Introduction to effective inventory management & price structuring

An introduction to the core principles of inventory management and price structuring in a retail setting. These principles are applicable to a broad range of community food enterprises and can help run
cost-effective operations.

This resource was created by Lydia Mofakhami, one of the Open Food Network Regional Food Activators. Lydia has a strong knowledge base of inventory management within a commercial & retail setting and now works closely with the Baw Baw Food Hub while managing a farm with her family in the Gippsland region.

What is inventory management?

In a nutshell, inventory management is the process of controlling a product or produce mix to maximise return on minimal investment.
Stock levels can be maintained or adjusted to support projected sales by controlling the product range, margin mix, product quantities & distribution (including delivery timing).
Fresh produce inventory management includes forecasting with seasonal parameters to plan timing of planting, picking, packing and storing as these directly relate to product quality and availability for market.

1. Cost markup (%) vs retail margin (%) of sales

The difference between cost markup (%) versus retail profit margin (%) in sales can provide visible and useful information when creating strategies, planning and adjusting to ensure the running costs and outgoings involved in running a food enterprise are covered.

Scenario of cost markup (%) versus profit surplus/margin (%) in retail:

Product: Biscuits

Biscuits cost price = $6.00

Apply Cost markup of 30% = $1.80

Retail Sell price calculated as $6.00 + $1.80 = $7.80

The retail profit margin % is usually the difference between the cost and retail (after GST) with this margin expressed as a percentage of the retail price. The biscuits has a retail margin of 23%. This retail margin percentage, when cumulatively used across a product category (i.e. dairy, veg, fruit), can be easily applied for a quick estimate of income being generated by those items.

Cost markup is the % amount of a cost price which is added on to reach the retail price as shown in the above example, which in this case was 30% of that cost.

Why is the different between cost mark up (%) and retail margin important?

  • GST, produce discounts and any other price reductions are applied to the retail price without any reference to, or impact on, the original cost price.
  • When completing the mark up % at cost price, you need to take into account any instances that will affect the retail sell price (member discounts, wholesale discounts, re-packaging/labelling/handling bulk goods into smaller amount)
  • Freight is another separate cost that could be allowed for in a product cost markup %, if the individual product cost does not include this charge.

The biscuits example has a $1.80 retail surplus, which is 23% of the $7.80 retail. This gives us a 23% profit margin or surplus of that retail price, even though the cost mark up was 30% of the original cost.

This difference between initial markup from cost and final margin percentage of sales is important to be able to quickly assess and gauge cash flow on variable product category retail sales, and to be able to respond to and to address emerging issues in a product category mix.

The initial cost markup is a great deal more than the amount of surplus that will be available after any discounts , wastage, or overall running costs are applied at retail value sales.  This needs to be considered carefully when establishing what markup % will be used in a product category , and when planning and forecasting sales income generated by these categories.

If the product is taxable and has GST applied, the GST amount must be taken off before calculating the profit margin % of the GST adjusted retail:

Therefore the biscuits retail of $7.80 less 10% GST is $7.02, is now leaving only $1.02 as a profit surplus, which is only a 14.5% margin at retail, despite the initial 30% markup on cost.

Unsure if a food product has GST? Check the ATO GST food and beverage search tool

Tight surpluses will make it extremely challenging to cover running costs, unless the business can generate a much higher volume of sales to compensate for the smaller surplus percentage.

This can work as long as sales do not drop below the minimum higher volume needed to deliver enough surplus to pay those costs. This is only a sustainable strategy as long as the business has committed to a plan to ensure the higher sales volume is delivered; it is a risk to resilient trading if this low margin higher volume sales plan is not supported by bench-marked strategic sales volume planning to deliver the minimum needed increased sales result.

From a strategic planning perspective, a resilient business should generate enough cash-flow not only to cover costs and outgoings, but also for trading capital to re-invest in produce purchases. Where the business cannot generate cash flow for produce purchasing, reassess trading terms to allow sales to occur before invoice payment if possible, and a financing charge for potential extra funds, if needed, could be built in to overall planned trading costs.

Ideally a business should be able to plan and forecast sales and purchasing needs by product category (drawing from recent and historical category sales indicating potential trends), develop a purchasing budget in line with these sales to guide the strategic investment, and be able to estimate profit outcomes from this particular combination of surplus/margin income mix .

2.) Low margin with high volume sales planned to cover costs as a % of sales

Strategically increasing lower margin categories or items must have clear ongoing planning and adjustment to allow visibility for how and where the minimum income to cover costs lost in the strategic lower margin sales will be recovered .

This planning is what will allow strategy to be adjusted and implemented according to needs.

Scenario: a brick and mortar shopfront needs to cover rent, wages, freight and bills totalling $2500 per week.

A plan on how to achieve this on a weekly, monthly or annual basis is devised with the below possible outcomes:

   $ Sales Surplus % of retail sales (not markup at cost)  $ Surplus achieved
$10000 22% $2200
$11500 22% $2530
$17000 15% $2550
$20850 12% $2502

A decision to stay at lower margin of 15% in the above scenario plan would mean committing to achieving a minimum $17000 sales to pay running costs, while a higher average margin of 22% will still deliver similar profit from the lower sales of $11500 (if structured carefully to maintain value and competitiveness without impacting on sales volume).

This overall percentage is an average across the business, and will be the outcome of the mix and proportions of margins chosen by the business across all its produce categories.

Where sales for the chosen strategy are underachieved, an action plan can be implemented with adjusted forecasting and monitoring.

3.) Margin mix planning and structuring to cover costs

Strategic margins
Some product categories are set with a strategically low margin. Why? Some businesses do this to gain customers’ trust in the retailers value, and if the item is important enough it can be the initial reason a customer chooses to purchase from that retailer. The supermarket duopoly milk price war is an example of this and knowing that by strategically setting staple food items at a competitive price, they will probably get profit from the rest of the shopping trolley instead.

Other similar sales volume product categories could be selected to compensate for the turnover/sales at that lower percentage by having higher margins in equivalent volume to lift the average income overall back to the minimum needed to pay costs.

For example, $3000 sales of bread at 15 % of retail sales margin will deliver a $450 surplus to cost whereas $3000 snacks at retail surplus of 30% will deliver a $900 surplus to cost.

This higher margin product group can then cover its own minimum income as well as the extra for the shortfall in the strategically low margin group, in order to achieve the funding for minimum running costs.

Unbalanced product margin mix
When a product margin mix is unbalanced, or only lower margin volume produce is selling, there will be extreme pressure covering operating costs from those lower margin sales if they are not adequately compensated for. It is critical when planning strategic low margin items, that an equivalent category margin is planned to manage and off set this for base resilience, or that a strategy is implemented to build and achieve the minimum sales volume increase in a timely manner.

4.) What to do in times of slow trading & opportunities in volume sellers

Review and monitor produce margin mix regularly (this does not mean an increase on all prices!) by:

  • Carefully reviewing opportunities
  • Completing cost price check
  • (if needed) Action adjustments by starting with top volume selling lines for each category. These items, due to the nature of their volume sales, will have the biggest impact on a business if they are low or high margin or priced incorrectly.

Top volume selling items:
The top volume items per category are most critical for volume and sales, as they are the fastest contributors to either poor or strong margin impact due to their high turnover. These items may also be able to tolerate small (even just 25c or 50c) adjustments that will help relieve the profit or income pressure during slow trade times, faster than large adjustment on slower trading lines (as long as sales volumes and competitive value are not impacted by these adjustments.)

Top volume item products in key categories need reliable stock levels at all times with purchase planning to ensure forward cover beyond the next order cycle to avoid out of stocks, as they are critical to support daily sales as well as meeting minimum customer shopping expectations.

Top performing items in dollars and unit volumes can have a seasonal pattern, and may need to be re-calculated quarterly taking in to account year to date trade pattern in line with previous year seasonal changes in upcoming months. For example: January to March has bananas as a highest volume line, but April to June has citrus or oats which will all need forward stock levels and margins reviewed and planned accordingly.

A review of key top sales items in either $dollar or units volume could begin with:

  • Cross check of recent actual invoice costs and charges for these items, to check for any bulk invoiced or hard to detect increases in costs per carton , discounts or freight charges or other margin erosion events
  • POS system reported costs check, compared to recent invoices to eliminate any system pricing errors or omissions in cost price increases, and incorrect margin estimates
  • Competitor price check and RRP review on products to see how store prices sit in the market and if they are too low/ too high, see what adjustment can be made while still having a competitive offer.
  • Assess lost opportunities by noting out of stock or low stock periods, and action adjustment of sales potential and orders
  • Assess product as a percentage of category sales – is it stable, increasing or decreasing year to date? How does it compare to the same time last year, and does that indicate planning action or supplier forecasting of needs /units required to maintain or grow sales?
  • Opportunities in growth categories – these growing categories are strong strategic investment opportunities for range extension (evident in YTD (year to date) and LY (last year) sales comparisons). Increasing the width of product offer and trialling products in these particular areas is a priority to explore sales potential and support increasing turnover. New product lines also present opportunities to build a new and differentiated stronger margin mix, while becoming a higher impact consumer destination for that category.

5.) Quantifying potential from ‘out-of-stock’

Any produce items that are out of stock during the week should be recorded and communicated so action can be taken asap to get a top-up delivery, or implement a plan to adjust the next order significantly in line with the recent sales potential,  considering use by dates and perishable life spans as applicable.

The timing of the out-of-stock occurring is critical in assessing product sales potential and new reorder quantification.

An out-of-stock opportunity and action tracking form may be developed and be used interactively, kept up to date by staff for easy reference and visibility prior to ordering.

 Scenario: There are 12 units of cheese stocked in the hub. The cheese is delivered and on sale Tuesday, and sells out by end of Wednesday. If Tuesday and Wednesday sales represent 60% of the trading week, then there is an estimated sales potential of 20 units of cheese per week – if it was kept in stock. Potential units is simply calculated by # of units sold divided by % of sales (i.e. 12 / 60 x 100) .This is the new quantity adjustment to the next order, to be reassessed the following week until stock levels are maintained to a minimum agreed forward cover, or one full order cycle, to be able to evaluate a pattern of sales potential going forward.

This is a particularly important assessment to make on new products and any trial line in-store.

    6.) Inventory management to optimise return on investment and lower risk

    The cost of stock held to achieve sales is an indicator of the speed and efficiency of sales turnover, relative to the investment required in achieving those sales.

    Stock levels need to be balanced to avoid lost opportunities and out of stocks, as explored in the previous sections with key item management, but stock levels that exceed sales turnover needs, or stocks heavy in slower moving categories need to be very carefully monitored.

    Return on investment
    Any stock occupying space in a retail or online store needs to provide a return on investment in a reasonable timeframe, otherwise it is occupying space that has a weekly cost per square meter with little return.  This cost applies in both warehousing as well as retail space.  The timeframe of return on investment can be calculated in forecasted sales, or weeks forward cover needed until that item of stock needs to be reordered.
    Calculating timeframe of return on investment:
    achieved by monitoring unit sales relative to the number of unit stock on hand (or last ordered) for that product. Ideal stock on hand could be considered to be 1.5 weeks sales on a weekly order cycle, or 5 weeks sales on a 4 weekly/monthly order cycle (best before dates permitting, and assuming all stock is rotated first in first out).  The ideal stock levels should be enough to maintain forecasted sales plus provide a buffer for extra sales growth opportunities or as an allowance for delivery delays.

    Bulk Orders
    Where bulk orders are deemed more cost effective, the margin or surplus for that produce should be increased to allow for expected storage and handling. For example a bulk delivery representing 12 weeks sales potential will require warehousing, re-packing and multiple handling over its three month lifespan that may impact on its profitability if this is not factored in to the final retail price.

    Another factor to consider is the true value of bulk or minimum order values to achieve an offered discount or free freight.
    Scenario: if only three products are needing to be ordered (totalling $250 sales a week or 120 units sales a week), then it is a better return on investment to just reorder these items and pay the freight of $50 and build it in to the retail price, than to process an order of $5000 across that entire product range to achieve free delivery, but then take twenty weeks to sell it while occupying 3 square meters of floor or shelf space. Range management does benefit from a minimum variety and options, but the depth in volume sellers should not be sacrificed for investment in a width of slower selling options. Likewise a minimum order value of $800 (instead of ordering only the $320 order needed to maintain sales), is not worth the 5% discount incentive if it ties up investment for the next 8 weeks that could have been spent in another priority category with a 2 week return, or takes up finite capital during tight cash flow that is needed for an upcoming wage cycle that week.

    Product with poor turnover
    If there is a product category with poor turnover, an agreed threshold can trigger a produce review or exit strategy to free up the non-performing investment. This may involve re-locating the poor selling line to an eye level position for a short period to assess sale impact when relocated, or reducing the sell price to clear item if re-merchandising and re-positioning is ineffective. An active plan on minimising wastage and establishing benchmarks can also be helpful in controlling the value of lost investment. Non performing or slow selling products are a space and investment opportunity cost that are best replaced as soon as practical to free up both capital and space.

    Consignment arrangements
    If trading capital is very limited, key produce areas need to be prioritised. To allow a less capital heavy stock investment, consignment arrangements can be considered for many products. This is particularly helpful in offering high risk or high value products with uncertain sales outcomes, or a very new product concept.  The supplier then shares the risk of that produce, as they are paid on sales achieved instead of on stock provided. This can be a way of low risk trialling of unusual or unknown items, while offering customers extended range with minimum investment.

    Overall, best management practices to achieve optimal sales performance and return rely on clearly defined analysis and timely communication of impacts to increase responsiveness and profitability in any retail trade, within a process of evolving and constant improvement.

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