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4/02/2008 10:43:00 PM

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Choosing the right trade-offs is key to making the most money

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Making money might best be described as maximizing profit and cash flow while minimizing the required investment.
For businesses that stock and sell products (goods), that generally means maximizing inventory turnover while simultaneously maximizing gross margin.

It's pretty hard to maximize two competing objectives simultaneously. Therefore, trade-offs are generally what we do:
  • "I'll reduce my selling price by 10 percent, sacrificing gross margin rate, in an attempt to drive more sales volume and inventory turnover." Or ...
  • "I'll increase my selling price by 10 percent, perhaps sacrificing some sales volume and inventory turnover, to improve my gross margin rate."
The trick is to know when the move you made improved your financial performance or worsened it. The good news is, we have two similar tools to help us determine which way is better:
  • Turn and earn.
  • Gross margin return on investment.
1) Turn and earn
Turn and earn is an index defined as inventory turnover multiplied by gross margin rate (%). The higher the index, the more money you are making. Examples:
  • Item A: Three turns times 50 percent gross margin equals 1.50 turn and earn.
  • Item B: Two turns times 70 percent gross margin equals 1.40 turn and earn.I
Item A is making more money. Its turns are 50 percent higher while its gross margin rate is only 29 percent lower.

Turn and earn can be improved by:
  • Reducing inventory while holding sales volume.
  • Increasing the selling price while holding sales volume.
  • Doing both at the same time.
  • Executing advantageous trade-offs between margin rate and turns.
The supermarket and jewelry industries are examples of two very different routes to maximizing turn and earn:
  • Supermarket: very high turns and low margins.
  • Jewelry: low turns and high margins.
2) Gross margin return on investment
Gross margin return on investment is a percentage index defined as annual gross margin dollars divided by inventory dollars. The higher the index, the more money you are making. Examples:
  • Product line A: $50,000 margin divided by $100,000 inventory equals 50 percent GMROI.
  • Product line B: $100,000 margin divided by $300,000 inventory equals 33 percent GMROI.
Product line A is making more money -- half the margin on a third of the inventory.
Another way to think of GMROI, using the example of Product line A above, is, it earns 50 cents in annual margin for every dollar of inventory investment.
The same actions that improve turn and earn improve GMROI. Both measures point at the same thing -- minimizing the investment while maximizing the margin generated.
Some managers prefer one of the measures, some the other. Use one or the other to make sure your trade-off decisions are moving your financial results in the right direction.

Mike Hulser
Source: The BizMD
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