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Comparing Turnover and Margin

There is more than one way to profit

Last month, Neighborhood Pet Supply decided they could do a better job of managing the inventory on their shelves by concentrating on the inventory turnover. Mr. Pet Guy explained that by improving the ratio of inventory on hand to sales, there would be less need for inventory to be sitting idly on the shelves. Instead, these dollars could be better spent by investing them in other categories of inventory.

When Neighborhood Pet Supply has annual sales of Chews dog food of $18,600, and a gross profit margin of 53%, the store needs to have enough Chews food so that there is always product on the shelf. However, there does not need to be so much Chews food that the store does not have to reorder more for the next 12 months.

In last month's issue, we found that having inventory of $8,742 provided only a one time turn which is the scenario we just described. However, if Neighborhood Pet Supply had inventory of only $1,457 at cost, and the same annual sales of $18,600, there would be a 6 time turn. There would also be $7,285 available to invest in other profitable merchandise for the store.

What Mr. Pet Guy did not show in the chart were considerations for annual inventory turns of 8, 10, and 12. The reason for this is that by attempting to stretch the inventory turn to numbers such as these, Neighborhood Pet Supply runs the danger of not having any inventory on hand when a customer comes into the store. A second possible problem is shown by attempting to reach these higher inventory turns, there will always be fewer bags of Chews dog food on the shelf. As the store works to achieve these higher inventory turns on Chews as well as all of the other items sold in Neighborhood Pet Supply, the store has an appearance to the customer as being poorly stocked.

The next step in the calculation to maximum profit for Neighborhood Pet Supply is deciding what price to establish for Chews dog food. Mr. Pet Guy illustrates the possibility with this chart as we consider changing the margin on Chews. In the discussion last month, we only examined Chews with a 53% margin. What if Neighborhood Pet Supply decided they could charge more for each bag of Chews? Instead of maintaining a gross profit margin of 53%, we will look at two other possibilities.

With each of the other examples, we still have annual sales of $18,600. This means that to obtain this amount of sales, Neighborhood Pet Supply will need to sell fewer bags of Chews dog food, but at a higher margin. And as the margin increases, so does the annual gross profit dollars. In the chart, the bottom line is shown in bold as this is the scenario we decided was best from the comparisons of last month.

Now Mr. Pet Guy takes the comparison a step further by considering the increased margin. As margin increases, in addition to increasing the annual gross profit, the cost of goods necessary each year to drive the $18,600 in sales will also decrease. While Neighborhood Pet Supply would appear to be pleased with the increased profit and the decrease in required inventory level, we will have to be concerned with what this change in the retail price does to the business.

One concern will be the possibility that this increase in retail price will cause customers to shop elsewhere for a lower price. This concern can best be addressed by Neighborhood Pet Supply taking the time to visit the competition to see what the price is on comparable products. Customers are usually willing to pay a premium for service, information, and convenience. The task is to decided how much of a premium Neighborhood Pet Supply can charge. The only way to determine this amount is by experimenting over a period of time.

The other concern that needs to be addressed is that of losing overall sales because of a poor price image. If the Chews dog food is a price sensitive item, much like a gallon of milk in a grocery store, customers will base their perception of Neighborhood Pet Supply on those items. If they see the store as being high priced on these items, the customers will usually take the bulk of their business to another store, and shop at Neighborhood Pet Supply only when it is very convenient or absolutely necessary. Instead of a store of first choice, the store becomes one of last resort.

Looking again at the chart, as Neighborhood Pet Supply considers changing the gross profit margin from 53% to 55% or 58%, while we see the annualized cost of goods decreasing, and the annualized gross profit increasing (both good signs) we again see our average inventory on hand and annual inventory turns decreasing (both not so good signs).

With the 55% gross profit margin, we see the annual inventory turns slipping from 6 times per year to 4 times per year. And with the 58% gross profit margin, we decrease even further to 3 times per year. Both of these annualized turns are numbers that Mr. Pet Guy showed last month that Neighborhood Pet Supply should try to improve on.

As compared to many situations where there are trade offs, the possibility of having a reasonable turnover, 6 times, and the increased gross profit margin will allow Neighborhood Pet Supply to enjoy the lower inventory on hand and increased annual gross profit. Of course, any or all of these four possibilities can occur only by the store studying the competition as well as the reports that the store generates while tracking the sales of Chews dog food.

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This article is copyrighted by Tom Shay and Profits Plus Solutions, who can be reached at: PO Box 1577, St. Petersburg, Fl. 33731. Phone 727-464-2182. It may be printed for an individual to read, but not duplicated or distributed without expressed written consent of the copyright owner.

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