There are three places where a business can drive profitability: Increasing sales, increasing gross margin, and reducing expenses. In this third installment of our Business Building series, we’re going to dive into the nuts and bolts of margin maximization.
While business owners would always prefer higher gross margins, they often lament that they feel stuck where they are. Let’s examine how a shop can maximize margin to drive profitability. To start, we should review some quick definitions.
Sales is the amount of revenue a shop receives when it sells an item. If a dealer has any returns or credits, these transactions are subtracted from sales to get net sales. For our example, we are assuming net sales.
Cost of Goods Sold is the amount the business owner paid for those items. That cost usually includes freight, handling, and any other procurement fees.
Gross Margin, Gross Profit Margin, or Margin is derived by subtracting the cost of goods sold from sales. The result should be a positive number; otherwise the situation calls for a larger discussion. The difference between sales and cost of goods sold is the gross profit, and that should cover the shop’s operating expenses. Hopefully, there is some additional money remaining once the operating expenses are subtracted. If there is a positive amount left after expenses have been subtracted from cost of goods sold, that amount is pretax profit.
Lots of brands and suppliers talk about the margin that they offer a dealer on a given product, product line, or brand. Determining true margin can be somewhat tricky though as freight may or may not be included in a sales program, and that affects cost of goods sold and margin. Terms may include early pay anticipation discounts, so the shop’s margin will only really be improved if the dealer pays early. Discounts of this nature can be tricky to achieve if the invoice is due well before the store has sold the product. Additionally, while the margin may sound good, the company may be difficult to deal with, and that can indirectly increase the shop’s cost of goods.
So let’s take margin apart a bit.
Terms discounts are offered to a payee that settles an invoice within the date of the agreed upon terms. An example is 2%-10/net 30. The dealer paying on or before the tenth day from the invoice date can apply an additional 2% discount to the invoice. If paying after the tenth day, the discount is not available, and the due date is thirty days after the invoice date. By taking advantage of the terms discount the shop’s overall cost of goods sold will decrease which in turn raises the shop’s margin overall incrementally. It’s clean, easy, and commonly used, as the dealer is rewarded for a timely payment. Keep in mind that the supplier should have the payment either in hand or electronically by the actual date. Terms of this nature are not based on mailed date or the date on the check.
Terms discounts are simple and clear but present the potential pitfall with payment period versus the time it takes to sell the product. If the dealer has some excess cash to pay the invoice to get the discount, the store wins big with a discount and an increased margin. However, if the store has to borrow to pay – which comes with interest charges – and can’t pay within the terms to take the discount, then the store’s cost of goods goes up, and the margin goes down with resulting in reduced profitability. In the worst case, the store pays late which triggers finance charges by the supplier that are booked differently than cost of goods sold. This hammers the dealer’s profit since it’s an expense and reduces profit.
Price discounts are also quite common in sales programs and predicated on the total amount that a shop purchases in the program in dollars or units. Again, the discount in price reduces cost of goods sold and increases margin. The vendor sells more and the dealer gets a bigger discount, which leads to a higher margin.
While price discounts are also clear and simple, the dealer needs to guard against being overzealous with the shop’s commitment so as not to buy more than the store can sell within the seasonal payment terms or the season itself. The best way to guard against over buying is first to choose the store’s assortment, create a sales forecast, and then derive open to buy which gives the shop an actual forecasted cost of goods sold by supplier. The open to buy number determines what the store has available to spend based on the store’s forecast. It is a good guide and can help to keep the store from being blinded by all the new and neat products for the coming model year, forcing a move from “I think that I can sell it” to “what and when.” This specificity is a good discipline to develop.
Some vendors offer rebates based on purchases over a time period, so they are really another “pay for performance” margin opportunity. Over a period of time the dealer can buy at a level that gets the shop a rebate at the end of the period. The rebate could be cash or credit, which, in either case, allows the dealer to book a discount on the items purchased, which then reduces the overall cost of goods sold, and drives the overall margin up.
This approach has its benefits in that the dealer is not potentially loaded with inventory to get the rebate but rather can accrue rebate over time. As items sell and reorders are placed, they can increase the potential discount. The flexibility of this model also allows a dealer to react more quickly to a new product introduction mid-season or to new product introductions that make the dealer’s inventory less desirable or even obsolete.
Freight discounts simply reduce the cost of procurement thereby decreasing cost of goods sold and increasing margin. Those discounts are not reflected in a vendor’s price list. Free or discounted freight is increasingly common in sales programs that have even modest purchase thresholds.
The only place to be wary here is whether or not the free freight offer is at such a level that the dealer is front loaded with more inventory than is appropriate based on the shop’s forecast and open to buy calculations. Free freight is only good if it is at a level that is digestible for the dealer.
Paying cash might be the easiest way to garner a discount or margin increase. It can be in conjunction with a terms discount or a sales volume discount wherein the dealer offers to pay cash (actually by business check or electronic funds transfer) at a certain time to gain the largest possible discount. Suppliers typically are fond of cash deals. They mitigate payment risk while helping the vendor to bridge the gap between the time that they paid their production costs and when their billed sales are received. Dealers with excess cash can see an extraordinary return on an inventory investment wherein a price discount was achieved through an early cash payment.
The potential downside is that paying early to get a discount means that the liquid asset (cash) is now in inventory. That means that the dealer can no longer quickly access it to replace a roof, make a one-time closeout buy, or deal with an urgent cash need situation.
Now that we have examined some of the ways to maximize margin on the purchasing end, it is time to look operationally at maximizing margin on the sales end.
So let’s get back to assortment planning. While it sounds dry and tedious, choosing what the store will stock, promote, and sell is a first critical step to building margin. This is the time when the dealer does a bit of homework on the brand’s availability online and the “street price” for which it is sold. The second part is to ask the vendor hard questions about its sales policies and active enforcement of them. If the dealer sees a much lower online price than the supplier’s MSRP or MAP, the shop has its answer and should avoid that vendor’s products since the ability to make a strong margin is not possible. On a related note, if the shop has a competitor in town that always discounts a product line, then find out whether or not this dealer will continue to buy that product line as the shop’s opening margin is going to be lower with a lower street price.
Once the dealer makes product-line choices, they need a realistic forecast. It should come from how much the dealer believes can realistically be sold based on projected demand, competition, promotional activities, etc. Once the forecast is created, the next step is deriving the open to buy amount, which is simply sales less gross margin for the item’s forecast. And remember that open to buy is not the same as open to pay or a cash flow forecast. Open to buy drives the cash flow forecast.
Finally, the store can turn to how it will price and sell the new items. While many stores simply sell at or near a vendor’s MSRP or MAP pricing, this is a place where the dealer should know if the item should be market priced due to its profile, or priced up due to its scarcity and/or more invisible nature. Scarcity is obvious as it allows one to price more based on limited supply. Invisibility is more reserved for service and small parts. These are the parts that the service customer is simply glad that dealer has or can get. Shops should be wildly profitable on these items.
At this point, the shop should create a plan as to how the new items will be merchandised and promoted both in the store and online. Alluring and creative merchandising will help sell an item at full margin than a sales person trying to convince the consumer that the item is a must.
When a season is in full swing, the savvy retailer should monitor sales weekly to determine performance by item. This approach looks at three categories of inventory: What is moving above its expected velocity and at full margin, what is moving as expected, and what is not moving as predicted. Do a quick assessment to see if the numbers correlate to factors like a lack of staff attentiveness to the item, merchandising, pop up internet pricing that has driven the street price down, or a product that has become obsolete.
The dealer should then look at the projected sales calendar and cash flow to see if the store will stock out before the product’s bill is due. If the item is slow, but there is enough runway in the season to sell out, then make certain to change its reorder status so that the buyer does not inadvertently order more. And make sure the staff gives the item in question a bit more attention to assure full margin sell through.
If, however, the price has changed, it might mean that the dealer has to reduce the shop’s price to be competitive and to assure sell through. Again consider how much is in stock, and whether or not it can be sold more creatively as part of a bundle at a modest discount as opposed to sold individually at a deeper discount. The whole point here is to maximize margin while the selling season is hot.
As time passes, if the item is not selling, then the dealer needs to implement a more aggressive markdown strategy to assure that the product sells through. While discounting the item does not maximize margin, done correctly and thoughtfully, the dealer can preserve and protect remaining margin. Be certain to start this process early enough to ensure the greater probability of sell through in accordance with the supplier’s sales policies.
As the store starts its push to move an item, the dealer should try new merchandising, bundling, placing a bounty on the item to create an incentive for the sales staff, or featuring the item more prominently in the consumer’s shopping path. The likelihood of selling the item faster and at higher margin is greatly increased. A critical mistake that dealers often make is becoming emotionally attached to product. Remember, inventory is not one of the store’s children that should continue to be clothed and fed.
As the season winds down, consider whether or not the item has carryover potential for the next season. Let’s use black cycling shorts as an example: the store does not have to worry about selling out of black shorts, as they are a year-round item. However, pumpkin spice nutritional bars may only be popular in the fall, with the complication of an expiration date to boot.
Lastly, while unpleasant and not optimal, some items simply can’t seem to be sold. In this case, think of three things: finding the right customer for a deal that is hopefully above but possibly at cost, a donation to an event for a cause the shop supports, or selling online to increase the possibility of a sale, but only if permitted by the supplier.