Which retail opportunities should you invest in to get the greatest return? How do you know if you will be able to cover the associated costs?
Investing in your retail business requires that you make important decisions involving risk. That’s why it’s wise to evaluate risks and potential returns to see how various investments might affect your bottom line.
I recently visited retailer, "XYZ Furniture" whose goal was to jump start store sales. Management was considering hiring a digital media manager and adding additional salespeople. At the same time, they were looking at options to expand the store's inventory. The purpose of the added investments was:
- Increase digital and in-store traffic.
- Add salespeople to engage the increased level of customer visits.
- Boost product selection to entice customers to buy.
I believed they were on the right track. After all, businesses are like trees, they either grow or die. Where this business needed help was deciding which payroll investments made the best business sense. Like this business you may be considering hiring a new employee, adopting an emerging technology, expanding inventory, or other possibilities.
It's a rare opportunity that can produce a return on investment immediately, and some never produce returns period. So, it is helpful to run some numbers to estimate how much more you will need to sell to cover the costs of investing and preserve profits.
It may not be intuitive, but different types of costs (fixed costs, variable costs, and inventory costs) require different sales increases to insure that profits and cash flow are preserved.
Fixed Costs
Fixed costs are incurred regardless of whether sales go up or down. Let's first look at "XYZ Furniture's" plan to add a digital media manager. This employee will be tasked with managing the company's AdWords, email marketing, Facebook ads, tweets, website content updates, online video content, and a host of other activities geared toward bridging the gap between the online and offline worlds. Let’s say the starting salary, a new fixed cost for the business, will be set at $50,000 per year. For this example we will assume that this is the “all in” cost for the employee including taxes, benefits, travel, etc. So, how much sales volume will this employee need to add to the top line to justify the $50,000 fixed investment? We can use the following formula to answer this question.
Break-even Sales = Annual New Fixed Cost / [(Total Annual Sales – Total Annual Variable Expense) / Sales]
Please note that the portion of this formula [(Total Annual Sales – Total Annual Variable Expense) / Sales] is also known as the Contribution Margin or CM. It is the percent of profit a retailer adds out of each sales dollar after break-even sales volume has been achieved.
We already know what the new fixed expense is $50,000. For this example let's assume that sales for the past 12 months were $5,000,000. The next step is to calculate total annual variable expenses. A variable expense is defined as one that is incurred as the result of a sale. Let’s suppose this retailer puts landed cost of goods sold, sales commissions, credit card fees, and finance fees in the variable expense category. With this information in hand, we can do the following calculations:
- Cost of Goods Sold (at a 50% gross margin) = $5,000,000 x .5 = $2,500,000
- Sales commissions (at an average of 7% commissions) = $5,000,000 x .07 = $350,000
- Credit card and finance fees (at an average of 3%) = $5,000,000 x .03 = $150,000
- Total Variable Expense = $2,500,000 + 350,000 + $150,000 = $3,000,000
Now, we have enough information to determine the sales needed to cover the cost of the digital media hire using the formula:
Sales Need To Cover Fixed Expense = Annual Fixed Cost / Contribution Margin = $50,000 / [($5,000,000 - $3,000,000)/$5,000,000] = $50,000 / .40 = $125,000
So, by taking their fixed costs and dividing it by their CM, we see that a $125,000 increase in sales is needed to cover the cost of the new employee. If new sales volume grows to $5,125,000, their profit and cash flow will not be impacted significantly by the expense.
When considering adding any new cost it is a good idea to go through this type of calculation. It forces managers to think of how an investment cost adds value. In the example (above) of hiring a digital media manager, the calculation reveals that she will pay for herself if she can produce enough additional traffic to grow annual sales volume to $5,125,000.
Variable Costs
What if the costs this retailer added would only be incurred after a sale resulted? In other words, they would be Variable Costs.
Suppose they add a commissioned salesperson that will cost the company $50,000 per year in commissions. How much volume would they need to add without the addition negatively impacting profit?
The answer is $0, provided the average commission rate holds constant. With a 100% variable expense there isn’t a fixed increase and the expense is just part of the CM%. Zero divided by anything is zero.
In the real world, however, with an expense such as adding a commissioned salesperson, there is a combination of fixed and variable expenses incurred. It takes time to get the salesperson up to speed, as well as training and payroll costs that should be calculated as a fixed expense increase.
And, performance with customer opportunities is critical. There could be hidden costs. If the new salesperson is not as effective with customers and produces a lower revenue per opportunity, the company may actually not realize the same volume when compared with a more effective person. However, if they add a salesperson at the right time, and get them trained properly to produce, they are easily the least costly employees to bring on.
Some people ask me, “If a business adds an additional salesperson, don’t they need more traffic?” Maybe, maybe not. I will say that I have seldom seen a top writer hurt by adding additional salespeople. My advice: make variable expense employees as effective as possible and grow in this area. It is the only way to expand brick and mortar volume without adding additional store units.
Inventory Costs
What about an expansion of Inventory Costs? If you think that cost of goods is a variable expense, and that inventory expansions will have little effect on hurting the bottom line provided there are some extra sales, you are wrong.
Cost of goods or inventory cost is not a variable expense. Cost of goods SOLD, is a variable expense. Unlike a service, there is an average holding period with inventory. If you have 3.5 turns per year, the average holding period before inventory is expensed would be 104 days (365 days / 3.5 turns). During these 104 days, carrying costs are incurred such as warehousing, damages, cost of people, and cost of money. Don’t fall into the trap of considering inventory as a variable expense. Expand only when inventory levels and sales volume capacities dictate.
So, what sales volume is desired for an increase in inventory? Inventory is an asset, not a variable or fixed expense with hidden costs. For these reasons, the formula is not as exacting as for a 100% fixed or variable expense. One measure to use is Sales Return on Investment.
Sales ROI = Sales / Inventory
Let’s run the calculation assuming that preservation of sales return on inventory is the goal. Suppose a retailer is considering expanding inventory by $100,000. Before the expansion inventory averaged $715,000 at landed cost.
When we plug these values into the Sales Return on Investment formula, the calculation yields the result: $5,000,000 / $715,000 = $7.
This tells us that seven dollars in sales would result from every dollar of new inventory invested. To achieve the same ROI in terms of sales, provided margins stay constant, we would calculate: $100,000 in new inventory x $7 = $700,000 in additional sales.
Assuming this occurred and the retailer in this example was above its break-even point, and holding other costs constant, the $700,000 increase would produce $280,000 in profit dollars ($700,000 x 40% Contribution Margin). In terms of cash flow, in this example they would put out $100,000, but recapture $280,000 over the period of a year. The net would be $180,000 cash in a year (without adding holding costs). If they wished to compromise overall sales ROA they could even justify the inventory expansion on less sales volume due to being over break-even. A caveat, oftentimes inventory expansions come with at least initial fixed cost outlays, so don’t forget to consider the sales required to cover those costs.
Conclusion
The one certain constant in business is change. It’s important to continually look to new areas of investment. Be sure to look at the type of expense and work through the calculations. You will get a better understanding for planning purposes regarding the level of sales needed to cover costs. You will increase your odds of making your decisions pay off.
By the way, after doing the above calculations, "XYZ Furniture" decided on doing all the above. In phases, they added two additional commissioned salespeople, one digital media manager, and expanded their inventory line-up. They are generating enough sales to cover and have added extra profit dollars for their business.