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Merchandising Management

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This article discusses Retail Merchandising Management. Generally, if a retail store manager is to be successful, sales and inventory should be reviewed periodically to:

  • See how many units of an item should be stocked and how much space should be given to them

  • Determine what should be done about slow moving items in inventory, and

  • Lay plans for sales, promotions and selection of new merchandise.

Two basic tools of merchandise management, which can help to determine how much of an item should be carried in stock, use gross profit as a basis for the calculations. They are:

  • Gross profit per square foot (or, profit/sq. ft.), and

  • Gross profit on investment (or, profit/investment)

Both of these tools help determine the average inventory which will bring the highest profit for each item. Once you understand them thoroughly, you can use a simpler tool, called stock-turn. When applied properly, it can often replace the more cumbersome calculations.

Gross Profit

Since the two basic tools are built on gross profit, you need a clear view of the meaning of gross profit.

In a retail store, gross profit is the difference between what you pay for merchandise and what you sell it for.

There are two ways of calculating gross profit.

1. The simplest way is to take the selling price and subtract the cost.

Selling Price (-) Cost (=) Gross Profit

2. In a retail store, customers often return merchandise, some of which then has to be sold at less than full price. There are also frequent sales. Accountants and many retailers therefore prefer to calculate gross profit by subtracting the cost of merchandise from net sales. Net sales means total sales (as rung up on the register) less returns. Cost of merchandise, again, is what the store paid for the units which were sold but not returned.

Gross profit can be calculated as shown:

Total Sales (-) Return (-) Cost of Merchandise (=) Gross Profit

Example: Gross Profit

A retailer buys merchandise for $10 and sells that merchandise for $20. If the retailer sells 1,000 units but accepts 100 units in returns, what is her or his gross profit?

Using the formula above, gross profit can be calculated as follows:

$20,000 Total Sales (-) $ 2,000 For 100 Returns (-) $ 9,000 Cost of Net Merchandise Sold

(=) $ 9,000 Gross Profit

The same answer can also be obtained using the simpler formula: Since the gross profit on each unit is $10 ($20 selling price$10 cost), and 900 units were sold (and not returned), the gross profit on the merchandise is ($10 x 900 units) or $9,000 - the same as above. In reality, this second calculation may not be as simple because there may have been a special price sale and therefore a different selling price for some of the units.

Please note that expenses such as rent on your store, utilities, cost of labor, and other operating costs are paid out of gross profit. The amount remaining after such expenses are paid is your net profit. Obviously, the higher your gross profit the higher your net profit will be. This is because most of a retail store's operating expenses are fixed and do not increase significantly with greater sales.

Also note that gross profit is arrived at by using the cost of the specific merchandise which was actually sold - not your purchases for the same period.

Profit Per Square Foot

Profit per square foot provides an indication of how much profit an item of merchandise brings from each square foot of selling space it occupies. It therefore helps to determine how much space should be allocated to each item. Since floor and shelf space in a store is limited, profit/sq. ft. can be used to help you make the best use of your space.

As the term suggests, profit/sq. ft. is calculated by dividing the gross profit of an item by the area of selling space for that item. The formula is shown below:

Profit per Square Foot =

Gross Profit
_________________
Sq. ft. of selling space

Example: Profit per Square Foot

Assume a retailer's business made $4,000 in gross profit last year on a particular line "x". The selling area for the line was 200 square feet of shelf and floor space. What is the profit per square foot on line 'x'?

Using the formula above, the profit per square foot on line "x" can be figured as follows:

Profit per Sq. Ft. =

$4,000 gross profit on line "x"
_______________________________ = $20
200 sq. ft. of selling area for item "x"

Allocation of Space Based on Profit Per Square Foot

To get the highest profit from your available selling space, you must study each of your lines and items to determine which give you the highest, as well as the lowest, profit per square foot. To do this, calculate the profit/sq. ft. on some of your best moving items, and on some you consider least profitable. This will provide you with your profitability range and, using that range you can decide on the amount of gross profit you want each square foot in the store to bring you.

You can then increase overall profitability by taking action on low profit items. This can be done by:

  • Promoting them more effectively

  • Reducing space allotted to them, or

  • Replacing them

If all items, even the poorest, are yielding a sufficiently high profit/sq. ft. but you would like to increase profitability further, you can achieve that by:

  • Increasing promotion and merchandising efforts on items

  • Expanding the store, or

  • Both

This raises the question:

"What is the lowest gross profit/sq. ft. that the poorest items should bring?"

This is not easy to answer. Every retail business has to carry some items which customers expect to find in the store, even if they are not profitable at all. That is why many retailers talk about "loss leaders". These low profit items, some of which may have to be sold at a net loss at certain times, should not be considered in the same manner as regular merchandise.

Every item of regular merchandise must bring a net profit (after all expenses have been paid). To determine what net profit an item or line will bring, you can calculate your expenses per square foot of selling space and subtract them from the gross profit per square foot to obtain the net profit per square foot for that item or line.

Gross profit per square foot (-) expenses per square foot (=) net profit per square foot

Expenses include salaries for employees, rent, insurance, packing materials, cleaning services, interest on loans, utilities, and other similar expenses as well as a fair salary for you. The sum of these costs are referred to as expenses per square foot.

For example, if all your expenses add up to $48,000 per year and you have 4000 square feet of selling space, then your expenses per square foot are $12.00, Any item or line which brings an annual gross profit per square foot (profit/sq. ft.) of less than $12.00 is not bringing you any net profit at all. In fact it is not paying its way and you should either promote it more effectively, or seriously consider replacing it with more profitable merchandise.

ON-THE-JOB ACTIVITY 1

This activity consists of two parts. In Part A you will calculate your costs per square foot and in Part B you will determine your gross and net profits per square foot for several items.

Part A

To gain some direct use in the topics discussed, calculate your expenses per square foot of selling space. This will require you to:

1. Either add up all your expenses from the previous year (or from several months, and calculate the annual costs), or ask your accountant to give you this figure..

2. Measure all your usable selling space where merchandise is kept - the shelves, the floor space underneath racks, the floor space where merchandise is displayed, etc. Do not include storage space in the back room - only space on the selling floor.

3. Divide the square feet of selling space into the annual expenses to give you the expenses per square foot.

Part B

Select several items which you believe bring you a nice profit and two or three which you feel are not very profitable. Calculate both gross profit per square foot and net profit per square foot.

If possible, discuss the results of your work with a person knowledgeable in this area; pursue any ideas which may arise as a result of this discussion.

Gross Profit On Investment

In most cases profit/sq. ft. (gross profit per square foot) is adequate to determine how much space to allow to an item or line. However, there is one group of items or lines where looking at profit/ sq. ft. may not be adequate to decide whether the item or line is profitable. This is the case with relatively small, or average sized merchandise in which cost per unit is much higher than for most other merchandise. For this type of merchandise you also have to look at gross profit per dollar of investment (profit/ investment). This means that for these items you should allocate space as with other items on the basis of profit/sq. ft., but you also must keep your inventory as low as possible to assure best profit/investment.

If all your merchandise is fairly similar in cost per unit, and the units are all of fairly similar size then you do not have to be concerned with profit/investment. If, however, you have some small or average sized items or lines where the cost is high in comparison to your other merchandise, then it may be worthwhile to pay special attention to them.

Gross profit on investment (profit/investment) is the gross profit made on every dollar invested in average inventory of a merchandise item or line. It therefore provides a way of determining how many units to keep in inventory.

Profit/investment is found by dividing the annual gross profit brought by an item, by the dollar amount invested in the average inventory of that item.

Profit / investment =

Gross Profit
_____________________________
$ Investment in average inventory

Investment in average inventory is determined by multiplying the number of units of average inventory, by the cost of a unit. Average inventory is the midpoint between the highest inventory, which occurs right after a new shipment is received, and the lowest inventory, which usually exists just before the new shipment arrives.

Example: Gross Profit on Investment (Profit / Investment)

Assume that a retailer sells $16,000 of a line of desk lamps each year The retailer purchases 100 units about once every 3 months for $20, each, and prices them at $40. If there are usually about 10 lamps left over when the new shipment arrives, then the retailer has $2200 invested in desk lamps, at the peak. When inventory is at its lowest about $200 are invested in these lamps. What is the retailer's annual gross profit and profit/investment? Gross profit can easily be found from the formula:

Total Sales = $16,000

(-) Returns 0

(-) Cost of Merchandise sold and not returned

(100 units x $20/unit x 4 times a year) $8,000

_________

Annual Gross Profit from desk lamps: $8,000

The retailer's investment in average inventory is the midpoint between $2200 (peak period) and $200 (low period). The midpoint is then obtained by adding the high and low figures and dividing by 2. In this example the midpoint is $1200; that is:

$2200 + $200
____________ =
2

$2400
_______ = $1200
2

Average inventory investment in desk lamps = $1200

The profit/investment can then be calculated from the formula, shown before, as follows:

Profit / investment =

$8000 gross profit on lamps
________________________________ = $6.66
$1200 Invested in average inventory

This means that an annual gross profit of $6.66 is made on every dollar invested in average inventory of this line of desk lamps.

Determining Inventory on Basis of Gross Profit on Investment profit / investment

To reiterate, items or merchandise lines which are small or average size and have high cost per unit should be given selling space the same way as other items - based on the profit/sq. ft. However, with this type, inventory must be carefully watched to bring the profit/investment as close as possible to that of other merchandise.

Probably the easiest way to do this is to calculate profit/investment (using the formula shown above) for several of the regular merchandise items; i.e., some with average profit/sq. ft. and some with high profit/sq. ft. This provides you with a range of desirable profit/investment figures.

This range can then become the goal for the high investment (high cost per unit) items. Simple actions to improve profitability of this type of merchandise are:

  • Promote more effectively.

  • Reduce average inventory by buying smaller quantities more frequently (if possible without increasing unit cost).

  • Obtain longer credit terms from the supplier (pay later so your investment is reduced by sales made from the time you received the shipment to the date when you pay for it).

  • If the profit/investment is very poor, replace the item or line with a more profitable one.

To decide when the profit/investment is so low that an item should be replaced you can:

  • Determine whether the money now invested in average inventory of an item elsewhere can be more profitably utilized within your business.

  • Ask your accountant to determine your total expenses (including your salary) per dollar invested in the entire inventory. If you subtract that number from the gross profit on investment (profit/investment) you obtain net profit per dollar investment. This net profit on investment should be at least equal to the cents per dollar you pay your bank for a loan. If it is not, you should seriously consider whether the item or line should be replaced.

ON-THE-JOB ACTIVITY 2

To see how profit/investment can be useful in your business:

a. Select a few items that are small or average sized and have high cost compared to other merchandise in your store. Then calculate the profit on investment for these items, using the formula shown above.

b. Select one or two very profitable items and one or two items of average profit/sq. ft. from the other merchandise. Calculate the profit/investment for these items.

c. Compare profit/investment of the high cost items with the profit/investment you obtain from the other items and, if the difference is very great, calculate the net profit on investment (as discussed above ) for the least profitable of the high cost items.

d. Decide what to do about any low profit/investment items.

Stock-turn.

Stock-turn. refers to the number of times the average inventory of a product has been sold. For example, if a retailer selling ball point pens has a stock-turn. of 5, it simply means that he or she sold 5 times the average inventory of that item over the period. There are two simple formulas for stock-turn.:

Knowing the stock-turn. of inventory allows you to adjust the level of your inventory and assure a desirable profit.

1. Stock-turn. =

Number of units sold
____________________________________ or,
Average number of units carried in stock

2. Stock-turn. =

Dollar sales of item for the period
___________________________________________
Value of average stock of the item (At selling price)

Stock-turn. is usually expressed in terms of an annual figure and can be calculated by completing the formula above.

Note that stock-turn. and profit on investment are similar

Stock-turn. =

Dollar sales of items for the period (net sales)
________________________________________
Value of average inventory (at selling price)

while:

Profit on investment =

Gross profit
______________________________
Value of average inventory (at cost)

Example: Stock-turn.

Assume that a certain retailer who sells $25.00 watches orders monthly about 20 watches ($500). When the shipment arrives, the stock has usually dropped to about 10 watches ($250).

Assume that there are no seasonal fluctuations. What is the stock-turn. on the watches?

Since stock-turn. =

Net sales (annual)
_____________________
Average inventory

Net sales are 20 units x 12 months or 240 units - equivalent to $6000 of sales.

Average inventory is the midpoint between 10 watches (just prior to arrival of shipment) and 30 watches (following shipment arrival) - or 20 watches; they are worth $500 at retail price.

Stock-turn. =

240 watches sold
___________________________ = 12, or
20 watches in average inventory

Stock-turn. =

$6000 net sales
____________________ = 12
$500 average inventory

This simply means that the average inventory of watches has been sold 12 times over the year.

Once you know what profit/sq. ft. you want on your regular merchandise and on your high cost items, then you can calculate the stock-turn. you need for these different types of items. The stock-turn. figure then becomes a shorthand way to decide on quantity to buy and quantity to keep in inventory.

Using Profit/Investment, Profit/Sq. Ft. and Stock-turns

Now that you know how to calculate profit/sq. ft., profit/investment and stock-turn., you can apply them to improve the profitability of your store.

These three concepts each have a useful place.

Gross profit per square foot (profit/sq. ft.) can help you decide how much space to give to an item or merchandise line. If you find the items giving you the best profit/sq. ft. you have a goal to attain in giving space to other items. Furthermore, if you calculate your expenses per square foot, you can also determine which of your lowest profit items are being carried at a loss, thereby allowing you to rectify the situation.

Profit on investment can serve as a check for your high cost items to tell you which are very profitable and which require so high an investment in inventory that you should question whether they are worth carrying.

Stock-turn. is an easy way to decide how much to order, especially of staple items.

Once you have calculated the stock-turns for several profitable items, you can use the stock-turn.

Meir Liraz

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