This article originally appeared in the August/September 2019 issue of Canadian Music Trade magazine.
By Michael Raine
There are over 7,000 brands represented at the annual NAMM Show, a great number of which are launching new products across every conceivable category. Needless to say, MI dealers have a lot of purchasing decisions to make at the show and throughout the year. So, of course, managing your inventory is essential to your store’s financial success. With this in mind, financial expert Daniel Jobe of Friedman, Kannenberg & Co. and his colleague, Alan Friedman, gave a NAMM U presentation at the 2019 show in Anaheim to help MI retailers avoid purchasing mistakes and better manage their inventory.
Before any inventory purchase, Jobe and Friedman tell their retail clients to ask themselves four basic questions. If the answer to all four is “yes,” then it’s likely a good buying decision. They are:
Can you sell the product? “Yeah, people are only buying gear if they think they can sell it,” says Jobe, “but these buyers are musicians and sometimes musicians fall in love with something that looks cool to them but they can never sell it to anybody else.”
Will I make a profit? “‘Make a profit’ simply means, will I be able to sell it for more than what I can buy it for? Again, it sounds rudimentary, but a lot of people have said, ‘I am buying this to sell it for the same price I bought it for’ and that doesn’t always make the most sense,” offers Jobe.
The answers to questions one and two are usually pretty obvious; questions three and four are typically where the decision becomes a bit more complicated. Those are:
How quickly can I sell it? “This is where the rubber meets the road with this conundrum of: How much inventory should I have? How much can I afford? And how do I try to be a music store that looks like a legit music store without just being bare walls?” says Jobe. “It comes down to time and how quickly you can sell it. If it’s something you can sell in 30 days, then you buy it, in my opinion. If you can sell it in 60 to 90 days, it’s still a good buy. When you start looking over 90 days, you have to look at how much profit you can make off of it versus what your payment terms are.”
How fast do I have to pay for it? “An example is, if it’s a COD vendor that wants cash upfront to even ship you the product, then you want to sell that and recoup your investment of dollars as quickly as possible,” says Jobe. “Versus, if a manufacturer says they’ll give you a 30-day term, 60-day term, or 90-day term, you have bought yourself some time, but you’ve still got to be careful and can’t fall asleep with managing your inventory.”
To help guide the purchasing decision, Jobe and Friedman offer a formula they call “Alan’s Rule of Thumb” for buying inventory. The formula is: buy the product only if you know you can sell it in X days or less, where X is equal to 360 days multiplied by your gross profit percentage (360 days is used instead of 365 only because it offers a nicer rounded number).
Here’s an example from Jobe: Let’s say there is a high-velocity item that you expect to get a modest 10 per cent margin on. So, 360 x 0.10 = 36; therefore, “you need to sell that within 36 days to have what would be considered a good inventory management metric on that particular item,” he explains.
One of the useful things about the formula is it works equally well as a guide for high-margin/low-velocity items as it does for low-margin/high-velocity items. Let’s show one more example. You’re purchasing an item for $600 that you expect to sell for $800. That’s a 25 per cent profit margin. So, 360 x 0.25 = 90. You should be confident the item will sell within 90 days to be an advisable purchase.
“For example, some retailers will go buy 20 of a particular item when they can only sell four in 90 days. That retailer will tell me, “but there was a NAMM Show special for 20 items”; however, you had to look at it and say, ‘OK, but what’s the special and can I really do things to accelerate those selling terms and to maybe sell 12 in 90 days versus just four?’ Or do you say, ‘Look, it’s a great deal but I’ve got to leave it on the shelf because I am not sure I can even sell four and, frankly, if I can sell four, I’ll turn around and buy more if I need to,’” Jobe adds.
Now, what about managing your purchased inventory? Jobe says a well-run store must effectively manage the productivity of its inventory, and there are three simple metrics for doing this.
“The first two are very straightforward. Most retailers will understand them pretty easily, and the cool thing is they both play into number three,” he begins. “Number one is you look at gross profit margin – how much am I selling this for and am I making good profit? Number two is inventory turns, which tells you how fast you’re moving it. You can get your inventory profit margin straight from your income statement. As for inventory turns, you will need both the COGS from your income statement and your inventory investment shown on the balance sheet to compute that ratio. But then there is one last one, which is a combination of your profit and how much inventory you are carrying. It’s called GMROI, which stands for ‘gross margin return on investment.’ Our investment here is our inventory. Simply take your gross profit from number one and you divide that by your average inventory from the balance sheet used in the second calculation and that gives you a percentage.”
So, gross profit is simply the total sales minus the cost of goods. Let’s say there is $1 million in sales and the inventory cost $600,000; that leaves a gross profit of $400,000, or 40 per cent. That’s simple and obvious to all retailers.
Inventory turns means the cost of goods sold divided by the average cost of inventory on-hand. To give a simple example: the cost of goods sold for a year is $500,000 and the store’s average cost of on-hand inventory is $500,000. So, 500,000/500,000 = 1; therefore, the store is turning inventory once a year.
“Most retailers aren’t turning every piece; they’re turning some of the items three times a year and then there are others turning every year-and-a-half or even less,” says Jobe. “A lot of inventory managers ask how often we think you should turn it. Knowing availability of product, most music stores’ goal, in our opinion, should be to try to turn their inventory two to three times per year.”
Now, let’s look at the third inventory management metric: GMROI, or gross margin return on investment. To calculate the GMROI, the gross profit for the year is divided by the average cost of on-hand inventory. For example, the gross profit is $400,000. The average cost of on-hand inventory is $300,000. So, $400,000/$300,000 = $1.33. That means that for every $1 invested in inventory, the store earned $1.33.
“When we get involved with a retail operation, many times they’re running about a 70-cent GMROI. For some retailers, it’s 70 cents and they’re doing great, but this can be because they have low overhead, they’ve been in business for a lot of years, and they’re basically debt-free. The more debt-free you are, the lower your GMROI can be – not should be, can be,” says Jobe. “But, if you have debt obligations or you’ve got big overhead because you’re in a prime retail space or need more people to run your organization, if that GMROI is not running at least a dollar, it’s going to be tight. It is a game of cash flow management and cash flow is going to be tight if you aren’t doing a good job managing your inventory.”
Ideally, Jobe says, they like to see GMROI get up around $1.50. “When people start getting their GMROI around $1.50, that is when they really start experiencing good, consistent cash flow. It’s that moment when the owner says, ‘OK, this really makes sense and we can manage this.’”
“The last thing I always like to say is, keep in mind that you always make better money on the buy because a lot of sales pricing is being dictated by what’s going on in the international marketplace,” Jobe says in closing. “Many times you’re hoping for that lower purchase price to provide some extra profit, but don’t forget that taking advantage of other rebates and shipping programs can put some extra money to the bottom line. Remember, when you invest in inventory you want to get a return on that investment. Squeezing as many profit dollars as you can from that inventory is how you’ll produce the cash flow to drive your business.”
Michael Raine is the Senior Editor of Canadian Music Trade magazine.