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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