Maximizing profits through inventory management

With the increasing number of products available and the wholesale price of cannabis dropping steadily, now, more than ever, the role of an inventory manager for a marijuana retailer can be both terrifying and critical.

Although legal cannabis is a relatively new industry, the inventory management concepts used by traditional retailers such as Nordstrom, Costco and Barnes & Noble can easily be applied in the emerging market of marijuana retail.

In the words of retail strategists Patricia Johnson and Richard Outcalt , “There are many ways to succeed in retailing. But retail failures have only one cause: financial.”

To help illustrate better inventory management practices, Marijuana Venture spoke with professionals inside and outside the cannabis industry who specialize in categorizing, analyzing and tracking inventory turns.

Due to the plummeting wholesale price of cannabis, Patricia Johnson of The Retail Owners Institute says retailers would be better off running out of inventory rather than buying too much.

Cannabis by Category

Alyson MacMullan, co-founder of Cannabis Retail Advisors, says establishing a classification structure is the first and most important step for retailers.

Products should generally be divided into 10 to 15 different classifications, MacMullan says. Most point-of-sale systems have built-in software to incorporate the classifications. The first few should be easy: topicals, cartridges, tinctures, accessories, etc. Classifications for products such as raw flower, concentrates, pre-rolls and edibles should be broken down so that no single category encompasses more than 10% of the company’s total monthly sales. To avoid muddying the monthly results, she says each classification should have a similar rate of sales and profit margin.

“The worst thing that can happen is when a business is up 20% or down 20% (in monthly sales) and they don’t know why,” MacMullan says.

At the end of every month, run the sales and inventory for each classification. The sales for each classification should reflect the amount of inventory on hand. For example, if 10% of sales come from infused topicals, then 10% of the store’s inventory should be infused topicals. A good classification system should behave similar to 10 to 15 independent businesses, MacMullan says.

“You don’t need a degree to do this,” she says. “It’s a quick and easy, ‘back-of-the-napkin’ way to see if you’re in balance.”

Since the majority of cannabis retailers generate roughly 50% to 60% of revenue from flower, it should be broken down into separate classifications. The most common breakdown is the traditional etymology of indicas, sativas and hybrids. Some retailers have replaced strain names with moods, desired effects or color-coded categories, but the concept remains the same.

“After a few months you can compare month-after-month sales in each category,” MacMullan says. “This way, when retailers run the sales for each category at the end of the month and see that they lost money, they will at least know where to start digging.”

Retailers should divide inventory into 10 to 15 separate categories for better tracking of sales and to determine larger concerns such as inventory turnover.

Turn, earn or burn

Beyond developing normalcy and inventory balance, using a well-defined classification system can also help track inventory turns, another important component of understanding the inner workings of a retail establishment.

Outcalt and Johnson, founders of The Retail Owners Institute and principals of Outcalt and Johnson: Retail Strategists, LLC, explain inventory turns as a simple measure of how often a business sells its entire inventory in a single year.

To calculate inventory turns, divide the cost of goods sold (COGS) by the average inventory value (the sum of the beginning inventory plus ending inventory divided by two). For example: A product with a COGS of $90,000 and an average inventory value of $9,000 would have 10 inventory turns.

A classification with an inventory turn of 12 means the inventory would need to be replenished once a month; a turn of 16 would need restocking every 22 days. MacMullan says if a turn is too slow, “it’s just going to sit there and languish and the only way you’re going to get rid of it is through an aggressive markdown.”

“With prices coming down so much, that is a double whammy for the retailer,” Outcalt says. “In order to grow sales volume, they have to sell to more customers more often. They have to keep running faster and faster to keep even.”

“And every day the inventory is worth less,” Johnson adds.

Studies have shown excess inventory can cost traditional retailers an additional 25% to 32% annually. Losses can be caused by a variety of factors from drops in market value to insurance to theft. While marijuana retailers probably don’t have Costco-sized bulk inventory in warehouses, they’re impacted by high tax rates and minimal tax deductions compared to traditional retailers.

Using MacMullan’s classification system makes finding excess inventory easy; if topicals account for 10% of a store’s monthly sales and 20% of its inventory, the store has roughly double the inventory needed for that particular category. Using that same example, let’s say the store’s topical inventory is worth $10,000, meaning $5,000 is excess inventory. Even at the low-end loss of 25% due to excess inventory, the business could be wasting $1,250 annually on that product.

That number might not be alarming on its own, but as just one of possibly 15 classifications, it might do more than raise an eyebrow.

Gross Margin Return on Inventory Investment

While excess inventory can be a major problem, businesses shouldn’t cut a product solely based on total sales. The gross margin return on inventory investment (GMROI) is a reliable formula to assess inventory based on the profitability of each dollar invested. (There are many variations on how to calculate this benchmark, but the information it provides a retailer generally remains the same.)

Inventory Curve, LLC principal David Armstrong says this concept can inform retail buyers on how much they get in return for every dollar invested in a product. Armstrong has spent years teaching the GMROI formula to clients, students at the University of Colorado and in articles for the Harvard Business Review. He assures people that the calculation is both easy and reliable.

“The internal numbers are easy to get at from a CFO or financial analyst,” Armstrong says.

To calculate GMROI, divide the gross profit percentage (GP%) by the cost of goods percentage (COGS%), then multiply that number by the inventory turns.

The formula can reveal the annual profitability from the entire enterprise as a whole all the way down to a single SKU for each dollar invested in inventory.

“You can do this by segments such as by location or you can break it down into segments like accessories, edibles, buds, that sort of thing,” Armstrong says. “People frequently ask me, ‘what’s a good number?’ There’s not a magic number, but generally, the higher the better.”

For example, let’s compare two fictional products whose sales may be misleading:

In a single year, a retail store sold $180,000 of Kylo Ren’s Chocolate Bars; the COGS was $162,000 (90%) and the gross profit was $18,000 (10%). Meanwhile, the store sold $150,000 of Uncle Owen’s Infused Brownies, with a COGS of $120,000 (80%) and a gross profit of $30,000 (20%). Both products had 16 inventory turns during the year.

For Kylo Ren’s Chocolate Bars, the GMROI would be $1.78. For Uncle Owen’s Infused Brownies, the GMROI would be $4.00.

This example highlights that focusing on annual sales for both products could make a buyer think both products are roughly equal in value, when in truth the brownies are not only more profitable, but also more likely to be a safer option if the market value drops.

However, while the lower GMROI for the chocolate bars is clearly a disadvantage, “there may be a valid reason for that,” Armstrong says.

“The key thing to remember is that it’s a combination of the gross profit and the turnover,” Armstrong says. “How do you modify your GMROI? You can either modify your margins or improve the turnover, meaning carrying less inventory, replenish more frequently.”