I found this post to be challenging, mainly because the process of analyzing numbers is quite a ways down the list of things that I love doing. Don’t get me wrong, I love looking at top line business numbers, especially as they relate to sales growth. But margin analysis can quickly make my eyes cross, even in the midst of being a key to business growth. However, this information is key for booksellers and I had help making is as simple as possible.
During my stint as head of sales for a major book distributor, our CEO took our leadership team through what turned out to be a crash course on the mathematics of bookselling, which we found out later, he had adapted from a monograph by Leonard Shatzkin with the same name. By asking a simple question, he helped us understand bookselling better than most people in the industry. Buckle up. I am going to share my notes from this session in two posts.
What is more important in determining financial success? Gross margin percentage or inventory turns?
Let’s look at two bookstores run by Phil and Turner. Each has $100,000 to invest in inventory.
Phil purchases his inventory from publishers at publisher discounts – we will assume 50% for this exercise. Phil has to carry more units per title to make sure he doesn’t run out when the publisher takes a week or two to fill the order, and to make sure he can meet the minimum order requirements from the publisher. Phil is happy when he achieves four inventory turns per year.
Turner is a bit of a rebel, and decides to forgo the extra discount and orders his product from a wholesaler at 40%. Turner orders a lot more often because the order processing time is much quicker with the wholesaler – his orders ship the same day he orders. The other important benefit the wholesaler offers Turner is that all of his publishers can be added to the same box and shipped together. This allows Turner to stock more titles, even though he is carrying less of each title on the shelf. As a result, Turner achieves six turns per year.
Here is where we break out the math.
Assume that Phil and Turner both sell their books at full retail, and assume their costs (rent, financing, etc.) are the same. Which is better off financially? Let’s take a look.
Phil gets 50% discount.
Annual purchases are $400,000 ($100,000 x 4)
Inventory sold four times at retail equals $800,000 ($400,000/.5)
Sales = $800,000
Cost of Sales = $400,000
Gross Profit = $400,000 ($800,000-$400,000) or 50%
Turner gets 40% discount.
Annual purchases are $600,000 ($100,000 x 6)
Inventory sold six times at retail equals $1,000,000 ($600,000/.6)
Sales = $1,000,000
Cost of Sales = $600,000
Gross Profit = $400,000 ($1,000,000-$400,000) or 40
In this exercise, they are equal. They both end up with the same gross profit. Does this surprise you? It surprised me. I assumed that more discount meant more gross profit. This same inventory turn concept applies to publishers who work with short run printing. The more turns, the better the cash flow, even with less ‘margin’ on a book. Reducing risk, by printing less (especially true print on demand) is not only profitable, but the way of the future.
In the next exercise, we will see some interesting things happen with the numbers that our two retailers are experiencing.