Inventory and finance are the least enjoyable parts of running a product-based business, but they're also the most important. If you don't have a handle on these numbers it's very difficult to stay profitable especially as you scale.
Learn how you can tweak the profit-first method to fit your inventory business and the most important things you need to understand about your business financials.
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How Can Product-Based Businesses Use the Profit First Method?
Think of it as a cash management system; you're essentially just telling your money where to go. Instead of pouring everything into one big bowl, let's pour it into little cups that are designated for particular things.
Each week, after you've gotten your deposit from those weekend sales you'll divvy up your money across your different accounts. Each business owner may want to manage this differently but at a minimum, you'll want to have a tax account and an inventory account. Whatever is left over after you make those transfers is what you have left to play with.
How Do You Decide How Much to Put in Your Inventory Account?
The only money that gets added to the inventory account is the cost of goods sold from the sales you made; the inventory that went out the door.
If you made $100,000 in sales and that inventory cost you $50,000 to purchase from the vendor, then $50,000 is what you put in your inventory account. The ultimate goal is just to replace the inventory that was sold.
When you use that in conjunction with an open-to-buy plan then you know exactly what your buying budget is.
How Do You Know What is Included in Your Cost of Goods Sold?
The way you calculate the cost of goods sold is going to depend a bit on your business and product assortment.
If you're buying finished goods wholesale and then reselling them, the cost you paid to the vendor is your COGS.
If you have a subscription box, it's the cost of the items you bought and the box you put it in because that box is part of the product.
If you make your product, your COGS is everything that went into making the product including the materials, labor, and even the tailor's chalk you used to mark out your pattern.
How the Profit First Method Helps You Better Manage Your Inventory
Not only is it just a smart way to manage your money and ensure that you have your finances in order but it really teaches you to manage your margins and to focus on selling what you already have.
Learning to sell what you already have really comes into play when you're working out your open-to-buy as well because that OTB calculation is your sales goal, plus what you want to have on hand, minus what you're starting with.
Just because an item you have is stale or there's a category you don't want to sell anymore, you still have to include that in your on-hand calculation. You can't just ignore it so that you have more money to spend on new items.
How to Set Up Your Product Assortment for Maximum Profitability
In general, you want to shoot for a 60% margin across all of your product categories. Some will be higher, such as jewelry and accessories while others will be lower like brand-name items that have MSRP. But it should all even out to at least 60%.
When you're buying inventory for your store across multiple different categories you'll want to make sure that you're allocating the right amount of inventory to each category. You can also build out a ratio for each category.
Ciara had 5 categories in her boutique business. Accessories, basics, cardigans, denim, and gifts. She built out a ratio based on her average order value goal and the margin she wanted. So accessories were 3, denim was 1, basics was 2, etc. That meant for every 10 units of inventory, 3 would be accessories, 1 would be denim, 2 would be basics, and so on.
While accessories had a great margin, they were low ticket. In order to hit their average order value, they had to sell that accessory with something else. Ciara broke down the different ways the employees could hit the desired average order value and move through the inventory. Ex. sell an accessory with a top and a cardigan. Or sell two tops and a cardigan.
Focus on Buying What Sells
When you're building out your product assortment it's also important to just keep buying what sells. So often we get bored with our inventory, we don't want to keep selling the same thing over and over, but we have to stop “playing store” and treat this like the business it is.
Ciara and I both had our stores during the scarf craze. (Check out the scarf display at my cash wrap in the photo below) As long as people kept buying scarves, we kept stocking them.
Get Rid of Stale Inventory With Deep Discounts
If you do end up making some bad buys and you need to move through your inventory, the best option is to take a big markdown right from the start. This is especially true if you've decided you're no longer going to carry a particular category. Recoup your wholesale cost if you can and move on.
Think of Your Inventory as Cash on Hangers & Cash in Boxes
Inventory is an asset in a product-based business. As soon as you buy inventory it's cash. Your job is to turn that inventory into cash as quickly as possible. It's not worth anything to you if it's sitting there and not selling.
Lots of people struggle with letting go of items at or below wholesale because they're not making any profit, but that cash is like a seed packet. it's seed money that you get to plant and grow a new money tree.
Let's say you make $10 off of a shirt. Even if you paid $25 for it; doesn't matter. You got $10 out of it. Now you're going to use that $10 really wisely and buy something that you can sell for 30 or 35. Then you'll take 30 or 35 and buy something that you can sell for 80.
Ultimately, you're taking that worthless inventory and turning it into some money-producing trees.
What are Some of the Struggles Business Owners Face When Using the Profit First Method?
There can definitely be an adjustment period when you first start implementing profit-first in your business. Even if it's working well from the start, it's so different from what they've been doing in the past that it's uncomfortable. There are two main issues that business owners typically run into when they first implement the system into their business.
It Feels Tedious & Hard Even if It's Actually Working
Just like when you're training for a marathon at first you're super excited and motivated. You're working out all the time and even if you feel sore you're like, “It's okay because I know it means I'm doing something”
But then it's the day-to-day of showing up at the gym, doing the workouts, and not drinking on the weekend. Even though you don't like what you looked like or felt like before, you'd still rather sit on your couch binge-watching TV and eating Doritos.
Some people struggle with the discomfort of sticking to this new system. They don't want to go to market with a budget, they don't want to figure out the cost of goods sold for every item they sell.
They Struggle with the Lack of Cash Flow
This is usually the difficulty if they start out with a lot of debt. Unfortunately, it doesn't take very much time to get into trouble, but it takes a long time to dig ourselves out.
Cutting expenses, budgeting, trying to move through bad inventory, and not having much to transfer to the profit account. It can be overwhelming and people just want to give up because it feels too hard and they'd rather just go get a Shopify loan.
What Are the Most Important Financial Reports for Product-Based Business Owners
Aside from getting really comfortable with your inventory management, you need to have a handle on your profit and loss statement. Financials aren't fun, but if you don't have a handle on this you won't have a profitable business.
The profit and loss statement has 5 lines on it.
- Gross Margin (difference between sales & cogs)
- Expenses (rent, payroll, insurance, etc.)
- Profit (Gross Margin – Expenses)
Your profit line is what you need to be focused on.
At the end of the day, being a million-dollar business doesn't matter if you don't have any profit left over. You could be a $100,000 store and give yourself a $2500 paycheck every month. Stop dwelling on vanity metrics and figure out what success truly means to you.
How Inventory Management Can Increase Profitability
Let's say you do $100,000 in sales and your cost of goods is $50,000. That leaves you with a $50,000 margin. If it costs you $50,000 to run your store then you're breaking even. You have $0 left over.
What if we just tweak our inventory; what if our COGS was only $40,000? So we still sold $100,000 but we have a $60,000 gross margin. With our $50,000 in expenses, now we have $10,000 profit.
Our sales didn't increase, we didn't have to cut payroll or find new customers. All we had to do was either buy smarter or increase our markup.
What Are Some of the Biggest Mistakes Businesses Make With Their Finances?
Have you read the book, If You Give a Mouse a Cookie? It's essentially a lesson in cause and effect. If you give a mouse a cookie, he'll ask for a glass of milk. If you give him the milk he'll ask for a straw. And it just keeps going down this rabbit trail.
When Ciara was running her boutique business she wasn't paying close enough attention to her profit. They were a high-volume business doing millions in sales, and so of course she had to hire help. Then she bought a forklift, which meant she had to hire a forklift driver, then someone to manage the driver, etc.
Instead of growing off of profitability, she kept growing off of the top line. She just tried to sell more and more stuff. But if you're not paying attention, you're also growing your expenses.
It's very similar to the lifestyle creep that can happen as you start making more money. You get a bigger house, a nicer car, more expensive clothes, exotic vacations, etc. Before you know it you don't actually have any more leftover than you did before to put toward your retirement or to save for a rainy day.
Ciara is the founder and coach of Inventory Genius, a coaching program for inventory-based businesses. In addition to running businesses since her teens, Ciara has been recognized as a Small Business Champion through SCORE, has held a seat on the United States Chamber of Commerce Small Business Council, and is a Profit First Certified Coach. Through her coaching program, Ciara strives to motivate business owners to build profitability and peace of mind into their business