Inventory Risk and Inventory Management; Our Own Version of Musical Chairs?

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Janet Freeman, owner of the small but well established women’s snowboard apparel brand Betty Rides, has a problem. On October 17th, she told me, “It’s weird but Betty Rides has ALREADY been getting lots of re-orders for snowboard jackets and pants. We cut to order, and are sold out on most things.”

Naturally, I was sympathetic to her terrible problem and said, “Which means that you are holding margins, selling through at good margins at retail, creating demand without running a big promotional campaign, being important to your retailers, and minimizing your (and the retailer’s) inventory risk?  I predicted some products shortages a while ago and I think, for the industry overall, it’s a great thing.  I think you are also seeing that small retailers are dependent more than ever on small brands that have not blown up their distribution and on which they can make good money.”

Better ringing your hands over sales you missed then inventory you can’t sell. Of course, I recommended this strategy for smaller brands especially years ago but, for some reason, it’s suddenly gotten popular. You can track the article down on my web site if you want.
 
What’s Inventory Risk?
I imagine most of you don’t need that question answered, but there are a few points I want to make and that seems like as good a subheading as any. Mathematically, I suppose your total inventory risk is the cost of everything you purchase or make for resale. If you want to eliminate that risk, you don’t make or buy anything. But that seems a little extreme. Instead, let’s define inventory risk as the potential decline in the value of your inventory from what you expect it to be; from the anticipated selling price, that is. Once you sell it, it’s no longer inventory risk. It’s credit risk if you weren’t paid before you ship it. Retailers, of course, are typically paid before “shipping.”
 
Inventory risk gets managed in two ways.  First, by buying well. Hopefully, that helps you with the second part of inventory risk management- selling well. My last article for Canadian Snowboard Business actually talked about that. Maybe they’ve put it up on their web site and could put the link HERE?  I’ve also written about using a concept called Gross Margin Return on Inventory Investment (GMROII) as a tool to increase your gross profit dollars and, incidentally, reduce your inventory risk and you can see that on my web site here. 
 
You can never get rid of inventory risk, but if you’re buying well and using GMROII, you’ve probably done everything you can reasonably do to minimize it.
 
Who’s Inventory Risk?
It’s impossible to completely eliminate inventory risk and be in business. In a perfect world, a retailer would love it if the brand could give them only the stock they need to merchandise their store and then have replenishments show up over night. Oh- and they’d prefer it if everything they got was on consignment. The brand, sitting on the other side of the equation, wants the store to buy everything all at once and pay cash in advance. Obviously neither is going to get their way.
 
The original premise behind this article was that inventory risk was a zero sum game. That is, it existed and somebody- the retailer, the brand, or the manufacturer- had to shoulder it. Zero sum means that you can pass it around, but not reduce or eliminate it. The only question is who takes the risk.
 
I’m not so sure that’s completely true. After some thought, and some conversations with some smart people, I’m beginning to look at inventory risk as an indivisible part of systemic business risk. You can manage it, but it’s just not independent of overall business conditions and your relationship with your customer or buyer. It’s not zero sum because you can work together to reduce it.
 
Some Real Life Examples
 
“One you find the demand line and are honest about it, and start producing under it, you really start building your brand,” Jeff says.
And of course both the retailer and the brand reduce their inventory risk because they aren’t kidding themselves about demand. You can see where I’m going with this. Good demand planning at all levels of the supply chain can reduce the inventory risk for everybody- not just transfer it from one player to the other.
 
Sanction is a snowboard and skate retailer with shops in North Toronto and the Kitchener/Waterloo area. Co-owner Charles Javier says he dropped a lot of the larger snow related brands or lowered the quantity he bought this year. He’s been bringing in smaller brands, and does better with them than with some of the larger ones. In fact, they upped their total buy this year. “How we manage inventory risk isn’t about how we put risk off on the brand, but about how we buy,” he told me.
 
And he’s not particularly concerned that his smaller preseason orders with some brands will keep him from having enough product later in the season. “There’s always going to be inventory available,” he said.
 
A consistent theme in my conversations has been brands warning that they aren’t making product much beyond orders, and that retailers who want it better have gotten their orders in, and retailers not quite believing them, or not quite caring, or thinking they could substitute another brand. I guess by the time you read this, we’ll know how it worked out. I hope to hell there are some product shortages that make some of this stuff a bit scarce and special again.
 
Darren Hawrish is the president and owner of No Limits Distribution. Located in Vancouver, it handles Sessions, Reef, Osiris, Capita, Union and other brands in Canada. He and Charles at Sanction would probably get along just fine, as Darren, like Charles think you manage your inventory risk by how you buy. He’s been more diligent on inventory this year, looking at it weekly instead of monthly.
“Inventory is the make or break part of your business,” he told me. “You can’t increase sales [which they expect to do, though not as much as in previous years] without it.” But posted on their walls is a sign that says, “Inventory Is Death” so it seems they have a healthy balance in how they handle it. “The discount doesn’t matter if you can’t sell it,” he reminded me.
 
He’s seeing tightness all along the supply chain. He thinks it’s a lot tougher to make in season buys than it was 18 months ago or so. His goal is to sell what he gets in. On the face of it, that sounds kind of obvious. But in his mind inventory and buying are closely tied to having clearly defined growth and margin goals, so there is a strategic component to inventory that a lot of people may not be thinking about. And that is another way that Darren works to reduce inventory risk.
 
I’m not quite sure the musical chairs analogy I used in the title holds up. Inventory risk can’t be isolated from general business risk, and it’s not a known quantity that just gets passed around. A brand that sells its product and gets paid for it still hasn’t eliminated its inventory risk. What happens when all that inventory doesn’t sell and the retailer has to dump it? What’s the impact if they go out of business and aren’t around to buy anything next year? What if the value of the retailer’s inventory goes to hell because of the distribution actions of the brand? What’s the brand suppose to do when a retailer grey markets stuff outside of normal distribution channels?     Seems to me that inventory risk exists all across the supply channel and we’re all in it together.
 
It gets minimized when the sales plan is realistic and consistent with the brand or retailer’s market position and strategic goals. Not to mention market conditions. It is further minimized when you buy based on your best estimate of demand regardless of terms, discounts and or other incentives.
 
Current economic conditions are requiring us to reduce our inventory risk and to pay closer attention to all the management accounting and operations management things that, frankly, aren’t much fun. But we’ll be a much better run industry as a result and might even bring back to at least some of our product the sense of exclusivity it has lost over time.

 

 

Gross Margin Return on Inventory Investment A Tool for Our Times

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Since last fall, as our new economic reality has evolved, I’ve had a few things to say about what to do. They’ve included building your balance sheet, controlling your inventory and other expenses, focusing on the gross profit line, looking at gross margin dollars as well as percentages, and making good use of your management accounting system, which I consider a strategic tool in this environment.

All very sage and business like stuff I’m sure you’ll agree. Trouble is, I didn’t really have a method to help you do it all. Problem solved.
Serendipitously, Cary Allington, President of ActionWatch, the collector and supplier of sophisticated, detailed retail information on what’s selling at what prices and margins in our industry sent me an article on the Gross Margin Return on Inventory Investment concept (GMROII). He was pretty excited. So was I after I’d read it.
 
The concept isn’t new. It’s valid for brands and retailers. It comes as close as I could hope to drawing together most of the ideas I’ve been talking about lately. Hopefully, you’ll read this and say, “Oh hell, I already know and do all that.” But I don’t think so. Neither does Cary, who spends a lot of time talking with retailers and brands about the data they have or want and its quality.
 
What Is It?
GMROII is a conceptually simple method for measuring which inventory items (or categories, or brands) give you your best return on your investment in that inventory. It combines gross profit with inventory turns in a way that allows you to compare the profitability of snowboards (or a particular snowboard) with, say, surf wax at the gross profit level. It’s not perfect, and we’ll discuss the caveats below, but it looks like it can be very useful.
 
Just as a refresher, inventory turn refers to how many times you have to replenish your inventory for a given level of sales over the year. It’s important because the more turns you have, the less inventory you can carry for a given level of sales. And the less chance your inventory will have to be marked down. Carrying extra inventory costs you money in lots of ways including cost of capital, overhead, and opportunity cost when you have money tied up in something that takes a long time to sell and has to be discounted instead of in fast moving, full margin inventory. 
 
The GMROII calculation itself is simple. It’s just the number of gross margin dollars you make selling a product (or category or brand) over whatever period of time you choose to measure it divided by the average inventory at cost over the same period. Typically, it’s done over a year. The result is a number (in dollars- not a percentage) that tells you how many gross margin dollars you earned for each dollar invested in inventory over the period.
 
Having calculated these numbers, what might you do with them? For the first time, you’ll be able to compare what I’ll call the inventory financial efficiency (I just made that up! Kind of like it) of any item you sell with any other item. You can also do it for a brand or a category. You can actually say, based on the example above, I’d rather sell the same amount of Item A than Item B even though one sells for $600 and the other sells for $12.00 and they are in completely unrelated categories. You can see which ones you’re wasting your time selling (or at least recognize that there’s no financial reason to be selling them). You can eliminate too much emphasis on gross profit margin, which I think you can see in the table below can be misleading. You may significantly reduce your inventory investment.
 
Below is a table supplied by ActionWatch that calculates the GMROII for a number of categories using data they collected from their panel of retail shops.

 

 

The GMROII is the number of gross margin dollars generated for each dollar of inventory you had in that category over the period of a year. If you could plan your whole business around GMROII, obviously you’d get rid of everything but long completes and just sell them. But your customers probably wouldn’t go along with that.

That shoes are at the bottom of the list isn’t a surprise, at least to me. Given all the color, sizes, and styles you have to carry the inventory investment is pretty significant. The opportunity is to calculate the GMROII for each SKU and figure out how you can change your mix to drive that shoe GMROII up.
 
I was kind of surprised to see the GMROII for accessories as far down on the list as it was. We’re all favorably disposed to accessories and think of them as a high margin, profitable product. This particular analysis suggests they aren’t quite as spiffy as we thought.
That skate hard goods all had GMROIIs higher than soft goods was kind of a surprise. I’d especially note the high values for short decks. We bitch and moan that the gross margins need to be higher, but because of the speed at which short deck inventory turns, they look pretty good in a GMROII analysis. This analysis doesn’t break out branded from shop decks. That would be interesting to see.
Notice how increasing the annual inventory turns boosts the GMROII even when the gross margin percentages are lower. You’d rather have an extra half turn on that inventory than a couple of gross margin points any day. But how many of you calculate the inventory you buy based on the dollars you have to spend and the percentage gross margin you expect to make? You can’t ignore those factors, but pretty clearly turn needs to be part of the analysis. 
 
The basic calculation for GMROII is conceptually simple as you can see. But I’m afraid it requires some work. What an inconvenience.
 
The System Thing
You won’t be doing a lot with GMROII unless you have a quality management information system. For the calculations to be meaningful, your sales history and inventory tracking have to be solid. If you want to track it by category or brand, your chart of accounts has to have been set up to aggregate the numbers. And of course this isn’t a onetime activity. You need to keep it current as product comes and goes, as credits are processed, as write downs occur. You get the picture.
 
I’ve talked about the need for good systems before. I’ve gone so far as to say you can’t get by without one- especially now. Some systems do the GMROII calculations for you. I’ve been told that these include Cam Commerce, which offers it in their Retail STAR and Retail ICE applications. Win Retail also offers it. I’m not sure which systems for brands might offer it.
 
Other Considerations
You can’t just keep the products with the highest GMROII. Total dollars generated matter and there are other reasons besides financial to stock a product. You can have products with huge GMROII that wouldn’t generate enough gross margin dollars to cover expenses (and some bottom line profit besides would be nice).
 
You have to already have been carrying a product for a period of time before you can do the calculation. If you want to conduct a GMROII analysis at the item level, it works best for items that you replenish rather than replace. If you’re out of inventory for a period of time, that will impact the value of the calculation.   In general, the longer you’ve carried the product, the better the calculation will be because the average inventory number will be more accurate. 
 
Come to think of it, for those of you who are statistically inclined, I recommend calculating the mean inventory and the standard deviation (dispersion around the mean) rather than just average inventory. That would give you a good sense of whether or not you can calculate GMROII for shorter time periods. Though I suppose you’d need to calculate it for the same period for all products to get comparable results.
 
If only because it gives a result in dollars, GMROII is not a traditional return on investment calculation and should not be confused with one. It’s a way to manage your inventory- not your whole business. But inventory is often the biggest number on your balance sheet, so managing it well pays big dividends. How might you start?
 
To take the greatest advantage of the concept, you really do need the good system and data I describe above. Just to work up some enthusiasm, assuming your system isn’t quite set up to make the calculations, get a pencil, calculator, paper and inventory and sales records going back a year. Pick, oh, I don’t know, sunglasses. Choose a brand. Or a style or color. Whatever it’s easy to get the data for.
Figure out the total gross margin dollars (after all allowances and markdowns) you earned on that product or product group over the year. Now add up the inventory at cost of the product or product group at the end of each month over the last year and divide by 12. Divide the gross margin dollars by that average inventory number and you’ve got your GMROII.
 
Next, depending on what you decided to do the first calculation on, do it again for another brand, color, or style. Now you’ve got the GMROII for two groups of products. Is the result similar? If not, why not? Was a style you ordered the most of just a dog? One brand just cooler than the other? Did the order get screwed up?
 
What adjustments should you make in your purchasing so you’re selling more of the higher GMROII stuff?
 
Now, for even more fun, do the same calculation for surf wax. Or whatever. Which should you want to be selling more of; the sunglasses or the surf wax? Bet you didn’t have a way to figure that out before.
 
It won’t be as simple or clear cut as I’m making it sound here. It will never be exactly accurate, but the more you use it, the more useful it will become. It’s clearly harder to do with seasonal merchandise and changing styles, but I think it’s worth the extra work, though the quality of your information won’t be as good.
 
Cary has put a link to the article I referred to on the ActionWatch web site. You can access it in the section called “POS Tips Links” at www.ActionWatchReports.com.   The GMROII concept is worth some of your time. There’s a bunch of money on the table.

 

 

A Little Random Perspective on the Financial/Market/Credit crisis

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Once upon a time, way back in 2003, an investment bank could only have leverage of up to twelve to one. In 2004, the Security and Exchange Commission gave five investment banks, and only five, the ability to leverage up to 30 or 40 times or so. Guess which five they were? I almost don’t want to bother listing them, because the list is so obvious. But for the benefit of all the readers who have just awakened from a coma they’ve been in for most of the year, they are Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley and Goldman Sachs.

There’s a lesson there somewhere.

On my last posting on Zumiez, I wrote about how they had to classify their various investments under the terms of FASB 157. Basically, companies are required to “mark to market” their various securities. The problem arises when you know your securities are worth something, but you have no idea what because they aren’t trading. Should you carry them at $0.00?
Back in the early 80s, I was an international banker living in Sao Paulo, Brazil and having a hell of a good time. All the South American countries had defaulted on their debt to the American banks. It was a lot of money and if the banks had been required to “mark to market” all those loans, they would have been broke. A bank’s ability to lend depends on its capital ratios. If they have to write off all their loans, they have no capital and can’t lend. The Fed decided that would be bad so they let the banks keep those loans on their book, writing them off bit by bit as they earned profits to cover them. Eventually, they did get some payments. The loans were certainly impaired, but they weren’t worth zero.
 
This mark to market provision needs to be changed. Just because there’s not a market right this minute doesn’t mean the loans are worthless, and we shouldn’t treat them as if they are. And we can’t afford for our banks’ capital to all go away.
 
Which reminds me- as you hear this number of a bailout costing $700 billion being bandied about, remember that these loans do have some value. We’re not quite sure what the number is, but it’s not small and the net cost will eventually be a lot less than the gross number. In fact, because of all the fear out there, some killer investment opportunities in some of these securities exist and anybody who knows how to tell the good from the bad and the ugly should call me.
 
This morning I read that a local Seattle utility had only been able to refinance $28.5 out of the $30 million in debt it wanted to refinance. And it had to do it at 5.5% instead of 1.5%. The possibility that these additional costs would be passed through to utility customers if the credit markets didn’t get unstuck was mentioned, in case anybody out there thinks this might not impact them. If you’ve tried to get a credit card, mortgage, car loan or home equity line of credit lately and your credit isn’t pristine, you’ve probably already figured it out.
 
The discussion about the bailout is not about losing money. The money, however much it turns out to be, has already been lost. The discussion is about who’s going to absorb the loss. I’m afraid it will largely be you and me.
 
My reading of history is that the Great Depression happened largely because of a bubble that was left to correct itself and the paralysis that followed. Chairman Bernanke and Secretary Paulsen, no slouches when it comes to reading history themselves I’m thinking, have followed the drop in commercial paper issued, saw the sudden spike in its cost just in the last ten days, and decided this wasn’t something to fool around with. Hence, the package that’s before Congress right now. I’m hopeful it will be passed quickly and without a lot of other stuff tacked on.

 

 

The Last Intrawest Annual Report: One Benefit of Being Bought

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I’ve always admired Intrawest’s ability to combine and coordinate its real estate activities with the development and management of its mountain resorts. It always seemed like they managed to choreograph the two to maximize the value of both. That didn’t mean, however, that I looked forward to reading their annual  Form 40-F filing with Security and Exchange Commission and now that they are about to be acquired by Fortress Investment Group (probably a done deal by the time you read this) I guess I won’t have to do it any more.

 
But I’m a sentimental kind of guy. Just for old time’s sake, I decided to slog through the last one when it came out. And as long as I was being sentimental, I thought I might as well try and figure out exactly why Intrawest decided to sell to Fortress.
 
This all began with a February 28, 2006 press release in which Intrawest announced “…that it had initiated a review of strategic options available to the company for enhancing shareholder value…” Intrawest Chairman Joe Houssian is quoted as saying, “It makes sense for us at this time to evaluate all of the different ways in which we can capitalize on the opportunities in front of us for the benefit of shareholders, and to ensure that we have the bets possible capital structure in place.” Here’s a link to the Intrawest site where you can click through to see the press release: http://www.integratir.com/newsrelease.asp?ticker=IDR
 
Okay, well enhancing shareholder value is a fine thing. Who could argue? But my question was why they thought they had to go through this process to do it. Couldn’t they just run the business themselves? Did they need more capital than they could raise on their own? Were they concerned about softness in the real estate market? Did the diversification of their business (only 32% of revenue now comes from mountain operations) require a different kind of support? The release didn’t say.
 
By way of background, Intrawest went public in June of 1997 at $16.75 a share. The stock bounced around for some years, closing at $18.94 at the end of September, 2004. From there, it moved up smartly, closing at a high of $37.60 the week of May 5, 2006. It then reversed course and went down for eleven of the next thirteen weeks, closing at $26.70 the week ending August 4th. Then the sale of the company was announced and the stock rocketed up to $34.50 ($35.00 a share is the purchase price) and has stayed near that price since.
 
The June 30, 2006 balance sheet is hardly changed from the previous year and the changes are positive. Total assets are almost identical, while liabilities are down and equity is up.
 
Net income rose from $33 to $115 million. The contributions from resort and travel operations fell 11% to $89 million. Management services contribution fell 14% to $37 million. The real estate contribution, however, more than doubled to $143 million. That component of Intrawest’s income can swing around a lot from year to year. I guess it’s normal for that business, but it makes year to year comparisons a little difficult.
 
I thought a telling section of their Form 40-F was the section called “General Development of the Business. It listed what they consider to be “key developments” during the last three fiscal years. There were thirteen accomplishments listed and every single one of them was raised money, sold this, bought that, refinanced this, retired that debt, started our review of strategic options. No doubt these were key developments, but I thought it was interesting that not a one was focused on running and improving the core business operations. I mean, they must have done some good things in those areas. They’ve been doing them for years. 
 
You read the press releases, scour the documents, and listen to the conference call. You still don’t get a specific and satisfying explanation for why Intrawest sold.
 
But if you go to the web site of the Fortress Investment group (http://www.fortressinv.com/) and spend just a few minutes reading about it, you will learn that they are a large, diversified organization with access to capital and the ability support companies in putting in place financial structures that allow those companies to take maximum advantage of their opportunities. Whatever Intrawest can accomplish on its own, it can do more with the support of Fortress. With the support of Fortress, management’s time won’t have to be focused on refinancing, buying, selling and restructuring. They can worry about running the business.
 
If you read a bit about Fortress, the apparent generalities which Intrawest used to explain the motivations for the transaction make a whole lot more sense.       

 

 

Margins- Percentages and Dollars; Where to Focus?

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I always looked first at gross margin percentages when I was running a business. Before revenue, before anything. Because those percentages were what determined how many dollars I had to pay all the salaries and operating expenses. Higher had to be better. It just had to be.

 
Except that I was never dealing with major price differences in nearly identical products when I did my analysis. And I think maybe that changes the calculation for skate hard goods. Let’s see.
 
One Shop’s Numbers
 
I called a shop. It’s not just a skate shop- it does snow too. I talked to one of the guys who runs it and he gave me some rough numbers off the top of his head (You know who you are- thanks!).
 
They sell two to three hundred branded decks a year. They charge $50 to $55 for each one (more than some shops I think) with grip tape. Those decks each cost them a bit north of $30 each, he estimated. Let’s say $32.00.
 
They also sell around 500 blanks a year. Those sell for $30.00 each with grip tape, and cost them around $16.00.
 
If they sell branded decks for $53.00 each, and sell 250 of them, then their annual revenue from those decks, according to my antique but trusty Hewlett Packard HP22 financial calculator is $13,250. Their gross margin percentage is 40. Their total margin dollars earned on each branded deck is $21. The total margin dollars earned after they sell all 250 is $5,250.00. The total cost is $8,000.
 
Now let’s take a look at those 500 blank decks in the same way.
 
The first uncomfortable but unavoidable fact, of course, is that the shop is selling twice the number of blank decks as branded.   Two-thirds of this shop’s skate deck buyers think that a branded deck is not worth $23.00 more than a blank. Or they think it’s worth it, but can’t afford it.
 
Companies who are cutting their prices on branded product better hope it’s the later, and they better hope their brands are “cool” and they better hope they can earn at least the same number of margin dollars to afford the programs that keep or make a brand cool.
 
I’ll leave it to all your arbiters of coolness and fashion to figure out which brands are cool. Hell, I buy most of my jeans at Costco. I’m so uncool I’m even willing to admit it.
 
But I digress. That’s too kind a term, actually. I’m wandering around in the wilderness here, and better get back to the 500 blank decks the shop is selling.
 
So anyway, they’re selling these 500 blank decks at $30.00 a pop and getting revenue of $15,000 annually. That’s more than from the branded decks. The gross margin percentage is 47 percent. Total gross margin dollars earned is $7,000. Total cost of these inventory decks is $8,000- the same as for the branded decks.
 
I swear to god that I didn’t figure out these percentages and stuff in advance to make a point. I did it as I wrote it, unclear what I was going to come up with and what it would suggest. Much as I hate struggling to create a table, I think this is worth while one. I’ll leave it to the poor layout people at TransWorld to make it legible.
 
 
 
Branded
Blanks
Number Sold
250
500
Selling Price
$53
$30
Cost
$32
$16
Total Revenue
$13,250
$15,000
Total Cost
$8,000
$8,000
Gross Margin Percentage
40%
47%
Total Margin Dollars
$5,250
$7,000
  
 
A Little Analysis
 
There are a couple of caveats to this. First, I didn’t specifically include the grip tape. As both branded and blanks include it, I don’t think it changes the analysis. Second, different stores have different costs, selling prices, and mixes of branded and blank decks. Change those things and you obviously are looking at different results. Which means, as will be clear when I discuss the implications of this below, that every shop should be using this table to take a look at their own numbers. Not just for decks, but for every product where there is a non-branded alternative.
 
At the risk of inflicting a blinding glimpse of the obvious on you, I’m going to point out some things that the table already makes very clear.
 
The total investment for the shop over a year of $8,000 is the same for both branded and blank decks. I’m pretty confident that having to handle twice as many blank as opposed to branded decks doesn’t increase the cost of selling the product. If you invest $8,000 in branded decks, you earn $5,250 in gross margin dollars. Invest the same $8,000 in blanks and you earn $7,000. From a strict financial point of view, which would you rather do? Which is the best use of your $8,000?
 
If it didn’t affect how their customer viewed the shop, if they didn’t recognize that what the brands do is critical to the popularity and growth of skating, if branded product wasn’t important in getting customers into the shop and if those customers didn’t buy stuff besides skate decks, then this shop would rather sell blanks than branded decks. The return on investment is just better. Thirty three percent better.
 
Those are a lot of ifs. Important ifs. In spite of what the raw, maybe oversimplified numbers show, there is no way, not even in a strictly financial sense, that shops can not be committed to carrying branded product. Without it, they just aren’t skate shops.
 
But that doesn’t mean you can ignore this analysis.
 
What’s To Do?
 
For this shop, at least, these are not big revenue numbers. But each shop has to do this analysis and, as I said above, not just for decks. There is no retailer out there who does not want to sell more of whatever makes them more money. At least, I hope there isn’t and if there is, they won’t be around long.
 
Financial considerations never exist in a vacuum. After you do this analysis for your shop you have to ask:
 
  • Does the customer who buys a blank buy as much other stuff as often as the customer who buys the branded deck?
  • Does the customer buying the blank replace their deck more often and, therefore come in the store more often?
 
If the answer to those two questions is clearly “no,” then what the retailer wants to do becomes quite clear. Looking at decks in isolation, you may earn more selling blanks compared to branded decks overall. But you earn more margin dollars selling each branded deck than on each blank ($22 compared to $14 in this case). And the customer who buys the branded deck spends more money on other stuff and comes at least as often as the customer who buys the blank if, in fact, the answer to these questions is no. You certainly don’t get rid of blanks, but under these circumstances you recognize the value, in a broader sense, of the customer who is committed to a brand or brands.
 
What is that value? I don’t know! Figure it out. Ask your sales people. Look at your sales journals and see what went out the door with the branded, as opposed to the blank deck. Surely your point of sale system allows you to track customers by phone number or something. This is an important thing to quantify. It is a strategic issue especially if you are concerned that hard goods prices may move down. 
 
If the answer to those two questions looks like it might be “yes,” then the role of branded product changes. You don’t have to try and carry as many graphics from as many brands as you can plaster the walls with. It’s not that you don’t want to carry and sell branded decks, but some part of that space may be better used to sell other products.
 
The shop referenced in this article sells twice the number of blank as branded decks. So the return on investment calculations, focusing on just the decks in isolation, favors the blanks. In a shop where the numbers were more equal, that would change. The gross margin percentage on the blanks would still be higher, but the total margin dollars earned would favor the branded product.
 
So what we have here is a situation where gross margin dollars may be more important than gross margin percentage.  I thought we might get to this point.  But then again, depending on product volume and customer buying behavior, it might not be.
 
Do the little table above for your shop wherever you have a branded and a blank product. Figure out the typical buying behavior for customers of branded versus blank product. You will make some better decisions that will make your shop more money.

 

 

A Living, Breathing Thing; Cash Flow Management

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That’s actually the way he put it to me. Many years ago, the CEO of a company that had been in deep financial trouble and had clawed its way out said, apparently in frustration with my failure to understand his concept, “You don’t understand, the cash flow is a living, breathing thing.”

 Now I know he was right. You don’t just create a spread sheet and manage cash. Especially in conditions of seasonality or fast growth you massage, tweak, manipulate and coerce it. You plead with it and threaten it. You spend too much time trying to get the numbers just right even though you know they will be different the next day.
 
Like a complex computer program with some interesting bugs, cash flows sometimes seem to have personalities. Once you learn about the dynamics of that personality, you’ll be an effective cash manager.
 
In the beginning, most small business owners, be they retail or brands, manage their cash flow out of their back pocket. They know their bank balance and checks outstanding. They understand what bills have to be paid when and can estimate their cash receipts pretty closely. When the numbers are small, sales steady, and the business relatively simple, this works fine.
 
But things change with seasonality and growth. Other people are involved in decisions about receipts and disbursements. The sheer number of factors means keeping it in your head gradually, almost imperceptibly, becomes impossible. A business owner’s tendency not to share critical financial information with others can exacerbate the situation.
 
If you now recognize that you’ve gotten to the point where you have to take a little more formal and proactive approach to cash management, what should you do?
 
First, let’s talk about what we mean by cash flow. We don’t mean the traditional financial analyst’s definition of net income plus non cash expenses like depreciation. Regardless of adjustment for traditional non cash items, the accounting measurement of net income has very little to do with cash flow as I’ll explain below. You can have income and no cash. Not all that unusual a situation in the snowboard industry I’ve noticed.
 
Instead, look at your balance sheet. The assets are what you have and the liabilities are what you owe. The balance sheet is calculated at a particular point in time. Think of your balance sheet as a telephone pole on your street (bear with me on this analogy for a minute). Down the street is another telephone pole. It’s your balance in, say, two months. There’s a bunch of wires strung between them. Instead of electric current, the wires, in this analogy, carry the transactions that result in the changes from the balance of the first telephone pole to the second. Your cash flow is like a voltmeter. It measures the current and changes in the current in the wire.
 
How could you have lots of income and no cash? Let’s say that in the two months between telephone poles one and two you sell $300,000 dollars of merchandise. But the terms under which it is sold don’t require payment for 90 days. Two months later, your accounting based income statement will show sales of $300,000 and profit of whatever your margin after expenses is. But you won’t have a cent in a bank from those sales. Income, but no cash flow. Retailers, of course, are fortunate in not having to worry about that exact scenario since they don’t typically sell on terms, but it’s still important to understand the principal.
 
Now of course if you’ve sold $300,000 in the previous two months under the same terms with the same expense structure, then you could expect to collect that money in the current two month period. So you would have cash flow. And as long as your sales and expenses were the same from months to month, your net cash flow would basically equal your accounting income.
 
I guess everybody who has the same sales and expenses each month of the year can stop reading now. But in case your business isn’t quite so consistent, let’s talk about a simple way to begin to forecast your cash flow and develop good instincts about it.
 
First, let’s look at our two telephone poles. In the two months between one pole (balance sheet) and the other, the dollar amounts of what you own and what’s owed you will change. The net change in those amounts represents the result of all the transactions that occurred during that period of time. For example, let’s look at the inventory number on the two balance sheets. Say that at the first balance sheet date, inventory is $500,000 and at the second it’s $600,000.
 
It probably didn’t make that jump in one mighty leap. Product came and product went with the result being an inventory level of $600,000 at the date represented by the second telephone pole. At different times in the period, inventory may have been well over or under either of those numbers. But at the end of the day, you know you’ve got an extra $100,000 tied up in inventory. So you’ve used an additional $100,000 over that period to buy stuff. Had inventory gone down during that period, you would have a source of cash because less was tied up in inventory. That is, you would have converted inventory into cash.
 
Now, let’s look down at the bottom of the telephone poles in the what you owe section (liabilities) At the first telephone pole you owe the bank, say, $100,000 and at the second, $150,000. If you owe more, than you’ve taken in more money to work with. You’ve increased your cash by $50,000. If bank borrowings had gone down $50,000 instead of up, you would have decreased your cash position by $50,000, though you might be sleeping better at night because you owed the bank less.
 
You can see that the “what you own” (asset) accounts at the top of the telephone pole work exactly the reverse of the “what you owe” (liability) accounts at the bottom. Increase the asset accounts and you tie up cash. Increase a liability and you create cash to work with.
 
Decrease an asset and you free up cash. Decreasing a liability is a use of cash.
 
Probably, I’ve been doing this too long because otherwise I wouldn’t say that there’s a certain elegance in how the various accounts all work together, each related but at the same time independent of the other. Study a couple of balance sheets and think about how the accounts changed. When you begin to have some intuitive comfort with these relationships, you’re well on your way to good cash measurement and management.
 
To be really on top of things, you still need your voltmeter to measure the flow of current across the wires and the changes. Do it on a computer or a piece of paper. Here’s the format I recommend and use myself in various business situations. There’s no magic to the categories. Change them to reflect your business situation.
 
                                                            Jan.      Feb.     Mar       Etc.
Beginning Cash Balance
 
Sources of Cash
            Cash sales
            Collection of receivables
            Line of credit borrowing
            Interest income
            Other
Total Sources of Cash
 
Total Cash Available
 
Uses of Cash
            Product purchases
            Repayment of bank line
            Payroll
            Taxes  
            Rent
            Utilities
            Phone/fax
            etc.
Total Uses of Cash
 
Ending Cash Balance
 
The beginning cash balance is whatever is in your checking account plus (if you’re a larger company) any liquid investments you may have. The ending cash balance each month becomes the beginning cash balance for the next period. Depending on how quickly your situation is changing, your estimate of expenses can usually be based on your historical experience. But remember that just because you get your phone bill in July doesn’t mean you pay it that month. Typical many of your operating expenses will be paid in the month following receipts, and your cash flow has to take this into account.
 
If you’re a retailer, a lot of your product purchases are paid for well after the product is received, and the cash flow has to reflect that.
 
If you already have a budget and are creating and tracking it on a spreadsheet, use the program to adjust your budget to manage the differences between the budget and cash. If you don’t have to pay for your product for 90 days, reflect product costs from August as a cash expense in November.
 
Don’t get too caught up in the process of creating a perfect model. Get it done and work with it. Modify it as you learn more. Look at your projections versus what actually happens. Creating the model isn’t really where you get the benefit. Using it and watching the variables change with each other is. It’s a lot like learning a language. You only get better with practice and as soon as you stop speaking it, you start to lose it.
 
Print it out and hang it on your wall. As changes occur, use a pencil to change entries. Consider the impact of each change on future months. When there are so many pencil marks that you no longer can have a feeling for the cumulative result of all the changes, make those changes on a clean version, print it out and start over again.
 
You’ll quickly find that it is a living, breathing thing that responds to your attentions by surprising you less and less.

 

 

Business By The Numbers; Simple Questions a Shop Owner Can Ask Regularly to Stay in Control

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If your typical day is a series of disruptions and interruptions like that of many small business owners, then you may find yourself having difficulty controlling your business and knowing with certainty where you stand on a day to day basis. All businesses face challenges. Those challenges are most easily met if focused on early. What starts out as a minor inconvenience can become a survival issue if not identified and managed in a timely way.

But the disruptions and interruptions aren’t going to go away. So any system for anticipating problems and controlling your business has to be simple to develop, simple to use, and take not much time. It has to be your servant; not make you a slave to data collection. Here are some ideas on developing one that’s right for your business.
 
The first thing you need is a budget. To some people, this means a complex financial model on a computer projecting a balance sheet, income statement and cash flow. If that’s what you’ve got, great. But in the interest of keeping this simple, let’s assume you at least have a sharp pencil and some accounting paper with columns.
 
Write the 12 months of the year across the tops of the columns. Let’s start with the current month. Down the left side of the paper, enter the following row captions; sales, cost of goods sold, and gross profit.
 
Continue with the following expense categories; advertising, promotion, salaries and taxes, rent, telephone, utilities, maybe interest expense, and supplies. Finish up with pretax income for the month.
 
Now say, “I’m the only one who really understands my business” and change the categories to reflect the specifics of your shop. Maybe it would be helpful to split up sales among product type (boards, boots, bindings to use one example that comes to mind). Could be that the costs of keeping the doors open every month always total nearly the same and you’re comfortable with just one total number for these costs. Whatever works for you.
Now fill it in. Congratulations! You’ve got a budget If it took you more than an hour or two to do this in rough form, then you may have identified the first minor inconvenience that could become a survival issue; poor financial data.
Get yourself a manila folder, label it “My Control System,” and put the budget in it. You’re half way there. Now all you’ve got to do is ask a few simple questions on a regular basis and record the answers. The questions I recommend are:
 
1)    How much did we sell today? Get another piece of accounting paper, write the month on top, and the days from 1 to 31 along the left margin. Have two columns headed “Today’s Sales” and “Cumulative Sales.”   Fill in the two columns at the end of each day and put it in the folder.
2)    How much did we sell this week? Add a column to the daily sales sheet and put a weekly column every seven days. If you think it would be valuable, add another sheet of paper and look at sales by major product group weekly. At the very least, do that monthly.
3)    What’s the gross profit? Look at it weekly and at the end of the month in total dollars and record the information on another sheet of accounting paper. If you know your starting inventory, what you have received, what it cost and what you’ve sold, this is a simple calculation.
4)    How much inventory do I have? Record it weekly and at month end on another piece of accounting paper you slip into your folder. If you answered question three above, you’ve already got the answer to this one so the only additional work is writing the numbers down. A refinement you may want to consider is looking at your inventory by major product groups.
 
Now we’re getting somewhere. We have a simple budget, are tracking sales, gross profit and inventory levels. We can start to make some decisions. Trends can be spotted early and adjustments made with minimal pain. The magic of this is that the more you do it, the better those decisions will become.
 
Are inventory levels too high or too low given your sales levels? What should you try and see if you can get more of, and what should go on sale or be displayed differently? Your gross profit is higher than expected. Is sales of one brand with a particularly good margin outpacing other brands? Is this a chance to dump some stuff that’s not moving and still maintain your profitability?
Obviously, all these factors work together in a very dynamic way. With the kind of system I am describing here, you’ve got them all in front of you in a very simple format. Patterns will emerge and trends be more obvious. You don’t have to be a master of accounting to do this.
 
In fact, remember that this isn’t accounting at all; it’s management. You do not need precise numbers. I am not suggesting a physical inventory every week. Don’t count your nuts and bolts. Focus on the products that make up most of your sales.
 
Let’s move on to the expense side.
5)    What are my fixed monthly expenses? There’s a bundle of monthly operating expenses including things like rent, telephone and insurance that should stay pretty constant from month to month. Look at them monthly and don’t expect much variation. If you see it, ask why.
6)    What am I spending on salaries (including taxes and benefits)? Salaries should be reviewed weekly and at the end of the month. Weekly because they are a big expense item and can be managed relatively easily in response to changes in sales. Add another piece of accounting paper to your folder that by now has all of, oh, maybe five pieces of paper in it.
7)    What are my advertising and promotional expenses? Record them weekly or monthly depending on what right for your business. Use the same sheet of paper you use for salaries. Let’s keep this folder thin. In fact, put all your expenses on one piece of paper.
8)    How’s my cash flow? That’s probably another article, though by asking the seven questions I’ve listed above, you’re well on your way to predicting your cash flow. As a retailer, paid at the time of sale, you don’t have the collection of receivables to worry about. Your cash flow typically differs from your income statement in four basic ways. First, some taxes may be paid quarterly, though you expense them for income statement purposes monthly, as incurred.
 
Second, you’ve got terms from some of your suppliers. You recognize cost of goods sold for income statement purposes when the product is sold, but may not be paying for the product until some months later.
 
Third, you’re probably paying for fixtures and leasehold improvements at the time you receive them, but depreciate them over some period of time on your financial statements.
 
Finally, if you’ve got a line of credit from a bank, your borrowings and repayments are not reflected in your budget, though your interest expense is.
 
Shouldn’t be very hard to adjust your income statement budget for these differences and have a cash flow.
 
At the end of the month, look at your budget compared to actual and see how you did. Since you’ve been following things daily and weekly anyway, there shouldn’t be anything unexpected. As a modification, consider adding a column after each month of the original budget for inserting the actual numbers at the end of the month.
 
So here’s a tool for you to consider using. If you’ve already got a good accounting system, this can help you focus on what’s important. If you don’t, this will give you the minimum you need to control your business and anticipate problems and opportunities. This generic system should, of course, be adapted to the particulars of your business. The exact form it takes isn’t as important as using it regularly; every day, week and month. Invest a little time now and you will have more time later, and better control of your business.

 

 

By the Numbers; The Impact of Price and Margin Changes

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Two issues ago, I suggested one possible future for the skateboard industry that I really don’t want to see happen, but which we all have to consider. Last issue, I suggested some questions you needed to ask to figure out the financial impact on your company.

 
This issue, let’s drill down one more level and look at some general numbers and see how a company might actually be affected and why. Note that these numbers aren’t real numbers from a real company. But we all know enough about what it costs to make a skateboard and what they sell for to put together some rough numbers for a mythical company we’ll call “The Company.”
 
Three Years Ago
 
About three years ago, The Company was loving life. It had an income statement that looked something like this.
 
Net Sales                                              $20,000,000                  100.00%
Cost of Goods Sold                              $11,333,340                   56.67%
Gross Margin                                        $ 8,666,660                   43.33%
 
Operating Expenses
 
Advertising, Promotion, Team                $ 2,000,000                    10.00%
Overhead                                              $ 2,000,000                    10.00%
 
Total Operating Expenses                      $4,000,000                     20.00%
 
Pretax Profit                                         $ 4,666,661                    23.33%
 
Yikes! The Company has an impossibly good business. The pretax margin is twenty three percent. Here are the rather gross assumptions I made to put this together.
 
The Company sells nothing but branded decks at $30.00 each- sort of a blended rate between direct to retail and distributor pricing. So they are selling 666,666.67 decks. I have no idea who the fool who buys the last two thirds of a deck is. Hope he got a discount.
 
The decks, back then, cost them $17.00 dollars to have made or to buy. I’m assuming this is a distributor. Obviously, if it’s a manufacturer, margins get even higher, but there are manufacturing expenses to be added to cost. In real life, they wouldn’t just be selling branded decks. There’d be other hard and soft goods and probably various brands.
 
One Year Ago
 
Gee, what a fun couple of years it’s been. For The Company’s last complete year, sales were off thirty percent, declining to $14 million. Luckily, this was a hot brand and selling price and margins held. Assuming they kept their operating expenses constant, The Company’s pretax profit fell to $2.8 million as shown below.
 
 
Net Sales                                              $14,000,000                  100.00%
Cost of Goods Sold                              $ 7,933,333                   56.67%
Gross Margin                                        $ 6,066,667                   43.33%
 
Operating Expenses
 
Advertising, Promotion, Team                $ 1,400,000                    10.00%
Overhead                                              $ 2,000,000                    14.29%
 
Total Operating Expenses                      $3,400,000                     24.29%
 
Pretax Profit                                         $ 2,666,667                     19.05%         
 
Hey, that’s not so bad! You’ve still got a pretax margin of nineteen percent, down from twenty three. You can live with that. Your overhead doesn’t really go down much, but you kept your marketing expense at ten percent of sales by reducing your trade show presence, advertising a bit less, and cutting a few riders you considered marginal. And you’re just a bit stingier with that promotional product. No free t-shirts for Jeff this year. Damn.
 
But lurking in the lichens is the fact that your product is the same as everybody else’s, and keeping your gross margins depends on keeping the hype going, no matter what your sales are. Cutting those marketing expenses can be good financial sense in the short run, but be tough on the brand in the longer term. Still, you got to do what you got to do. Or you could maintain the marketing expense level at $2 million. You’d still have a pretax profit margin of a little over $2 million. Pretty nice.
 
Unless of course, The Company was a $10 million company three years ago, with an income statement that, today, with sales down thirty percent, looks like this:
 
Net Sales                                              $7,000,000                    100.00%
Cost of Goods Sold                              $3,966,667                     56.70%
Gross Margin                                        $3,033,333                     43.30%
 
Operating Expenses
 
Advertising, Promotion, Team                $   700,000                     10.00%
Overhead                                              $1,000,000                     14.29%
 
Total Operating Expenses                      $1,700,000                     24.29%
 
Pretax Profit                                         $ 1,333,333                    24.29%
 
Wow, that’s still pretty damn good! It’s amazing what a cash machine a high margin branded product can be. You can see why everybody wanted to get into this business. These kinds of pretax margins don’t come along that often.
 
Still, note how the total margin dollars available are dropping. It may be that at $7 million in revenue, The Company really needs to spend more than ten percent of sales on its marketing.
 
Retailers reading this should think about the gross margin dollars issue carefully. As much as I’m a fan of high margin percentages, you also need to think about the total margin dollars you generate. Do the numbers yourself, but you can sell fewer $50 decks with a lower gross margin percentage and still make more margin dollars than you make selling more higher margin percentage $30 decks. I think that’s probably worth a whole column next issue.
 
I confess to indulging in a little bit of gloriously naïve optimism in my discussion of The Company. A real company’s gross margin isn’t going to be lower than what you see here after you factor in discounts, freight, returns, etc. And I’ve conveniently not included any rider royalties. I also don’t think you can automatically reduce your marketing expense in this business to conform to a percentage of sales as those sales drop. So if the $7 million company shown above has only a 40% gross margin, for example, and has to hold its marketing expenses at a million dollars even with falling sales, the pretax profit is suddenly down to $500,000.
 
 
Next Year
 
Sales have stabilized and even started to recover a little. The Company wipes its brow in relief realizing that volume isn’t going to drop another 30 percent. But your average selling price has dropped as a result of cheaper product being available from overseas, the actions of some of your competitors, and some retailers and customers welcoming cheaper product. The good news, kind of, is that you also have the ability to buy some of this cheaper product yourself and, continuing to assume that The Company is just a distributor, it’s been able to get its domestic manufacturers to lower their price a bit.
 
If The Company is a domestic manufacturer, it has a different set of problems. Its volume is probably down, and its OEM customers have been squeezing it for better pricing. Lower volume may mean that the all-in cost for each deck is actually up, while customers have the leverage to get you to take less for each one. That sucks.
 
In addition, the price difference between branded and blank decks has become even more compelling, and some percentage of skaters finds the price difference too compelling to resist.
 
But as we see in the numbers, selling that high margin branded product is what makes this business financially attractive, and people are going to be fighting to keep their share of that. That probably translates into higher marketing expenses, assuming you have the money to do it.
 
Let’s run some of these issues through The Company’s grossly simplified income statement, starting with The Company doing the $14 million sales have declined to.
 
Except of course that $14 million isn’t $14 million any more. The Company is doing the same number of decks, but the average selling price has dropped to, let’s say, $25. You’re now doing roughly $11.7 million in business   but you’ve squeezed your suppliers some and your cost per deck is down to $13.
 
You squeeze your overhead for all it’s worth, but you’re doing the same number of decks so there’s not much to cut there. We’ll leave the marketing budget the same. As I said before, it might be that it should actually go up. 
 
Net Sales                                              $11,700,000                  100.00%
Cost of Goods Sold                              $ 6,067,000                   51.85%
Gross Margin                                        $ 5,633,000                   48.15%
 
Operating Expenses
 
Advertising, Promotion, Team                $ 2,000,000                    17.09%
Overhead                                              $ 2,000,000                    17.09%
 
Total Operating Expenses                      $4,000,000                     34.18%
 
Pretax Profit                                         $ 1,633,000                     13.96%
 
 
What we started with as a $20 million company is now doing less than $11.7 million, but it’s still okay, but only under my admittedly naïve, optimistic scenario. Look at the percentages as well as the numbers. What would happen if The Company was an $11.7 million business when this all started three or more years ago? Not a pretty picture.
 
The big unknowns, of course, are what skaters will actually be willing to pay for decks and what companies will actually buy decks for and from where. It’s possible that a brand’s selling price could have to go down further. But it’s also that their cost can be much lower as well. The issue for skating is how we make sure there will be enough gross margins dollars left when this all works its way through the system to allow the brands to continue the marketing programs that are critical to skating.

 

 

China’s Fixed Exchange Rate; What It Means for Snowboarding

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My very first article for TransWorld, which became Market Watch, was on foreign exchange. I guess in some sense we’ve come full circle. But it’s never much fun ending up where you started, so I want to ask your help in keeping Market Watch valuable to you and occasionally controversial.

It use to be, when the pace of change and general dynamism of snowboarding was greater, that my problem was picking among a bunch of topics I felt should be addressed. Now, for better or worse, the industry is a little less dynamic than it use to be. What are the issues that Market Watch should be focusing on now? Is there a continuing need for the column? Leading edge topics seem fewer and farther between. Got any ideas? Want me to just shut up and go away? I don’t want to write Market Watch just because I’m in the habit of doing it. Email me at jeff@jeffharbaugh.com. Thanks.
 
Meanwhile, back on China and its exchange rate. Maybe a month ago, somebody emailed me about an article I’d written in SkateBiz on production in China. They said, “Hey, what about the fact that the Chinese currency (the Yuan) maintains a fixed exchange rate of 8.28 Yuan to the dollars?”
 
They have a point and I really wish I could find that email to thank them by name.   I also wish I’d thought of it first.
 
Fixed Exchange Rate
 
Most major currencies (the Japanese Yen, Eurodollar, British Pound to name a few) float against the dollar. That is, the amount of foreign currency you can buy for one U.S. Dollar changes daily based on productivity, interest rates, economic growth, etc. Not so with the Yuan. By buying and selling currencies on the open market, the Chinese government maintains a stable exchange rate against the U.S. Dollar. So what?
 
Estimates are that the Yuan is as much as 40% undervalued against the Dollar. So What?
 
Let’s imagine for a minute that the Chinese suddenly allowed their currency to float and that over some period of time, it revalued by 40%. That is, your crisp greenback would, at the end of that period, buy 40% less from China for the same number of dollars than it had before. Another way to look at it is that the Chinese could buy 40% more U.S. goods for the same number of Yuan. Would that be a good thing or a bad thing for the snowboard industry? Would you be surprised to learn that the answer is, “It depends?”
 
The Chinese like this arrangement. It has been critical to the growth of their economy. Their exports to the U.S. doubled between 1997 and 2002 from $67 to $125 billion. During the same time period, U. S. exports to China have grown only from $13 to $19 billion. It means that Chinese capital tends to stay in China, rather than be used to purchases various foreign products, and that additional investment flows to China.
 
The general consensus, however, seems to be that floating exchange rates promote the efficient allocation of capital. Over the long term, it makes things better for everybody.
 
But in the words of the economist John Maynard Keynes, “In the long run, we are all dead.” He has a point, and he should know ‘cause he’s dead. Most currencies are managed to some extent by open market operations, tariffs and/or quotas. The U.S., the world’s greatest proponent of free trade, is no exception, so let’s not be throwing too many stones here. Well, let’s face it; it’s not always the role of a national government to make things better for the whole world. And imagine the outcry from consumers when everything they had bought from China was suddenly 40%, or even 20%, more expensive. Politicians aren’t necessarily great at dealing with stuff like that.
 
At a time when more and more snowboard product (hard and soft goods) is coming from China, who would be the winners and losers in a revaluation of the Chinese currency? Let’s look at a couple of specific examples.
 
Winners and Losers
 
I don’t think there’s a company in the industry that doesn’t get some product or product component from China. But to me there are a couple of companies that make for an interesting comparison.
 
K2 spent a whole lot of money and put forth a lot of effort to move their snowboard production to China. I didn’t necessarily like seeing it happen, but I thought it was probably the correct business decision given that they already had an established facility there. If the Yuan was suddenly revalued by 40% (which I don’t see happening as I’ll discuss below) what would be the impact on K2’s Chinese production? Assuming they kept the same price structure, their price in the U. S. would have to go up by 40%. Actually, I guess a little more than that, since the duty would go up based on the higher import price.
 
I don’t know what they’d do- move their production back to Vashon Island maybe? Kind of doubt it. To use the international technical financial term, they’d be shafted.
 
In obvious juxtaposition (god, I love that word) to K2 is Seattle based snowboard manufacturer Mervin Manufacturing. Mervin has used every technique of technology, waste reduction, process engineering and a generally positive attitude to keep making snowboards in the U.S. “Made in the USA” has been the major focus of their advertising. Now, even they are looking at bringing in a price point, Chinese made board. They don’t much like it, but they feel like it’s a necessary competitive move.
 
A 40 percent revaluation of China’s currency maybe wouldn’t solve all their problems, but it would sure make them more competitive, at least against Chinese made snowboards. I mean, if they are making ends meet now, what could they do if other companys’ products suddenly cost them 40% more? Assuming a substantial part of that cost increase was passed on to retailers and, ultimately, to consumers, Mervin’s products would look pretty attractive.
 
Yes, I know that China isn’t the only cheap place to buy product. Yes, I know that just because your costs go up doesn’t mean, especially these days, that you can raise your prices by the full amount of the cost increase and expect consumers to swallow it. But it’s pretty clear that the undervalued Chinese currency had a lot to do with K2 moving production to China and Mervin moving to get some boards from there.
 
And the interesting thing is that everybody has always focused on low Chinese labor costs as the driver of production moving to China. What I’m saying is that it ain’t. I recently read about another company (not in the snowboard business) that said, “Hey, we can beat their labor cost advantage with technology, but we don’t have a chance against that artificially undervalued currency.” My guess is that the guys at Mervin might echo their sentiments.
 
Kind of puts a new spin on things doesn’t it?
 
Don’t Hold Your Breathe
 
Waiting for the Chinese to revalue their currency to make competition “fairer,” that is. In the first place, they’re kind of happy with the way things are. In the second place a lot of American companies love buying cheap stuff from China. A lot of consumers (including all of us I imagine) like buying cheap Chinese stuff. The issue of the value of China’s Yuan is actually getting quite a bit of press these days. The consensus is that there might be some gradual revaluation, but nothing quick and dramatic.
 
One of the reasons is that the Chinese, as they like to remind our government, is the second largest buyer of United States Treasury debt securities. With our record deficit approaching $500 billion this fiscal year, we’d kind of like them to keep buying them, so we should back off, thank you very much. To buy them, they need all the dollars they get from selling us stuff cheap and not buying much in return, which requires a week Chinese currency. So snowboards are made in China.
 
Kind of a complicated, mercantilist, financial house of cards isn’t it. Didn’t work for the Dutch or the English or, come to think of it, for the Romans. Guess I’d better move on before it starts to sound like I’m taking a political position.
 
Floating exchange rates really do help level the competitive playing field, more or less. But in snowboarding don’t hold your breath.

 

 

Focus on Expense Control; A New Business Model for Skateboarding

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Well, maybe not a new business model. Expense control is always important. But somehow, in every industry I’ve ever seen, it’s always assigned a lower priority when you’re selling everything you can make. Cash flow makes it easier to not worry so much about how you’re spending your money.

 You’ve no doubt noticed that skateboarding (especially in hard goods) is going through a bit of retrenchment. Sales are down from last year. Lest this get too gloomy, remember that, as an industry, we’ve had substantial growth for a number of years and skateboarding is larger than ever. No serious business person thought that phenomenal growth rate would continue indefinitely. We may have hoped it would, and we certainly hoped when it stopped it would hurt somebody else’s company, but we knew it would end.
 
So now it’s ended? No. Our five year growth rate is still amazing even given the current decline. Being down over last year may suck, but it doesn’t make it the end of the world.
 
I should probably clarify that. Changing business conditions usually mean it will be the end of the world for some companies without the balance sheet and market position to weather the storm or recognize the changing business conditions. And there’s always the chance that kids will decide skateboarding ain’t cool any more. If that should happen, and it’s happened before, all bets are off, but that’s hardly a new consideration for the industry.
 
Old News
 
Whenever an industry goes through a period of consolidation, a number of things tend to happen to one extent or another. As I’ve written about them before in nauseating detail, I’ll just describe them briefly and move on to dealing with the new circumstances they represent. Remember these trends aren’t unique to skateboarding or action sports. They have been just as prevalent in the automobile, computer, funeral home, and waste disposal industries as they consolidated. There’s nothing surprising or unique in this list.
 
·                 Growth slows (Duh!). There’s more competition for market share.
·                 Margins decline at the retail level.
·                 Retailers have more power.
·                 Cost management and customer service become more important in competing
·                 Size matters. You either have to be big or own a very clear market position. Companies in the middle get lost.
·                 Consumers get smarter- marketing loses some of its effectiveness.
·                 International competition increases.
·                 Industry profits fall. This may be temporary. Or it may not be.
·                 Over capacity can become an issue.
 
That’s an ugly list, but you can see its relevance to the skateboard industry at this point in time. Of course, it’s not necessarily so ugly for the skateboarder, who tends to get a better product at a lower price.
 
What’s To Be Done?
 
Every company is of course different, but from the 10,000 foot level, the general strategic issue is clear, and more or less the same for everybody. If sales are down, and the product appears to be more of a commodity, then marketing is even more important is differentiating the product. In skateboarding, of course differentiation has come almost completely through marketing.
 
But as the consumer has gotten smarter, marketing has maybe lost some of its effectiveness. So you have to what? Spend more on marketing? But your sales and maybe your margins are down. But unless you were large and very profitable, that can be impossible to do without spending yourself into oblivion.
 
The interesting thing is that this is where strategy and operations come together. By that I mean an important part of a company’s strategies at this point is expense control. Unless and until margins improve, or sales start growing again, there isn’t much of a choice. You can either reduce expense or earn less, or no, money.
 
The sad part is that this fundamental change in the business model means that some companies have a hard time making it. They had the illusion of prosperity because growing cash flow allowed them to keep paying their bills. As long as the money comes in just a little faster than it has to go out, it doesn’t matter if your balance sheet- the measure of your financial viability as a company- is a disaster.
 
Now it does matter, because unless you are a very unusual business person, you didn’t foresee the change in the business climate far enougn in advance to adjust your business model. Your competitors weren’t doing it, and you sure weren’t going to cut your marketing and other expenses unless they were. So now, as you scurry to adjust spending to reflect revenue and margin levels, it’s your strong balance sheet that allows you to stay in business as you make those adjustments.
 
When I ran action sports companies that had to deal with a tougher market, here’s some of the things I did and that you should consider too.
 
·                 Reduce the trade show presence and the number of people from the company who attended. The booth was refurbished- not built new. People didn’t get to go as a reward, but because they needed to be there.
·                 Let go of people who weren’t doing an outstanding job or who weren’t needed given the lower sales level.
·                 Stop selling to people who aren’t paying. There’s no cash flow in a sale- only in collecting the cash.
·                 Get rid of old inventory for whatever it brings. Old inventory is never worth more later.
·                 Order or produce only what is pretty certain to sell. Minimize your inventory risk. Lower volume on higher margin can be better, for both cash flow and for the brand, than higher volume on lower margin.
·                 Review the team roster. Top riders are probably worth what you’re paying them. The ams and others getting maybe just product and photo incentives are keepers. It’s the mid range riders I’ve always looked most carefully at. As hard as it may be, there’s usually some money to be saved there.
·                 I cut the advertising and promotional expenses that I’d sort of done because I could when times were better, and it was easier to just pay the money than throw the rabid marketing manager out of my office for the 12th time on the same issue.
·                 Ask your suppliers for better terms. They’re probably struggling to keep customers too.
·                 Have good financial information.
 
Your goal is not just to cut expenses. It’s to have a budget that makes sense given a realistic expectations of sales and margins. Look, I understand the pressure to run the two page, four color spreads because marketing is the basis of your competitive positioning and that’s what the other companies are doing.
 
But the best advertising campaign in the world won’t save your bacon if you can’t pay your bills.
 
Hard vs. Soft Goods
 
Interestingly enough, I’m hearing that the shoe and apparel companies are holding up noticeably better than the hard goods guys. That surprised me at first, but I’ve formed an opinion as to why that might be and as long as you’ve read this far, you might as well finish the article and see if you agree with me.
 
Hard goods companies only sell to people who actually skate. Soft goods and apparel companies sell a lot of product to people who don’t skate. They are increasingly lifestyle companies even with their roots in skate. If skating is somehow not as popular, or at least growing more slowly, it’s the skaters who decide that and lead the trend; they skate less and therefore buy less product.
 
But out in the world of non skaters who buy skate influenced shoes and apparel are a whole lot of people who were late coming to the skate party and, in the same way, are later in realizing that the party is maybe not quite exciting as it use to be. Besides, they still need shoes and clothing even though they never needed skateboards.
 
So they keep buying, though maybe influenced by soft economic conditions, until their perception of skating and its “coolness quotient,” for lack of a better term, changes. When that happens, the shoe and apparel companies that have made the jump to lifestyle brand and are less connected to skate than when they started, can succeed anyway. Those too closely tied to skating may find themselves, though with the impact delayed, in the same boat as hard goods companies.
 
It will be interesting to watch. In the meantime, your job, as an owner or manager of a skateboard industry company, is to restructure and manage your business so that it operates under a viable financial model in this business reality for however long it lasts. Part of that will involve a new focus on expense control.