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Independent Business Owners

Understanding Merchandising Inventory Allowance and Open to Buy "Why suffer Results, When you can Engineer Outcomes"

By Bob Moorman, Senior Business Analyst and Consultant

One of the most confusing elements in merchandising is the Open-to-Buy (OTB) process, meaning "how much money I should be spending". Many buyers today in our industry are very good at controlling their dollars; however, there are also many furniture buyers that really do not have a clear point of view on inventory allowance. Whatever your case, hopefully, you will find some important considerations within this article.

The components that comprise merchandising OTB Systems for a company are:

  • Turn Rate
  • Sales Forecasting
  • Gross Margin
  • Cost of Goods
  • Special Order Percent
  • On Hand
  • On Order
  • GMROI

The actual Open to Buy process, in its purest form, is really the investment strategy you have for your company, or if you are a buyer within a company, then it would be the categories you are responsible for buying. The term, investment strategy, is always one that is not well understood in our industry. Investment strategy means the way in which you select to run your company from a dollar standpoint (TURN RATE), and how much money are you willing to spend in order to get the results you want. When you buy product, you build an inventory to have what the customer wants, when they want to buy it. This is a simple enough thought, or is it?

Let us take an example and say your store is forecasted to do $3,500,000 in annual sales.

  • How much inventory should you have on hand on average?

  • What should your optimum inventory level be set at?

If you are struggling answering these questions, then you have a problem understanding the basic fundamentals of an OTB process.

The first component as mentioned above is turn rate. Until you have ample historical data on which to base a turn rate goal, the buyer should select a turn rate based on coverage. In other words, how many months of supply do I need on hand to make my sales goal for the retail store’s sales.

Most buyers will tell you that turn rate is the number of times I turn my inventory in one year. This is absolutely correct if you are looking at results. What I recommend is that you use turn rate to engineer an outcome. You would do this by selecting the turn rate on which to run your company and then determine the product you are going to stock. There are other considerations, of course, such as vendor lead times and the amount of special order business.

EXAMPLE:

Sales Forecast:     $3,500,000

GM % Goal:          47%

The Cost of Goods is (100% - 47%) the other 53% or $1,855,000

Once this buyer has determined the amount of product they are going to sell at retail, then they can determine how much inventory they should have on hand on average. This is called the optimum inventory level. Special order product does not require inventory backup other than floor samples. Floor samples should not be included in their inventory calculation if they are tied down and not available for sale. However, if they are available for sale now or in the future, then they need to be included in the calculation.

Note, the higher the inventory turn rate, the lower the inventory allowance or months of supply.
 

Turn Rate

Equity %

How much inventory you have bought and paid for totally.

Sales On Hand @ Landed Cost

Months of Supply

2

75%

6

2.5

69%

4.8

3

63%

4

3.5

57%

3.4

4

51%

3

4.5

45%

2.7

5

38%

2.4

5.5

32%

2.2

6

26%

2

6.5

20%

1.8

7

14%

1.7

7.5

8%

1.6

8

0%

1.5

 
For example: the $3,500,000 store has a GM% of 47% and a Cost of Goods of 53% (or the COG = $1,855,000).

A turn rate is selected based on vendor lead times and how many months of sales they wanted on hand at cost.

Selected Turn rate:    3.0     (4 months of sales on hand at cost)

Next, they had to determine an optimum inventory level for their company based on a selected turn rate.

 Inventory Level =    $1,855,000 Cost of Goods

3.0 Turn rate

 Optimum Inventory level is $618,333

One requirement of a buyer or owner is that an inventory “point of view” must be understood. The investment strategy is based on turn rate and must be followed by everyone involved in buying inventory. Inventory pricing formulas and mix determines who you will be in the market. Remember that inventory control is important; however I still never discount the intuitive nature of buyers to develop a new line or exploit an item they believe in. Remember to keep in mind that inventory will always be your fastest depreciating asset.

If you have a grasp on the above concept, it will become easier to understand the month-to-month strategy of running a successful merchandising strategy from a dollar investment.

In the example of the $3,500,000 store above:
 

Sales Forecast: January  February   March     April       May   June   
  $264,000 $321,000 $293,000 $255,000 $400,000 $380,000
Gross Margin %: 47% 47% 47% 47% 47% 47%
             
Cost of Goods $139,1000 $170,130 $155,290 $135,150 $150,000 $140,000

 

(the other 53%)

Selected turn rate:      3.0

Optimal Inventory Level      $ 600,490

 

Minus On hands                    - 525,000

Minus On Orders

(store inventory)                    -   50,000

 Open to Buy                           $  25,490

There are many sophisticated operational systems that are in use; however, they are rarely used effectively. Many things must be taken into account when analyzing an OTB worksheet or Point of Sale system reports. It is not just the numbers we see; it is the other factors, such as the amount of old product ownership you have on hand. If it is not “cleaned” regularly, an overstock situation will be eminent. You still have to buy back your number 1, 2 and 3 (best seller) items, etc. Monitor (GMROI) Gross Margin Return on Investment = Gross Margin $ Annualized divided by Inventory Level. How much money are you making for every dollar you have invested? As a guide, if your GMROI is below $2.00 it could be an indication that your current assortment lineup may not be working. However, if your GMROI goal is, let us say $4.00, then your conclusion may be the same.

If you don’t take your old inventory ownership into account, you will be laying new inventory on top of old. The risk of not measuring or tracking old inventory is that the amount of old inventory could continue to grow unchecked forcing you into higher inventory ownership. The result could be higher inventory ownership without the sales to support a good turn rate; it then becomes even more expensive to operate the company with additional handling and more cash outlay.

Management of inventory and the dollars you use to buy that inventory does require a strategy and considerable energy. Blindly buying what you like without the consideration for turn rate and cleanup of old product (product that has not had an acceptable rate of sale over a specific period of time) is a sure path to future hardship.

The most successful companies in our industry understand turn rate, sales forecasting, and gross margin goals. If you are one of them, great! If not, now is the time to change!

“Why suffer Results, When you can Engineer Outcomes”

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