You have to make a profit to stay in business. But what do you do with slow moving items? I have a friend in the used car business that marks up his cars when he purchases them, and he holds them on the lot until they sell at his cost plus his predetermined markup. His attitude is that he has to make a profit on each car or he will go out of business. In a way he is absolutely right. However, my friend fails to understand that there needs to be a balance between margins and volume.
As a retailer, you have a great amount of money tied up in inventory. That inventory, sold at a markup, provides the gross profit contribution to the operation of the business. Sales less costs of goods (or cost of the product held in inventory) provides the gross margin contribution, which pays sales, general, administrative, and interest expenses; with the end results being (hopefully) a profit for the accounting period.
Let’s look at our investment in inventory from this perspective – how much money can we make off this investment. The same question we ask ourselves when we evaluate our investments in CD’s, real estate or bonds. Let’s look at the following business with an investment in inventory of $250,000. If that business turns the inventory three times a year at an average markup of 35%, they would make $403,846 in gross profit. However, if the inventory could be turned 25% faster and at a slightly lower overall gross profit margin of 32.5%, the business would realize a gross profit contribution of $464,285. An improvement of $60,439.
I believe that retailers need to have a system to maximize their investment in inventory. It will do one of two things for them: allow them to reduce the amount of money they have tied up in inventory, or allow them to make more money on that investment.
Inventory should be cycled every few months (or weeks) depending on the type of product it is. If an average book is sold in five weeks, the books that have not been sold in ten weeks should be reduced in price, sold to recoup the cost of the product and reinvested into something that is selling. The objective of the business should be to maximize the amount of gross profit earned and not be so concerned with holding gross profit to some artificial percentage of sales. There needs to be a careful balance developed between the two disciplines to maximize the return on the dollars invested in inventory.
