Edge Retail Academy Blog

Determining Your Optimum Inventory Level, Part 1

by David Brown

The first thing to understand, when it comes to determining your Optimum Inventory Level (OIL), is that it doesn’t start with inventory. There are three other steps required first to ensure your OIL is calculated accurately, rather than based on guesswork and hope.

It starts with understanding that your retail business is simply a ‘tool’ to help you achieve your living and wealth needs both now and in the future – what we refer to as the GAP analysis. The GAP is not an acronym. It is a metaphor to describe the difference, or gap, between where you stand financially now, compared to where you need to be.

Only after 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?”

Also referred to as the ‘Bottom Up’ budget, there are four steps to the ‘GAP’ Process. These are:

  • The ‘GAP Analysis’ (see below)
  • The Gross Profit ‘GAP’
  • The Sales ‘GAP’
  • The Inventory ‘GAP’

The ‘GAP Analysis’ also consists of four steps:

  • Retirement / Exit Planning (including succession planning)
  • Personal Exertion (your own market salary)
  • Return on Investment (this is different than GROI)
  • Other Operating Expenses

I know the idea of basing your sales budget on all of these factors can be a daunting, even downright overwhelming, but it truly is the only way to determine a meaningful OIL.

So assuming you at least have a good grasp of what your own ‘GAP Analysis’ would reveal – and that based on that information you’ve have been able to calculate your ‘Gross Profit GAP’ and ‘Sales GAP’ – we are ready to continue with Step 4 and answer the question, “how much inventory do I need to achieve my sales budget or optimum inventory level?”

A good definition of OIL is:

 The right amount of inventory to give your customers the best possible choice, while giving you the best possible return on your investment,

without affecting future sustainable sales growth.

 The objective here is to help you understand and calculate your own OIL. However, because this is a complex and highly important process, it will be broken into smaller steps.

When calculating your OIL, it is important to take into account other business circumstances such as:

  1. Is your business growing, static or declining?
  2. Are you intending to include 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. Categories which may show a below average gross margin return on investment (GMROI,) but deliver a high return on effort (ROE).
  5. What percentage of your total sales volume comes from custom work, special orders and repairs? Because you don’t need inventory for these income lines.
  6. How quickly can you replace your fast sellers, etc?

A quick word on Memo stock. When it comes to inventory management, as compared to financial management, we don’t care who owns the product. It could be you (in the case of asset inventory,) or your vendors (in the case of memo.) We only care about the product performance. In other words, if it doesn’t sell, it doesn’t matter that someone else owns it. It’s no good and it’s taking the place of something else that could be turning for you. So expect the same performance from memo as you would from your own asset inventory.

Having taken these factors into account, you are now ready to calculate your OIL- but do so understanding that GMROI is not an exact science but a ‘rule of thumb’.

Also, remember that it is difficult to sell what you don’t stock. In other words, investment precedes dividend. You don’t get interest from your bank until you deposit some money and it’s the same with retailing.

Arguably, it is possible to achieve a GMROI of 200 (i.e. $200 of gross profit per annum from every $100 invested in inventory.) This should therefore be the basis for calculating your OIL if you are striving for ‘best practice’.

However, because most stores are achieving well below this, a more realistic ‘Rule of Thumb’ for a growing retail business is that every $1.00 of well chosen, well managed inventory will produce between $2.50 and $3.00 of retail sales per annum (excluding repairs, custom designs and special orders.)

That means, if your inventory level is $400,000, you should be achieving between $1m and $1.2m in retail sales.

Looked at another way, if your ‘GAP’ sales budget is $1.5m and you do 20% of your sales from repairs, custom designs and special orders, your sales of finished product would be $1.2m and the OIL would be between $400,000 ($1.2m ÷ 3) and $480,000 ($1.2m ÷ 2.5).

     GAP Sales Budget

  Stock to Sales Ratio

         Optimum Inventory Level

    $1,200,000

   3

          $400,000

   $1,200,000

  2.5

         $480,000

Important: Anything less than this level of performance and you are under performing, which means you either need to address the lack of sales compared to the inventory you are carrying, or you need to address the excess inventory. Our preference is that you consider both before deciding on a strategy; because often the inventory is not the real problem – the lack of sales is!

Action Steps:

  1. Note any changes to your business circumstances as outlined
  2. Calculate your Optimum Inventory Level (OIL) as explained
  3. Calculate your ‘Inventory GAP’ by comparing your OIL with your current inventory level
  4. Based on your ‘Inventory GAP,’ determine if your strategy moving forward will be to increase sales, reduce inventory or both

This concludes Part 1 of this series. Stay tuned for the next Monday Market Trends newsletter, which comes out on August 15th, for Part 2.

If you need help accomplishing this for your store, please do not hesitate to reach out to The Edge Retail Academy.

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