By David Brown
When it comes to determining your optimum inventory level (OIL), the first thing to keep in mind is it doesn’t start with how much product you have in your showcases. In fact, there are a few things you must ascertain before you can accurately calculate your OIL. More about these shortly.
What do I mean by optimum inventory level? Well, OIL is the right amount of inventory to provide customers the best possible choice, while giving the retailer the maximum return on their investment—without affecting future sustainable sales growth.
Calculating your OIL starts by understanding your retail business is simply a ‘tool’ to help you achieve your living and wealth needs, both now and in the future. This is what I mean when I refer to GAP analysis. GAP is not an acronym; instead, it is a metaphor to describe the difference—the gap—between how you stand financially, compared to where you need to be.
Fall into the gap
Also referred to as the ‘bottom up’ budget, the GAP process comprises the following four steps:
1) GAP analysis (i.e. retirement/exit planning, including succession planning; personal exertion, such as your own market salary; return on investment, which is different from Gross Margin Return on Investment [GMROI]; and other operating expenses);
2) Gross profit GAP;
3) Sales GAP; and
4) Inventory GAP.
Only once careful consideration has been given to the first three steps, can you answer the question, “How much inventory do I need to achieve my sales budget?”
I know the idea of basing your sales budget on all these factors can be a little daunting or even downright overwhelming, but it is truly the only way to determine a meaningful OIL.
Assuming you have a good grasp of what your own GAP analysis would reveal and you have been able to calculate your gross profit GAP and sales GAP based on that, we are ready to continue to the fourth step and answer the question, “How much inventory do I need to achieve my sales budget?” Given this is a complex and highly important process, we will break it down into smaller steps.
When calculating your optimum inventory level, it is important to take into account other business circumstances. Consider the following:
1) Is your business growing, static, or declining?
2) Are you thinking about including new product ranges in your ‘buying plan’ to boost certain areas of your business?
3) Are you planning to drop certain product lines that no longer fit your business model or market position?
4) Do you have categories indicating a below-average GMROI, but deliver a high Return on Effort (ROE)?
5) Since you don’t need inventory for custom work, special orders, scrap gold, and repairs, what percentage of your total sales volume comes from these income streams?
6) How quickly can you replace your fast sellers?
