Retail, an asset allocation problem

I have been working in retail for almost two years now and have been learning a whole deal about how a good retailer is run. When you think of retail there are many components that make it great but at the core is one simple concept, what return can you get from your inventory investment and how do you maximise it?

There are two metrics that play a huge role in answering this question:

1) Gross profit Margin
2) Inventory turn


These two combined produce a version of return on inventory investment with the equation being [Gross profit] / [Average inventory investment through the year]. The way I have simplified it into an investment problem is by asking the following questions:

1) How much can I make off each investment? (GP)

2) How often can I make investments in the year? (Inventory turn)


Obviously this ignores any funding of the inventory but that is more of a financing decision than the raw economics inherent in each retailer. If the base numbers work then any gearing you can achieve is pure upside.


By driving either 1 or 2 you can significantly improve return on inventory. Another way to think about it is if you have a target Return on Inventory then you can set your strategy to either maximise GP% or inventory turn, example a petrol retailer has very small margins and are most likely fixed so if you were to Target a return of lets say 30% in the year and the margin was 2% then you would need to turn the inventory over 15 times. If you currently only turn it at 12 times a year then you know where to concentrate.

That's an example of a one product retailer, for a multiple product, multiple brand retailer the problem gets more complicated. If we had say three brands x, y and z the CEO would need to decide how much capital to dedicate to each brand to maximise return by either maintaining inventory or trying to grow inventory that has a superior return. At the next level each brand executive would need to allocate their pots of money to products to maximise the return of the brand. In essence these two people in the retailer are making the same decisions as an investor of funds would make, which funds do I allocate my money too and how much. Then at the fund level the fund manager asks what are the best allocation % to what stocks to maximise return.

The question for me is what good practices and techniques can a retailer use that the investment industry currently uses?

Next I will follow the concept but break it down for South African retailers that are publicly traded to get a feel for how differently each retailers economics are.

Hope you have a good 2011