SNEWS® Retail Merchandising Training 101: Understanding stock turnover

Last week, we debuted our new 10-part Retail Merchandising Training 101 series by covering the most basic of concepts -- knowing how to determine your gross profit or margin on the sale of an item. Of course, we know that there might be some who imagine that if they can now calculate what money they made on the sale of an item, a brand or a category, or how to predict what money they might make on a sale in the future, school is out. Not so fast!
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Last week, we debuted our new 10-part Retail Merchandising Training 101 series by covering the most basic of concepts -- knowing how to determine your gross profit or margin on the sale of an item (click here to read). Of course, we know that there might be some who imagine that if they can now calculate what money they made on the sale of an item, a brand or a category, or how to predict what money they might make on a sale in the future, school is out. Not so fast!

We wish it were that simple…we really do. In reality, though, most merchandising rules are not fixed, but rather dynamic. As an illustration, let's say you decide you need 36 percentage points of your net sales to just cover your overheads, financing, depreciation etc. Plus, we assume you want to keep a few shekels to grow your business or plan for retirement. So maybe you need 40 points.

It certainly seems simple enough to only buy items that will deliver that gross margin, right? But all products don't do that. Your inventory will likely be delivering all over the map, margin-wise that is. We're guessing you won't abandon categories that consumers expect you to carry simply because they have low margins.

Further, there is another critical question that store owners, managers and buyers need to ask: How many times a year do you make your 40 points?

If, on average, for your entire assortment, you do it once a year, you're probably looking for a new line of work. If you can do it four times a year, the odds of surviving are in your favor.

As long as we are in an illustrating mood, let's imagine that your store is expecting to generate approximately $1million in annual net sales. And, let's also imagine that you know you will need $400,000 to cover operating and financial overheads and to keep a little bottom line at year's end to open that new store or send junior to college.

In a very simple world, you need to buy and then sell $600,000 worth of Gizmos to make ends meet.

If you're lucky enough to have an extra $600,000 available and nothing better to do with it, stock the store and let 'er rip.

But, very, very few of us can afford to have our cash be so inefficient, either because we don't have that kind of a nut or we're paying the bank for the use of its nut -- and dearly, too, we suspect.

Imagine how much smarter you will look with your money if you simply invest $200,000 in Gizmo inventory, sell those Gizmos, turn around and buy $200k more, sell them again, and repeat the process.

It is that process of buying, selling and then restocking inventory that is commonly referred to as stock turn or turnover.

Realistically, it's more complicated than that. We don't know of too many stores that can literally sell-through all their stock, and then begin again next Saturday like the arugula guy at a local farmer's market.

So we need a calculation that captures this moving dynamic.

"Turn" is most commonly (though not exclusively) calculated on a 12-month basis. For simplicity, that's what we'll use here.

Turn can be calculated based on units, cost dollars or retail dollars. For our examples, we'll use cost.

There are many ways to express cost. Typically, retailers capture the amount charged by the vendor, less the cash discounts (those not tied to when the bill is paid), plus the cost of freight to get the goods to the store. Others may also toss in trade discounts (those discounts that are dependent on when a vendor is paid, e.g. 5 percent net 60 days) and shrinkage. You decide. The only rule is to be consistent.

Turn can be calculated on any segment of your inventory array: One style, one brand, one merchandise department, men's, women's, blue stuff or the entire inventory.

For our example, we're going to use the entire inventory. The more detailed analyses will rely upon a computer system.

Calculating stock turnover

The basic formula we will use is: Cost of Goods Sold (for the year) divided by Average Inventory (also based on a 12-month period). You can, of course, also change the formula we are about to use to reflect any time period, be it a quarter, or half a year or even a month.

Once again, all your values need to be consistent. If you prefer working on a cost basis, calculate entirely on a cost basis. If you prefer to work on a retail basis, then calculate entirely on a retail basis. Dividing retail sales by cost inventory will leave you with wacky numbers and the illusion of genius.

With an ongoing business, you do not need to wait until fiscal year end to do this.

First, determine which 12 months you want to analyze. For our exercise, we're going to focus on the calendar year -- January through December.

For Cost of Goods Sold (COGS), you will use your most recent 12-month history of purchased inventory (if you were calculating a quarter or half a year, this history would be either three months or six months). This history is referred to as a "trailing" sales figure. So, for the year, add up the 12 months of figures. January COGS + February COGS + March COGS + April COGS + May COGS + June COGS + July COGS + August COGS + September COGS + October COGS + November COGS + December COGS = Total COGS

For average inventory, add up these 13 figures: The beginning inventory value (BIV) for month #1 (12 months back) and the ending inventory values (EIV) for months 1 through 12. (Remember, you are working in cost, not retail.) Divide by 13. Voilá! Average annual inventory. If you were calculating a quarter, it would be four figures -- BIV for month #1 and then EIV for months 1, 2 and 3. Got it?

So, to return to our formula for the year: Average Annual Inventory = [Jan BIV + (Jan EIV + Feb EIV + March EIV + April EIV + May EIV + June EIV + July EIV + Aug EIV + Sept EIV + Oct EIV + Nov EIV + Dec EIV)] divided by 13.

Divide your annual COGS by your annual average inventory and you get annual turn. So COGS / Average Inventory = Turn.

What's the value of knowing how much inventory turn I achieve?

OK, the next obvious question is, "What's a good turn number? When do I win? How can I get an 'A'?"

There is no fixed number, or mathematical constant we can give you that will guarantee a benefit to your business for every style, category or brand. Overall, for a Specialty Retailer, for your whole store's stock, if you are in the realm of three or four Stock Turns a year, you're doing pretty well. Less than that and the bank is doing better than you are, or you have your trust fund tied up in a slow-performing venture.

Footwear typically turns slower: To sell one pair of boots, you need to stock many styles, many sizes, a few colors and enough widths to fit your customer. A SKU and turn nightmare. Two to three turns a year might be just fine.

On the other hand, accessory turns should be five- or six-plus, since we have so many just-in-time suppliers.

Seasonal categories (skis, down parkas, swimsuits) can look very good compared to 'biners, since half the year you may be completely out of stock, so you'll need another time bracket to evaluate these.

Generally, higher is better, but only to a point. We've heard proud retailers boast of turn rates at eight or 10 turns or higher and our next questions are always, "How often did you run out of stock?" and "How many sales did you miss?" and "How many customers did you let walk out your door empty-handed that won't be coming back?"

Stock-outs can make your turns look great, even as your sales volume circles the proverbial bowl. Don't be misled.

If:

1. You have a good handle on your inventory and reorder frequently and schedule your preseasons often, AND

2. Your supplier can replenish you quickly and completely, AND

3. You can get the goods out of the receiving area and onto the floor right away, then higher turns are a good thing and you can repeat the profit event, over and over again, with the least cash investment in inventory.

Computer entrepreneur Michael Dell was a master of this, with his sub-contractors holding the parts inventory and shipping to the factory daily to assemble and ship to the consumer. Dell's turns were into the hundreds.

OK, so now you know how to accurately calculate gross margin, and you know how to calculate and make your inventory turns work for you, so you're done, right?

Not so fast. Because all things being equal, knowing how many gross margin dollars your inventory investment actually generated to pay for overheads, financing, depreciation and little junior's college fund that really matters. And that's known as gross margin return on investment, gang.

But that's another story best suited for article three in our Retail Merchandising Training Series.

Have a question that is not answered here, or an observation, or even a better way of going about the business of retail merchandising planning than we have offered up? Then the SNEWS® Retail Merchandising Training 101 Forum is for you. Click here to enter a private chat section open only to SNEWS® subscribers.

This article is part of a 10-part Retail Merchandising Training series produced by SNEWS® and authored by Michael Hodgson and Geoff O'Keeffe. SNEWS® president Michael Hodgson, in a former life, was a manager for five years with Adventure 16 and the general manager overseeing a team of buyers and store managers for three years at Western Mountaineering. In those roles, he learned, sometimes the hard way, how to make a living and make a profit (or not) in the world of specialty retail. Geoff O'Keeffe has held retail senior management positions at Granite Stairway Mountaineering, Adventure 16, Patagonia and PlanetOutdoors.com, as well as having served as president of Lowe Alpine Systems USA and Mountainsmith. He is currently the vice president of operations at American Recreation Products, which he is managing to fit in while working on new projects at his home in the mountains above Boulder, Colo., where he is a fourth-generation resident.

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