Guest Columnist: Drew White – We thank Drew for sharing with us his insight on perhaps the most improtant factor in profitable merchandising. Drew has helped retailers improve their profitability for over 22 years as a Senior Merchandise Analyst for RMSA and can be contacted at msaguy@fuse.net or 513-470-9550.
Return on investment – ROI – perhaps more accurately ROII, return on inventory investment. If I were to ask 20 merchants to define or calculate it, I would likely get 20 different responses, so this is my attempt to explain it without too much complexity. In fact, the ROI computation is a simple fraction: a ratio; a numerator divided by a denominator. It’s “are you smarter than a fifth grader” math.
What makes ROI valuable as a benchmark calculation is that it’s a distilled or pure representation of “bang for your buck.” It defines how many gross margin dollars you receive in return for every cost dollar you, the merchant, have invested in inventory.
Any merchant knows if they can improve their ROI, they’ll have a more efficient and profitable business. So let’s define it exactly and then see how it can become one of the most important merchandising tools in your tool box.
As stated previously, ROI is a simple fraction. The numerator is gross margin dollars generated. The denominator is average cost inventory dollars owned. So, simply said, it is dollars divided by dollars over a period of time – the time frame is usually a rolling 12 months.
If the numerator can grow while keeping the denominator constant, the ROI calculation will go up. If the numerator remains constant and the denominator decreases, the ROI calculation will go up. If the numerator increases and at the same time the denominator decreases the ROI calculation really explodes – up!
Let’s talk about the numerator: gross margin dollars. All effective retail inventory management software calculates $$GM. In order to improve gross margin, a merchant needs to understand the relationship between two things – the initial mark up (IMU%) as new goods come into inventory and markdowns (MD%) associated with the generation of sales.
Now the denominator: average cost inventory. All effective retail inventory management software calculates turnover. We understand if turnover rates can be improved it’s healthier for the business. If we can own less over time and generate the same sales result, our business is more cash flow efficient.
All effective retail inventory management software calculates ROI in some fashion. Where exactly? At the style level, at the vendor level, at the class level, and at the store/company level. For the sake of brevity, where the calculation is best suited for merchandise decisions is at the class level.
Here’s why.
When the merchant sees immediately across all classes to what degree they are contributing, then a course of action can be rendered and a strategy can be employed. Weaker classes can be targeted – but is it the numerator or the denominator that has the most potential for improvement? Remember in the ROI fraction if the numerator can’t be readily increased due to, let’s say, competitive pressure on initial markup, then emphasis shifts to reducing the denominator.
There are pressures against increasing initial markup in many cases; for example, athletic footwear as an industry enjoys a lower IMU% than other classes. That suggests that turnover is the critical element to ROI imporvement. As the merchant revies the ROI contributions, one may see that a lower IMU class with a fast turnover can contribute as much ROI as a class with much higher IMU but a slower turnover.
So what comes to the surface is a solid strategy of what to target and how to execute. A store may have a broad range of inital markup across its classes, which means every numerator will have a different result. That’s okay. As long as the merchant understands how to improve the denominator, ROI improvement can occur across all classes.
A well-constructed OTB plan will allow the flow of new goods to meet the demands of the selling season, will promote turnover and reduce the impact of markdowns against your gross margin. A well-constructed OTB plan impacts the numerator and the denominator.
What should your ROI be? What’s acceptable? What’s the minimum? Let’s talk about the minimum. ROI has to be greater than 1.00 – remember the fraction, dollars divided by dollars. A dollar back for every dollar invested ins’t good enough! What about expenses? It costs about 40 cents of every sales dollar to cover overhead, so lets add the 0.40 as well. Therefore a good rule of thumb is ROI greater than 1.40 is a healthy contributor to the business.
Here’s your challenge: Find the ROI reports in your report menu. Sort it by department/class. You’ll see where the “bang for your buck” is the loudest. Then do something!
