How to Plan Inventory For Profit

Do you have an inventory plan/forecast? If not, you’re in the same boat as many of my clients were the first time we met up. As a Part Time CFO, I inform them quickly that an inventory plan/forecast is essential for reducing risk to the business owner and managing cash flow, and we start on one immediately. Everyone needs it (specifically distribution and manufacturing companies), but more than most, retailers need an inventory plan/forecast because inventory represents one of their greatest risks.

 

An “open to buy” plan is not the same as an inventory plan/forecast (and not just because most retailers already have one). An “open to buy” plan is something you get by taking your projected sales in product classification, adding the ending inventory you desire at the end of the buying period, and finally subtracting the beginning inventory for product classification—the end result will tell you how much you should buy, aka what you are “open to buy”. You can use units, retail dollars, or cost dollars (personally, I like using units as it keeps things simple), and include other factors such as average mark-ups or planned marked downs.   Another thing to note is that retailers usually use the previous year’s sales to represent the projected sales in product classification. They should really find a CFO to help them prepare more legitimate sales forecasts by taking the retailer’s knowledge of their customers, and other economic or market variables into account.

 

An “open to buy” calculation should look like this:

Product class Calculation Item Units
Phillips Head Screwdrivers Projected Sales 400
Add : Desired Ending Inventory 10
Less: Beginning Inventory 150
Open to Buy 260

 

Other factors that retailers often consider which will increase your “open to buy”:

  1. If the buyer thinks a product will be “hot”, it will increase your projected sales, therefore increasing your “open to buy”
  2. You may decide to carry larger or smaller sizes for a specific customer segment or have to fill sizes from beginning inventory to complete size runs
  3. If you add certain colors because you think they’ll appeal more to your customers
  4. If you have merchandising plans with high requirements for filling racks or shelves properly
  5. If in beginning inventory for product classification there is an obsolescence or bad product mix, you will need to reduce the beginning inventory to account for that
  6. If the supplier offers better payment terms
  7. If the supplier offers extra discounts for certain quantities
  8. If the supplier pressures you to buy more by threatening to open a competitor
  9. If the supplier pressures you to buy more by giving you more advertising money
  10. If the supplier pressures you to buy more by reminding you of support or favors they gave you and acting like you owe them.

 

Some of those factors justify what could be seen as over buying as a calculated risk (items 1 through 5, and 6 if you consider the timing of shipments), some do not (items 7 through 10 are traps, and are not worth going over your “open to buy” limit for), but all will create more risk. Clearly, it’s easy to succumb and overbuy (which some may say is the greatest sin in retail). That’s where the pivotal importance of an inventory plan/forecast comes in.

For the sake of argument, let’s say you don’t succumb to any pressure. You rely on your own knowledge and experience to decide if you should go over your “open to buy” limit, and you only ever do that if the situation is one of the first 5 items on the above list. Despite being smart and cautious, and having these legitimate reasons to overbuy, you still assume a greater risk whenever you overbuy, and you need to be able to see clearly the extent of that risk. You need an inventory plan/forecast.

“Open to buy” analysis for most retailers consists of product classification and not much else. They miss out on having an overall top level inventory receipt plan and an inventory forecast, which they need because with them, the retailer can see how over bought or under bought they are and what the impact on cash flow will be. Seeing that makes measuring their risk and being aware of what will really happen at a company-wide level possible for the retailer.

An inventory plan/forecast adds the inventory receipts on order to the beginning inventory and lists them by the month they will be shipped in, then subtracts the costs of the projected sales by month to determine ending inventory by month. This will compare the projected ending inventories by month to last year’s monthly ending inventories, but you still won’t be able to tell if you over bought the previous year. For this answer you need to enter your inventory plan into a business and cash flow forecast. The projected cash flow will tell you if you are over bought.

You also have to plug the months supplier invoices will be paid into this forecast. You are likely overbought (and therefore taking a great risk) if the business and cash flow forecast tells you that you are going to be out of cash during the year.

An inventory plan/forecast for a 3 month period should look like this:

Inventory Plan – Numbers in ($000) Jan Feb Mar
Beginning inventory $ 90.0 $ 95.0 $120.0
Add: Projected Receipts Product on order 45.0 65.0 75.0
Less: Cost of Goods sold on Projected sales 40.0 45.0 55.0
Ending inventory $ 95.0 $115.0 $140.0

 

A/P Trade Plan – Numbers in ($000) Jan Feb Mar
Beginning Trade Suppliers Accounts Payable $55.0 $ 45.0 $ 65.0
Add: Projected Receipts Product on order 45.0 65.0 75.0
Less: Payments to Trade Suppliers (30 Days) 55.0 45.0 65.0
Ending Trade Suppliers Accounts Payable $45.0 $ 65.0 $ 75.0

This is an example in which the retailer may want to rethink purchases as inventory is rising. Of course this could be an example in which a busy period is coming up, but even when that’s the case whether or not you’re bringing inventory in too early needs to be assessed (more so if your trade terms are 30 days or less).

Like I said before, it’s when it can be plugged into a business and cash flow forecast that an inventory plan/forecast works best, but it’s always useful for giving the retailer the macro view of the impact of inventory ordered. You should also prepare the trade accounts payable plan as part of the inventory plan/forecast.

Reducing risk is a major responsibility of the CFO, and inventory is the greatest risk to a retailer. Take it from someone who has seen many a retailer overbuy their way right out of business. Retailers should all find a CFO to help guide them through setting up an inventory plan/forecast.

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The Importance of Accurate Financial Statements

Over 4 years as a Part Time CFO, one disturbing trend that I see continuously is the large number of business owners who have inaccurate financial statements.

 

Two things business owners want to know no matter how interested they may be in financial information are: what their sales are, and what their net profit is. Even business owners the most detached from financial information will want to know those two metrics. If you have inaccurate financial statements, you can forget about knowing those two metrics accurately.

 

There are several beneficial points to having accurate financial statements:

 

Making better business decisions – It’s impossible to make decisions regarding, among many other things, what vendors pay, pricing, capital expenditures, collections, or inventory purchases without accurate financial statements.

 

Getting bank financing and obtaining leases – If your financial statements can back up what you tell the bank, they will take you a lot more seriously. And adversely if your banker sees an inaccurate financial statement (which they can usually tell from a correct one at a glance), your chances of getting a loan diminish greatly.

 

Keeping bank financing – Credit lines that need converting to term debt are something most business owners have to take care of. Without an accurate financial statement, best-case scenario is you making your banker nervous and the worst (and most likely) scenario is that you won’t get your credit line extended at all and you’ll have to pay off the credit line immediately.

 

Allowing better financial analysis – There’s no basis for strategic planning or problem solving without an accurate financial statement. You can’t do a business and cash flow forecast or solve cash flow problems, for example. You also have no way of knowing with certainty whether or not a change in your business model is working for your business.

 

Better Estate Planning – It’s critical that your financial statements are accurate if you want an effective estate plan.

 

More Security when selling a business – Critical to its valuation is the amount of earnings a business has. A buyer will discover inaccuracies in your financial statements during the due diligence process, putting your deal in jeopardy.

 

Similarly to selling a business, accurate financial statements are pivotal in all of the following situations, because inaccuracies discovered later in these processes could be detrimental to any deals being made to your benefit:

Shareholder Buyout or Disputes

Employee Stock Ownership Plans

Litigation or Divorces

Shareholder Buy and Sell Agreements

 

A very cost effective way to keep the accuracy of your financial statements in check and alleviate any problems you may have with the aforementioned events is hiring a Part Time CFO.

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What to Do with Excess Cash Flow

What to do with excess cash flow is something many of my clients ask me about. Some companies do produce excess cash, even in these trying economic times. It’s usually because of a seasonal fluctuation in business, sometimes it’s just because a business is really good. The first instinct many seem to have is to put the extra money in an interest bearing bank account. As a Part time CFO, I have seen money market and CD rates and know that if you went with that instinct, you’d be lucky to get an interest rate of 1% per year.Other options for your excess cash that might be more productive:

  1. Some Trade Vendors offer early pay discounts as a matter of policy, and some can be convinced to accept a higher discount. Call them to check, because you may be asking at a time when they need cash.
  2. Your landlord might also give you a discount for prepaid rent.
  3. Pre-paying your expenses to your expense vendors is another opportunity for a discount.
  4. If you can dip back into it and your bank doesn’t freeze you as you try to do this, you can pay down your line of credit.

Points 1 to 3 will have to be paid in the near future anyway (they’re operating expenses). It’s different from point 4, which involves additional money aside from ordinary operating expenses (so with respect to the credit line, you should make sure you can borrow back into it). Anyone of these options should yield much better results than an interest bearing bank account.

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CFO Services-An Option to Consider

Business owners’ relocating is a situation I run into as a Part Time CFO. Owning the building you do business in has always been a strategy I like. You may as well build equity through the facility payment if you have to pay for facility costs anyway.

I made the mistake of missing out on this with an insurance agency I have interest in owning. Since 1983, I’ve had this equity interest. We continuously leased this same office space for years. Over 27 years, we paid close to $700,000 in rent.  If we had actually bought the property at any point in all of this, we probably would have still paid the same facility costs, but we could have enjoyed tax advantages, and own an asset with resalable value.  This was a scenario where I really fell asleep at the wheel.

I believe the right choice for a business owner is to own the building they work in, even with the real estate market down. Banks actually love SBA 504 programs, and they provide good financing options. Banks like to see a large percentage of the loan (among other things) guaranteed by the SBA. And a lease with an option to buy is a very productive strategy if you can’t finance a purchase today.

If you have a lease with the option to buy, you have:

  • Control of the property (and it can’t be sold from you).
  • The option of trying the property to make sure it’s a good fit before you buy.
  • No commitment to ever buy.
  • Time to work toward a down payment.
  • The ability to lock in an option purchase price that’s favorable in the current real-estate market.

In this real-estate environment, you can usually negotiate any non-refundable payments you may have to make for the option. The purchase price is what any non-refundable payments you make should go towards, if you exercise that option. Over all, getting a lease with an option to buy is a great way to set your self on the path of ownership, instead of the path of accumulating rent receipts.

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