A way to turn more profit

How inventory controls can increase your profitability

If the title of this article said we were going to discuss financial ratios, many of you would quickly turn to another page. The majority of businesses demonstrate little interest in this type of information, whether it means discussing gross margin return on investment, asset-turnover ratio, or any number of statistics we can calculate using a financial sheet.

Let me persuade you to take a couple of numbers from your financial sheets and use them to make a few extra bucks. I promise the results will be there.

Grab your pencil and financial sheets. Within a couple of minutes, we are going to make decisions that will fatten your wallet.

For example, let’s use an imaginary business called Ed’s. In looking at Ed’s profit-and-loss statement (also called the income statement) for a 12-month period, there is a line titled “cost of goods sold.” It tells us how much the inventory cost Ed. For those 12 months, that figure is $185,000.

Taking Ed’s balance sheet, we quickly calculate that the average inventory on the shelves at Ed’s for the same 12 months was $58,500.

To determine Ed’s inventory turn, we divide the $185,000 by $58,500 and get an answer of 3.16 turns. What does this tell us? More important, can we make money with this information.

The answer to the first question is, Ed is restocking his business 3.16 times per year. As a typical example, let’s use a product for which Ed pays $22 and sells for $39.99. That means Ed has a gross profit of $17.99.

This situation is repeated 3.16 times each year. The product provides a dollar contribution for the year of $56.85 (3.16 times $17.99)

Common knowledge says that every business could have more profit by increasing the number of turns or the price. We do not know if the price of $39.99 is all that the market will bear, but folks in the grocery business—who operate on much smaller margins—often have turns in excess of 20.

With this in mind, let’s help Ed make more money by looking at ways to increase his turns.

The first possibility is to decrease his quantity on hand. In addition to increasing the turnover, this move will allow Ed to invest the same dollar in other items he can offer his customers. This idea may work if Ed has several of the first product on the shelf. The key is for Ed to make sure that there is always one of the first product on hand when the potential customer comes in the door, but not to stock so many of it that he is tying up his cash.

The second way of increasing Ed’s turns (and profit) is to increase sales. To increase the sales of our example product, Ed can advertise the product, display it in a more prominent location within his store, or lower the price from the current $39.99.

In brief, advertising could bring on additional expenses, while the more prominent display idea simply involves Ed’s time and efforts.

Let’s take a more serious look at the idea of lowering the price. Ed gets 3.16 turns on this product and has a gross profit of $17.99. His markup is 45 percent, and we have already calculated that the dollar contribution for the product is $56.85 per year. Let’s compare this to other items in Ed’s business.

At the front of his business, Ed has a rack of candy bars. Ed buys the candy bars in a box of 48. The best selling candy bar sells for 69 cents, but has a margin of only 11 percent. There is a gross profit of less than 8 cents per candy bar.

Nonetheless, Ed has a high traffic count in his business, and many people buy one or two candy bars each time they visit. Ed is buying a box of candy bars every week. How much do the candy bars contribute to the profitability of the business?

Do the math and you will find that the candy bars contribute $199.68 a year to his profitability, which is 3.51 times what the first product contributes to Ed’s profitability. The nontraditional item makes more money for Ed than the item everyone expects to find in his business.

This same profitability index may be occurring with other fast moving items within Ed’s business. Of course, it would be difficult for a business to perform this type of review on every product sold by the business. But, it is an important approach that leads to extra profits.

Let’s look back to our attempts to increase Ed’s profits with the first product. What if Ed were to decrease the price to $29.99? His gross profit is now $7.99. If, by changing the price, Ed finds a substantial increase in the sales of the product, he may make more money. However, he must now sell eight of the product per year to make as much money as he does selling three of it at $39.99.

Let’s look back to our attempts to increase Ed’s profits with the first product. What if Ed were to decrease the price to $29.99? His gross profit is now $7.99. If, by changing the price, Ed finds a substantial increase in the sales of the product, he may make more money. However, he must now sell eight of the product per year to make as much money as he does selling three of it at $39.99.

The hardest part is determining which price spurs an increase in sales. Perhaps cutting the price only $5 to $34.99, would spur the same increase to eight sales per year. In that case, Ed would almost double his gross profit on the product.

Conversely, if he were to increase the price to $49.99, he would still need to sell two of the product to make as much profit as he does selling three of the item at $39.99. An additional consideration is to determine whether the increase price will cause customers to perceive Ed’s business as being high priced, which could hurt sales overall.
   
The key to maximizing profits—regardless of whether it is a high priced or inexpensive item—is to determine which price generates the best results. You want to determine whether you can hold the price, or even increase the price, and not lose the number of turns. The flip side is to determine how far you must cut a price to clear out stagnant merchandise and free up your shelves and cash for more profitable items.

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