe manufacturing countries (with the exception of Mango which still has a good portion of its merchandise produced in Spain). And, finally and most importantly their prices are extremely low, as low as $12-$15 for a pair of women shoes (the same style in its branded/designer version could be $300-500).

What if you are a store selling running shoes and apparel for athletes and enthusiasts, could you follow this model? Of course, not! The product you sell, while it must be current and incorporate some fashion elements, must deliver high quality and functionality to your customer and that doesn’t come cheap or as a copy of other brands. However, it’s important that you remember that your customers are exposed to these other stores which strive to fill their windows and shelves with fresh product every day and they come to expect the same of you. The freshness of your inventory is what gets your customers back over and over again and gets them excited. Turning your inventory frequently allows you to do just that.

The price of your merchandise is also a key factor in inventory turnover. If you sell low price merchandise, with a low margin, your inventory turnover had better be high – i.e., you must sell a lot of product because you need volume sales to have a healthy cash flow, pay for your expenses and make a profit. However, if you sell high price and high margin product your inventory turnover is often going to be lower – you will sell less product and you will not need as many sales to cover your expenses and make a profit since your margins are higher.

Does your entire inventory need to be low margin or high margin? No, you will likely have most of your stock in higher price, higher margin, low inventory turn items and the rest will be lower price, lower margin and higher turnover items.

Here is how you calculate inventory turnover:

Net Sales ÷ Average Inventory at Retail Value = Inventory Turnover

$420,000 ÷ $85,000 = 4.94

In this example, your net sales for the year were $420,000 which divided by your average inventory of $85,000 (the sum of your beginning of each month inventory at retail and the end of the last month divided by 13), gave you almost 5 stock turns. Are 5 inventory turns good? Yes, close to spectacular performance for shoes. Also note that the above formula is at retail value. Some systems use the formula of cost of goods sold divided by average inventory at cost. This is not the formula used by retailers and it will tend to inflate the turnover number.

There are 3 levels of inventory performance that I recommend for shoe retailers:

Good Inventory Turnover: 3 turns per year
Better Inventory Turnover: 4 turns per year
Best Inventory Turnover: over 4 turns per year

BETTER NOT!

In your quest for high performance inventory turn, always make sure you do not compromise the high level of service in your store. It is clear that one easy way to achieve high rates of inventory turn is to have limited product in stock. Fewer products may mean less space to display them, less cost to buy them and possibly newer product that can be brought in more frequently. However, you must balance those positives with some negatives if you have too little inventory. For example, how long do you think a customer would continue to shop with you if every time they came to your store you didn’t have their size? Depth of assortment (number of items in that style, color, size, etc.) is as important as breath of assortment (number of styles, colors, etc.) and that is why less (inventory) is not always more (profitable). Remember, shoes are what we call SKU intensive (Stock Keeping Unit – the lowest denominator in describing/buying a product) and this SKU intensity demands that we keep a higher inventory than items that have less SKU intensity. To sell one pair of shoes you often need to have up to 14 or more pairs in stock (at least one of each size), but to sell one pair of socks, often less than 2 SKUs are required. That is the issue of SKU intensity.

Gross Margin Return On Inventory Investment (GMROII)

Let’s go back for a moment to our example of Wal-Mart and Pampers diapers. As soon as Wal-Mart collects the money from its customers from the sale of its diapers, they do not need to pay the supplier for another thirteen days, so they invest the money from the sale in short-term money market accounts, yielding interest income up to the day they need to pay the supplier. A larger percentage of Wal-Mart profits are now coming from the interest they collect on their supplier’s money. Now, as we said earlier, you are not Wal-Mart and the money you collect from customers cannot be easily re-invested because it needs to be used to run your business. But ‘investing’ is what you are actually doing every time you buy inventory and unless you are able to deliver a good return on that investment, you will not be able to survive.

Imagine if a family member gave you $100,000 to invest in stocks. Even without anyone telling you anything, you would know that they would expect you to invest the money wisely and make it grow. Would your family member be happy if after a period of time you handed them the same $100,000 back? I don’t think so. Yes, you may not have lost any of their money, but to give the same $100,000 back that you were originally given to invest was not only a poor return on the investment, but if you factor in inflation, you really lost money.

Think in the same terms when it comes to inventory. If the owner gives you $500,000 to buy product for the store and all you do is generate $500,000 in gross profit, why would anyone invest money that way? If what you make in gross profit equals the amount that you used to buy inventory, then you are in big trouble. You may have made enough to pay for the inventory, but how about expenses? How do you pay the rent, salaries, the light and HVAC bill?

GMROII tells you exactly “How much you are getting back for every dollar you have invested in inventory” . And as with inventory turnover, it is generally calculated over a one year time frame. The higher your GMROII, the ‘smarter’ your investment, i.e., the more profitable you are.

The way you calculate GMROII is the following:

Gross Profit $ ÷ Average Inventory at Cost Value = GMROII

$180,000 ÷ $45,000 = $4

Is a $4 GMROII good? Yes, it is quite good. As we said earlier a GMROII of $1 is not worth the effort, since you are not in business to lose money and your expenses would not be covered at this level. The same is true if your GMROII was $1.50, you could possibly break-even at this level because the fifty cents over your initial investment would likely pay the bills, but breaking even is not what you are in business for. $3 is what you should set as a goal.
The 3 levels of GMROII performance that I recommend for specialty retailers are:

Good GMROII: from $2 to $3
Better GMROII: from $3 to $5
Best GMROII: over $5

Just like when you are investing money in stocks or other financial tools and you need to look at how each investment in your portfolio is performing individually to get rid of the low performers and buy more of the good ones, you will need to calculate GMROII for each of your categories or classifications as well as by vendor (which can be a real eye opener!) and look at each category/vendor individually to take specific actions – i.e., get rid of low performing products, buy from vendors that ship complete and on time, buy more and deeper in best sellers.

BETTER NOT!

Remember that GMROII traditionally only tracks the physical movement of inventory, not the financial. To get a completely accurate picture often you need to factor in your payment terms. If you bought items with 60 or 90 day payment terms, you may need to calculate average cost of inventory from the date when you paid your supplier. However, if you have very few vendors on extended payment terms, then it is often not worth the additional effort to recalculate average cost of inventory.

Stock-to-Sales Ratio

“Your stock-to-sales ratio is a second measure (the other one is inventory turnover) of how well your inventory level matches your sales. As an illustration, if you wanted to ‘turn’ your inventory 12 times a year, your stock-to-sales ratio would need to be 1 to 1. Each month you would stock just the amount of inventory that you were going to sell that month. And if you wanted to turn your inventory 3 times a year, your stock-to-sales ratio would need to be 4 to 1. Each month you would have in stock 4 times the amount of inventory that you were going to sell that month.”1

Ultimately, your goal is to have the level of inventory that you need to support your sales plan. If you have more inventory than you need, you have money invested in product that does not sell and therefore does not generate the return that you need to be profitable. It also gets older and less valuable in the eyes of the customer and you will need to mark it down to get rid of it. And finally, it ties up cash that you will need to bring in newer product for the customer. Conversely, if you have less than you need, you can lose sales and customers.

Generally a lower stock-to-sales ratio is better, because it means that you are not carrying excess inventory. But again, remember the SKU intensity we discussed before, if you have an article that comes in 12 sizes, it is difficult to get that article to a three or four to one stock to sales ratio. Not impossible with smart tailoring of the inventory, but very difficult.

The way you calculate stock-to-sales ratio is as follows:

Beginning of Month Inventory at Retail Price = Stock-to-Sales Ratio
Total Sales for the Month

$800 = 4
$200

Is 4 to 1 a good stock-to-sales ratio? For most specialty retailers it is. The levels of desired stock-to-sales ratio that I recommend for shoe specialty stores and chains are:

Good Stock-to-Sales: from 4.5 to 5
Better Stock-to-Sales: from 3.5 to 4
Best Stock-to-Sales: from 2.5 to 3

BETTER NOT!

Remember that the above are averages for then entire year. There will be some months that you will be significantly above this average and others that will be much lower. While it is normal that stock-to-sales ratio goes up and down throughout the year, it should never be high during your peak sales months. That is when you should be selling a lot of product and your inventory should be at its lowest in relation to sales. So expect a very low stock to sales in peak running season and a very high stock to sales in January or August if they are your lowest sales months.


Jim Dion, founder and president of Chicago-based Dionco Inc., is an internationally known consultant, keynote speaker, trainer, and author of the best-sellers Retail Selling Ain’t Brain Surgery, It’s Twice As Hard, and Start and Run a Retail Business. His newest book The Complete Idiot’s Guide to Starting and Running a Retail Store, is available at http://www.amazon.com or http://www.dionco.com




The Complete Idiot’s Guide To Starting & Running A Retail Store (Alpha, April 2008) available at http://www.dionco.com


Go to http://www.dionco.com to purchase.

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