One of the most important lessons I learned is that business is a math problem. Yes, you need customer service, wonderful products, great employees and all the other things that come along with having and running your own business, but in the end, to make money in your business, you need to understand that business is a math problem.
Let’s talk about making money. Your sales dollars and margins will vary, but the formulas are the same regardless of the business type. I was lucky enough to attend Texas A & M and Don Rice taught some of the classes. He is a brilliant man and excellent teacher, and I learned more from him about how to make money in business than from anyone else. The information I am sharing with you here is mostly from him, but I have modified it somewhat, so it isn’t so industry specific.
1. Buy Lower
- Keep quality in mind, but also look at where the quantity breaks are when you purchase.
- Partner and negotiate with your suppliers; if you know you are going to use a certain amount of a product during the year and can make a commitment to that quantity with scheduled releases from your supplier, you both win. They can plan their production and you get a better price based on a larger quantity. Keep in mind there will be charge backs if you don’t take the quantity you contracted for.
- When you negotiate a blanket purchase with releases, you are lowering your costs by creating fewer Purchase Orders (PO’s).
2. Sell Higher
Raise your prices!
“A” products are those items that move the fastest. In the grocery store, they would be the eggs, milk, and bread. You NEVER want to run out of “A” products. Your “B” products are the things customers buy regularly, and you don’t want to run out of “B’s” but you don’t buy them every time you go shopping. “B” products would be things like mustard, canned soup, and salad dressing. If the store is out of chicken noodle soup, you might buy vegetable beef or another brand instead. You wouldn’t stop shopping there just because they didn’t have exactly the soup you wanted unless it happened repeatedly. “C” products are those things that you want but would not stop shopping at a store if they didn’t have them. You are willing to special order and wait for these items. These would be things like sardines, artichoke hearts, and other specialty items.
- A – products get raised 1/2 of 1% (except items on contract) = .50 per $100
- B – products get raised 2% = $2.00 per $100
- C – products get raised 5% = $5.00 per $100
- Whenever you get a price increase from the manufacturer, raise it 1/2% more (inside sales can tell you which products you can raise it on)
- Raise the price as much as you can on anything you can to make up for the items you have to sell below a reasonable margin. Most of your “A” items go too cheap, so you may have to make 400% on others to make up for it. You are not taking advantage of the customer; you are staying in business. The customer is worried about what he pays for items he buys in quantity all the time, the odd items he usually does not check on. Keep in mind these are the items that sit on you shelf, and you have holding costs because you have money tied up in them. They may even expire and have to be thrown out. You have to make up for this somewhere. You should look at your inventory and see stacks of dollars on the shelf.
- Write fewer credit memos – Try to get it right the first time. Errors cost you money to fix.
- Add freight charges; you can’t afford to pay all of this yourself
- Sell value
- Sell service after the sale
- Provide training (especially for new products or new product releases)
- Reduce the discounts you give
- Charge extra for putting customer’s part # on their products
- EFT (Electronic Funds Transfer), it’s less expensive than paper
- Pay salesmen for selling more and selling higher
3. Collect Sooner
- Shorten invoice processing time
- Mail Invoices sooner; better yet, email them and save yourself the postage and stationery costs
- Apply better credit collection techniques
- Shorten (lower) number of days receivables
- Do not offer cash discounts!
- Threat of lien or suit if they don’t pay
- Bill right the first time
- Lower comfort zone, collect sooner, don’t let it go past 36 days if you allowed Net 30 terms
4. Negotiate Extended Dating
- When taking on new product lines, negotiate extended dating for as long as possible, but keep in mind you must be a significant customer for a supplier to consider this and you must also pay your bills on time. Manufacturers want to grow distribution, so if you can get their products in stores such as Whole Foods or New Seasons, you may have a relationship they do not have. There is value here for both of you.
- Goal is to reduce asset base & sell it several times before you pay for it
5. Turn Your Inventory More Often
- Think about inventory as money on the shelf and if it sits and does not turn it is no good to you.
- GMROII – Gross Margin Return on Inventory Investment
Keep in mind this example is from the industrial distribution industry and that tends to be a low margin business.
Managing the Balance Sheet
Each $1.00 in inventory must make $1.50 to $2.00
There are only two variables in managing the gross margin dollars earned on inventory. They are the turns and the percent gross margin.
Rule of Thumb:
Every $1.00 invested in inventory must earn a minimum of $1.50 to $2.00 per year in gross margin (GM) dollars as calculated by the Gross Margin Return on Inventory.
Sales – $5,475,000 GM – 25% COGS – 75%
COGS $4,106,250 ¸ 5 Turns = $821,250 Average Inventory
Using the GMROI formula, this inventory should yield:
$821,250 X 1.67 = $1,371,488 in gross margin each year.
Cost to own: $821,250 X .10 = $225.00 daily value of money
365 invested in inventory
GMROI = Gross Margin Return on Inventory
= Inv. Turn X Percent GM
1 – Percent GM
= 5 X .25 = $1.67 = Every dollar invested in inventory earned
.75 $1.67 in gross margin this year
The goal is to identify and reduce the “C” (slow moving, inexpensive) items and reinvest in “A” (fast moving, more expensive) items in order to gain more sales with a higher service level from the same amount of dollars invested in inventory.
Results of reducing “C’s” and reinvesting in “A’s”:
A) Improved customer service
B) Increased sales
C) Increased sales from same inventory dollars
D) Increased inventory turn rate
E) Reduced order processing costs. When the service level from stock goes up, you have less back orders.
F) When the inventory is reduced the inventory carrying cost will go down.
G) When you sell more (at the same percent gross margin) and keep the fixed expenses constant, the profit goes up.
6. Improve Operating Efficiency
A. Implement the Quality Process
- Change the system
- Remove the waste
- Improve the quality
- Lower the cost
- Capture the market
- Make more money
- Stay in business
- Provide employees with job security
B. Manage the Balance Sheet
C. Improve Employee Productivity
PPR = Personnel Productivity Ratio
= Total Compensation
Gross Margin must maintain a relationship to expenses to provide the planned net profit.
(1 – order, 1 – fill, 1 – ship, 1 – bill) = Order Cost
(1 – order, 2 – fill, 2 – ship, 2 – bill) = Order Cost x 2
Back order on a back order = x 3
Ship complete orders – customer doesn’t want a stack of paper.
Develop a unique selling strategy
Most really successful businesses have developed a method of differentiating themselves from their competitors.
Zero Errors in:
- Order Entry
- Material Handling
If you had zero errors in these, you would be unique. What is your process? Where does it go bad? 85% of errors are caused by bad system processes.Service level should be measured on # of orders you get that you can fill form inventory.
Example: ABC Company
Owners Invested Capital – $431,603 (Net Worth)
Return (Desired) 30% on Net Worth
Projected Net Sales – $1,500,000
Projected Gross Margin 25%
Remember, you can’t spend Sales, you can only spend Margin $
Net Profit = Net Worth (Owner’s Investment) x Rate
= $431,603 x .30
Gross Margin = Projected Sales x Rate
= $1,500,000 x .25
COGS = Sales – Gross Margin
= $1,500,000 – $375,000
Expenses = Net Sales – Net Profits – Cost of Goods
= $1,500,000 – $129,480 – $1,125,000
= $245,000 Allowable Expenses
If sales are up more than margin (% wise) you are working harder to make less!
We now have $245,520 to spend to generate $1.5 million in sales.
Allowable Expenses – Actual Expenses = Expense Shortage or (Overage)
$245,520 – $304,050 = ($58,530) This comes out of Owners pocket
Owners Expected Return – Expense Over Run = NPBT (Owners actual return)
$129,480 – $58,530 = $70,950
Where did the $58,530 come from? From the owner’s pocket:
You were only able to pay $70,950 to the owner instead of the $129,480, they expected $129,480 – $58,530 = $70,950
Example of non-allowable expense & how it adds up!
Delivery driver decides to drive home (lives 10 miles out), for lunch through town everyday for a week. The truck costs $1.05 per mile to drive.
20 mile round trip X 5 days X 50 weeks X $1.05 per mile = $5,250 per year.
So there you have it in six easy pieces. I know, it isn’t easy, and it takes some study. You have to apply the formulas and rules to your business. Regardless of the type of business you are in, if you have inventory, you have cost and how you manage that cost determines how much money you make on the money you have invested. I know this is a lot of information but if there is interest in this I may talk about the parts and pieces of this overview in greater detail in future newsletters. Let me know what you think. We are all in business for a variety of reasons but one of them has to be to make money or you won’t be in business long.