Deciding Which Products to Stock in a Business
At one time I thought I was pretty good with math, but this one has stumped me. Can you help figure it out?
I run a small mail order business; Inventory is purchased from various vendors, stored in a warehouse, until it’s sold and shipped to the buyer. I have limited cash and limited storage space, so I would like to maximize profit by carrying the best possible mix of products.
On many of my sales, I do not charge the customer any shipping costs, as I pay for the shipping out of the profit in the item. The shipping costs for my items vary greatly since some items are light and others are heavy. So for a simplified example, if an item sells for $50.00, costs me $20.00 to ship, and $20.00 for the cost of the item, I have made $10.00 gross profit, or 20% gross margin. I always use gross margins to compare products; so if product #1 has a 20% margin, it must be better than product #2 that has a 15% margin. Lately I have been realizing that this may not be the best answer. Comparing these examples:
- Product “a” sells for $200.00 including shipping. Item costs me $65.00, shipping costs me $95.00, leaving $40.00 in profit, 20% margin
- Product “b” sells for $200.00 including shipping. Item costs me $145.00, shipping costs me $15.00, leaving $40.00 in profit, 20% margin
Although both of these examples have the same margin and profit, “a” is drastically better since I only have to lay out $65.00/pc inventory. When the customer pays me $200.00 and I prepare the shipping label, only then do I incur the shipping expense, for which I’ve already been reimbursed. So if I only compare products based on margin I’m not accounting for the fact that some products are very heavy, so the high shipping costs penalize them unfairly. Taking it to an extreme, if I had a product that cost me $50.00 to buy, $500.00 to ship, and sold for $600.00, the margin would look very low (under 10%), but I would be doubling my initial investment. This has me thinking maybe I should consider “markup”, instead of “margin”.
In addition I have to consider the absolute profit. Calculating my overhead and dividing it by the average number of items I sell gives me an expense of about $2.00 for every order. So buying an item for $0.25 that makes me $1.00 in gross profit would look great on a markup calculation, but would put me out of business.
I also have a space constraint, and products take various amounts of space to store. One item may take up 6 cubic feet, and other item only 1 cubic foot. If these items cost the same and sold for the same markup, I would much rather stock only the 1 cubic foot items, as I would have 6x the capacity in my warehouse. Further complicating matters is the fact that most of the vendors I deal with have minimum order requirements, say 100 pieces, so sometimes merchandise may sit on the shelf longer than desired, making the space used very valuable. It costs me about $0.35 per cubic foot of usable rack space per month. Of course the lower my asking price, the faster the merchandise will sell, and the less rack space required.
So do I fill my shelves with $10.00 items that I make $10.00 profit, or with $200.00 items that earn me $40.00 profit...what if the $200 items take up much more space, or vice versa...what if one of the items sits on the shelf longer...
Do you have any ideas of a formula that I could use to score or grade products, allowing me to maximize my profits by replacing low scoring products with higher ones; I think the formula would need to consider:
- Absolute amount of profit
- Turnover rate (and production lead time) Suppliers take various times to deliver an order, some vendors can have an order at my door in 2 weeks, others take 90 days. With these longer delivery times, I usually order more than I need, using valuable capital and space.
- Volume of stored inventory.
Any ideas on how to build this formula and weigh these variables?
Re: Deciding Which Products to Stock in a Business
There will be no "formula" you will have a linear programming problem (probably) when you quantify all of your costs.
Originally Posted by EricW