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Every Friday, I post a small insight into running Curio City and/or Blue Hills Editorial Services. My most recent posts are directly below. You can also start with the first post, or use the subject labels to the right to home in on particular topics. Feel free to comment on anything that interests you.
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Friday, July 04, 2008

Your Open to Buy is Now Closed

This topic crops up so frequently that it deserves its own post, in which I shall attempt to define the problem, if indeed a problem there be, and brainstorm a remedy.

“Open to buy” is simply the budget that’s available for buying merchandise. I calculate mine very simply: Take the average cost of goods sold, increase that percentage by as much as my P&L spreadsheet says I can, and spend that percentage of gross sales as the money comes in (and as the need arises). The problem is that the need always arises before the money comes in.

I was using two different formulae to figure my OTB percentage: one for my inventory history to date, and another for merchandise that’s in stock right now. The first formula gave me an effective cost of 49.83%. The second formula gave me 48.33%. This year I have been devoting 50.89% of gross sales to my OTB. If my cost numbers are right, that ought to cover the cost of goods sold with a smidgeon left over.

When I examined these very carefully, my cost numbers were not right.

First, and most egregious: I had reversed total markup and total cost. The actual cost numbers should have been 50.17% and 51.67% respectively (versus the 50.89% I’m actually using).

Second: I was factoring markdowns and discounts into one of my calculations, yet I also track those as line items in my profit-and-loss (P&L) spreadsheet. Using them in OTB counts them twice. When I removed those numbers my historical cost, unadjusted, changed to 48.51%. That comes from a very simple formula:

Cost of inventory + Shipping costs / Total retail value = Cost percentage

Third: My other calculation (the one for in-stock merchandise) omitted shipping costs. Here’s the corrected formula for this much more relevant number:

(Quantity Sold * Cost Each) + (Quantity Sold * Freight Each) = Cost of Sales

(Quantity Sold * Retail Each) = Gross Dollars Sold

Cost of Sales / Gross Dollars Sold = Cost Percentage

This comes out to a cost of 49.14%, vs. the 50.89% that I’m actually allocating to OTB. That’s not so bad. I should be able to replace the goods sold while increasing my available inventory dollars by 1.75% overall.

Knowing that my formulae are fixed (I’m not still reversing markup and cost, am I?) gives me a warm fuzzy feeling, but it doesn’t explain why my OTB is constantly bleeding red ink. So…to the Internet!

Surfing eventually brought me to the Retail Owners Institute website. I should put some time into reading this site. Here’s what I’ll call “the official formula” for figuring your OTB:

Planned Sales + Planned Markdowns + Planned End of Month Inventory - Planned Beginning-of-Month Inventory - On Order = Open to Buy

I had a eureka moment while staring at that formula: My OTB method addresses the cost of replacing merchandise that already sold, rather than the cost of merchandise that I intend to sell in the future. So far, this year’s sales are running more than double last year’s. Where does the additional inventory to support increased sales come from? Not my OTB budget. That’s why I am always in the red, and will be for as long as sales keep growing dramatically. If it weren’t for deficit spending, I’d still be working within my opening inventory level.

The official formula also allows for seasonal stock levels: You need a lot more stuff in November than you need in July. Using my method, the inventory dollars to support Christmas sales don’t show up until the sales actually occur, which is too late. Once again, I have to drive my budget way into the red to cover anticipated sales.

I’m going to have to either switch my OTB calculations to the official formula, or adjust my own simpler formula to accommodate expected growth and seasonal stock levels – accept and institutionalize the deficit spending, as it were. Since I don’t have a clue how I’d tackle the latter, let’s try to plow through the former.

Planned Sales is easy enough, even though actual sales have demolished my plan every month so far this year. Planned Markdowns is also easy. Since I don’t do very much discounting or hold seasonal sales, I can just plug in my standard markdown plus discount percentages. The number is minor and doesn’t fluctuate much.

Inventory numbers are more elusive. Amazingly enough, QB and my Excel sheet agree to within $131 on the value of the merchandise that I own right now. But what should my inventory levels be? This opens a topic that always makes me glaze over: merchandise turn rates. I found two different ways to figure out my turnover:

Inventory turnover = sales / average inventory at retail, OR

Inventory turnover = cost of goods sold / average inventory at cost

Industry benchmarks say that my turn should be a bit more than 4. The first formula says my turn is 0.83. The second says it’s 0.85. That’s right: The amount of stuff in my cellar exceeds the amount that I sold all of last year, when it should ideally be about 25% of LY’s sales. Having so many dollars tied up in nonperforming stock is another source of red ink, since they aren’t available to buy performing stock (or try new products).

Here’s a hot tip for my blog readers: If you have not checked out the Specials section lately, it’s worth your time. Everything there just went down by anywhere from 50 cents to five bucks, and I added a few more slow sellers. I wonder if I’d get a tax deduction for writing off some things entirely. Some small percentage of my stock is not going to sell at any price. Do I need to start selling remainders on eBay again?

Theoretically, I should only reorder those items that are turning more than four times per year. That would be lighted caps, Switchables, golf balls, a few gardening items, a few gadgets, a few clocks (DayClocks FTW!), and maybe some smoking and drinking accessories. Those are the only lines that promise to approach four turns.

Also: I don’t have much faith in those low turn numbers. I’m comparing my current stock level with last year’s sales numbers. If current sales trends hold up, and I keep my inventory level under control, my effective turn rate for 2008 should be closer to 1.5. That’s still a long way from 4, but not quite as dismal as it looks at first glance.

OK then, some conclusions:

  1. My old OTB calculation is broken because it’s reactive, not predictive.
  2. Using the official retail OTB formula would require me to define a planned inventory level.
  3. The officially recommended inventory level depends on my turn rate, and would require me to either dramatically reduce my current stock or quintuple my sales with the same stock level! Either way, I’d have no OTB until my inventory comes into line with my sales.
  4. I might achieve #3 by holding a massive sale and buying nothing but caps.
  5. Doing step 4 would turn Curio City into Cap City, so improving my turn has to be a very long-term project.
  6. Defining my OTB problem is a long way from solving my OTB problem.
  7. This all looks hopeless and depressing.

Upon arriving at point 7, I tried to bypass OTB entirely. I added up my cash, subtracted all expected expenses (even federal taxes that aren’t due until the end of the year), and found $683 that’s not currently obligated for anything. That’s peanuts. Rather than apply it to OTB I’m going to keep it as a cushion.

Now I’m back to the dilemma that started this whole thing: Should I loan the company enough of my own money to retire the OTB debt and bring in a few new products, even though my cash balance is positive?

As I keep saying, I cannot sell what I do not have. I should buy what I need, and to hell with the red ink until it actually drains the treasury. I can play the float more aggressively. I’ll loan the company money if I really do have to bail out of a cashflow crisis. Or maybe – horrors! – maybe I’ll even carry a balance on my credit card for a month or two. Maybe the company doesn’t need to borrow the money from me.

Oh, who am I kidding? I can’t stand to pay interest. I’ll use my own money before I borrow it from a bank. But I’ll consider this one a short-term loan to be repaid from Christmas receipts.

So now it’s about logistics. On one hand, I shouldn’t rack up debt until closer to Christmas, when I can expect to pay it down rapidly. OTOH, I had my biggest sale ever two weeks ago, and another very substantial one just last week. The business is there now. Even though I should reduce my inventory to improve my turn rate, and my OTB certainly ought to be closed, I am still placing orders, and I’ve still got a new-product wishlist to work off.

Yesterday I placed some orders that drove my OTB deficit to a record level. There is no longer any reasonable hope of getting back up to zero. If it’s a bigger risk than I’m comfortable taking, at least I understand why I’m taking it. We shall see how it pans out.

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  • Legal Extortion

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