Retail excites me a lot because it is a simple business of buying and selling goods and yet it covers almost every complexity under the sun. It has a complex supply chain from raw material to finished goods, yet seeming so simple and convenient when we add items to our shopping cart in offline and online stores. One of the most interesting aspects of retail distribution is the calculation of return on investment by various stakeholders in the supply chain.
If you are a manufacturer, you will witness both suppliers upstream and the distributors downstream investing in your business. Suppliers setup factories, invest in raw materials, labor, technology, etc. for your products. Similarly, distributors or retailers buy your finished products, invest in warehouses, technologies and partner with you in distributing the product to your end customer. Both these stakeholders invest capital in making and/or distributing your products and will look for profits in doing so. While IRR is probably the most sound way of calculating the ROI of an investment, most distributors and suppliers you meet always do a quick back of the envelope ROI calculation and it is never far away from the IRR(internal rate of return) method in its results and is really cool to work with suppliers and distributors on the various parameters that go into it.
“Across all kinds of investments, ROI is more common than IRR, largely because IRR is more confusing and difficult to calculate.” – Investopedia
As businessman, all vendors, distributors and retailers are interested in the return on working capital employed (ROWCE). After all there is only so much cash in the bank! Distributors and vendors are concerned about two key aspects: profit and cash – maximize profit by minimizing cash requirement. ROI can be increased by increasing profit and by reducing investment requirement. Increasing profit can happen by increasing sales revenue or by reducing expenses and in expenses cost of goods sold (COGS) is the major component that is focused on. However, one has to check all other retail components such as goods returns, payments, transportation charges and other options to reduce costs.
But more important than anything in business is CASH. Vendors and distributors want cash to 1). hold inventory and 2). extend credit in the market. As the turnover starts to increase, the inventory requirement starts to increase and credit requirement in the market increases. This increases the cash requirement for vendors in the market and blocks lot of capital in the market. As inventory requirement increases, there are advantages of ordering full truck loads (FTLs) and holding the inventory for shorter periods of time too, but it depends a lot on category lead times. Therefore, distributors are always on top of their ROI calculations to keep a check on their business situation.
Let us look at various cases to understand ROI calculations:
You are buying a product at Rs.100 on day 1 of the month and you sell it to another stakeholder at Rs. 110 immediately. The stakeholder will give you the Rs. 110 exactly after 1 year. What is your return on this business? Simply put, the answer is Gross Profit/Investment = 10/100 = 10%. The formula is also nothing but (earnings – expenses)/(investment).
You are buying a product at Rs.100 on day 1 of the month and you sell it to another stakeholder at Rs.110 immediately. The stakeholder will give you the Rs.110 exactly after the end of one month. What is your return on this business? You 100 rupees in inventory at the start of every month and you get Rs.110 at the end of the month. So, I make Rs.10 every month and that multiplied by 12 times for 12 months makes it a return of Rs. 120. Return of this business is 120/100 = 120%
The difference between case 1 and case 2 is not in the margin percentage but in the number of rotations of the invested capital. It is actually about margin * number of rotations of invested capital. In the first case, the margin is 10% and the number of rotation of invested capital in one year is only 1 – hence 10%*1 is the return. In the second case, the margin is 10% and the number of rotations of invested capital in one year is 12 – hence 120% return.
But, when you meet a supplier or a distributor, he will tell you that he has invested in a special account manager for you, a special warehouse for you, a special machine for you, etc. So, there are direct and indirect expenses. It is important to break-down the vendor or distributor’s expenses and account it correctly. The formula comes down to ((Gross Margin)*(Number of rotations of invested capital) – (Expenses direct/indirect))/(Capital Invested)
While the cunning business guys always tell you that they’ve invested in warehouses, human resources and machinery only for you, typically they will always serve more than one customer or vendor. So, it is important to understand their overall business value and your contribution to that and take expenses in proportion to that. If a supplier is supplying to 3 customers and you are contibuting to 40% of their business. It is safe to say that you should take 40% of the human resources, depreciation of the machinery, etc. into the expenses and not the entire expenses of the human resources and depreciation expense.
You are buying a product at Rs.10 and selling it at Rs.11 immediately. The Rs.11 is given to you after the end of the third day of the sale. However, in this business, you have to invest in a machine worth Rs.36 and has a lifetime of 3 years. Return is ((10%)*(number of rotations is 120 because you are getting money every 3 days) – (depreciation expense of Rs.12 for the first year – straight-line depreciation method))/(Rs.10 as capital invested)
The important thing is you don’t take the entire 36 rupees invested in the denominator. Most suppliers and distributors will do this in their calculation when they discuss with you. But, that is sitting as an asset in the balance sheet with only depreciation as an expense coming into the profit and loss calculation.
Let’s take a new case. At the start of the month, you bought Rs.200 value of a stock. You are selling Rs.100 value of stock every month to another stakeholder and that stakeholder gives you Rs.110 at the end of one month. The return of the business is: ((Rs.10 profit*12 times) – (direct/indirect expense))/(200). If I ignore expenses for a moment, your return has dropped from 120% in case 2 to 60% straight. This is because of the Rs.100 capital invested in the stock that has not moved for the entire year. Your return on investment drops by the ratio of the non-moving stock (or non-rotating capital) to the overall stock (overall capital) invested. You might think that the Rs.100 non-moving inventory should not be entered in this calculation and instead, it should sit on the balance sheet (as inventory under assets). However, that is not true for stocks that are not being sold for such a long time. In fact, many companies start taking only 85% of the value once it is not sold for 3 months and 60% of the value once it is not sold for 4 months. This is assuming that one needs to give steep discounts to sell something that is not sold for such a long time and the inventory is losing its value in the warehouse because of natural depreciation, wear and tear, theft and outdated technology. However, this very much depends on business to business and product to product.
You bought Rs.100 of stock at the start of the month and you sell it to another stakeholder. You will get Rs. 110 from that stakeholder at the end of two months from the sale. This means the return is: (10% margin)*(6 rotations) = 60%, a drop from case 2 primarily because of the reduction in number of rotations.
In the above case if the Rs.100 is taken from a loan then the investment is only the interest paid and not the entire amount of Rs.100. Distributors and suppliers would again include the entire amount as a common trick.
A healthier ROI for most suppliers and distributors ranges between 25-40%. From the above cases, we learnt that the product margin is important, but rotations of capital invested in inventory and how much investment is needed matters a lot in retail.
The number of rotations of capital invested in inventory for a period is calculated as 365 divided by (the average number of days of inventory held during that period). In cases where it is complicated to calculate the average number of days of inventory, closing inventory for the period is used as a proxy.
In case 1, you would want to improve in rotations. If your rotations are good, you would want to improve on margins. If both margins and rotations are good, then you would want to improve on overall business volume.So, profits are about the business volume, absolute margins, the number of rotations of capital and the capital in rotation. It is not just about margins, it is about how much money is required to invest and how many times can someone rotate that money.