A common problem with small businesses, especially retailers, is the expense of advertising and its lack of effectiveness. Getting sales can be a viscous circle because one must advertise to bring in business. Yet if the money isn’t there to market the business, how does one get people in the doors? For this article, I will assume you are making enough sales in order to convert that not-so-effective part of your inventory into marketing dollars and faster-moving inventory. Also, since I want you to get the biggest bang out the advertising dollars you generate, I will give you a marketing tip that may forever change how you advertise.
First, businesses have advertising budgets with a finite amount and often they never seem high enough. One of the reasons budgets are restricted is because too much money is tied up in inventory. An often asked question is, “How do we get that money out of inventory so we can put it to efficient use?” To me, the smarter question is, “How do I know which part of my inventory sells better than the other and how do I convert the slower items to cash?”
Most business owners are intimately familiar with their inventory and know which parts of it are old and slow to sell as well as the fast movers. It’s the in-between parts that need scrutinized. To scrutinize with accuracy and power, I suggest the use of GMROI. It stands for “Gross Margin Return On Investment.”
Here’s what it means. For every dollar of inventory you have, how much revenue are you getting back? For example, if you have $1,000 in average inventory for the year that generated $2,004, your GMROI is $2.04. Is $2.04 good? It depends on your niche. Whatever industry you’re in there will be norms. The norms will be your minimum target as you will want to shoot higher than the norms. Plus, the most important thing is that you measure it religiously so you can always make adjustments.
Before you can measure your GMROI you must know how it is calculated. You can calculate your GMROI on a yearly basis or you can calculate a moving average of GMROI. (It’s not as hard as it sounds) The moving average means you forecast your GMROI into the future based off your current sales and inventory. However, if there is seasonality in your business this will be difficult to do accurately. The good news is, you can go back to previous year’s Profit and Loss statements (P & L’s) and calculate your numbers so you won’t have to wait until your fiscal year is finished. This is a good idea to do because it gives you a baseline.
The first thing to figure is your average inventory. CPA’s often like to take your beginning inventory plus your fiscal yearend inventory, add them together and divide by 2. This is acceptable but for more accuracy I prefer adding each month’s inventory to the last month in the period and divide it by 13. Divide by 13 because you’re adding the previous year’s ending inventory to the next 12 months. For easy math, say your monthly inventory was $1,000. Take 13 times $1,000 and divide by 13 and you obviously get $1,000. Save that figure and we’ll get back to it shortly.
The next figure you need to know is your margin. In other words, what was the total gross profit on all your sales. If you have good accounting, your monthly P & L’s will show month-to-date and year-to-date numbers with margins.
Let’s say for this example your margin on sales was $3,000 for the year. The next step is to divide your Gross Margin Dollars by your average inventory value. In this example, that’s $3,000/$1,000. Thus your GMROI is 3. This means for every dollar you had in inventory, it returned to you $3.00.
Now here’s the cool part. We just calculated the GMROI for your entire store. What really matters is the GMROI for your departments. When you can measure departments (and even categories) for GMROI, it’s very easy to spot what items you need to convert to cash and not rerorder. The storewide GMROI is like dipping your toe in the water. Department and Category GMROI’s are like jumping in the pool to see what’s really going on. (Note: When I talk about category, this means these are the units that make up the departments. So a department of tools may have categories such as power tools, saw blades, screwdrivers, and so on)
Assuming you keep good records on your inventory you will find this to be handy. You will find departments that stick out like a giant, glowing and pulsating red dot in a sea of white – it will be that obvious. What’s more, when you compare year end results from one year to the next, you can easily see where you are or are not making progress.
Here are some important considerations you must know while working on this. First, if your business has seasonality to it, it’s difficult to measure GMROI on a moving average because seasonal sales or lack of them can skew your GMROI dramatically. You can’t make good data-driven decisions on skewed information. Thus, stick to doing a yearly one unless you’re super talented at statistics. Second, as you’re figuring your GMROI, your results are totally dependent on your data. If you have inaccurate numbers on inventory and margins, you cannot make a good business decision on GMROI. Your numbers must be accurate – period!
Now you know how to decide how to reduce or eliminate parts of your inventory. Yet, has it occurred to you how to get your GMROI higher? After all, when you get your GMROI higher and higher you have a great business that’s very marketable to interested buyers.
When you consider the formula, which is gross profit dollars and average inventory, then there are two things you can do to drastically improve your GMROI. We already know that lowering your average inventory is one of the keys. What about the gross profit dollars? If we can increase our margins we can also increase our GMROI. If we do both, it’s like we have a double-barrel retail shotgun! Although this article isn’t about increasing your margins, I will say take a close look at your variable pricing and see where you can get higher pricing. Also check if your pricing is too high on items that should obviously be modified. (ie. Do comparison shopping) Generally, the less that an item is a commodity, the more you can raise the price, within reason.
There is much more I would like to tell you about GMROI because it’s so important. I urge you to research and understand as much as you can about it.
Lastly, I promised you a valuable marketing tip and it is this. Advertising can be expensive and is often ineffective. Expensive does NOT equate to effective. In fact, I would argue the opposite is true. I would also argue that if it was expensive yet very effective, then it was actually inexpensive. That said, ask yourself what you can do to bring in customers that’s effective. Focus on effectiveness first. Ask others what they do that works. Hit me up for ideas too. How can you use the options you have and make them more effective (and inexpensive)? What options are you not using that are right under your nose? In future articles, I’ll offer you ideas I’m betting you’ve never used. See what you can come up with while you work diligently on your GMROI to get more money out of your inventory.