Work smarter, not harder

1. Take your each month-end inventory number (at cost, of course) and sum them.
2. Divide by 12 to determine your average inventory.
3. Divide your sales by the average inventory to get turns.
4. Calculate the total of your cost of goods sold. This is the sum of all production-related expenses (cuttings, seed, bulbs, growing media, containers, tags, fertilizer, chemicals, heating fuel, production labor, etc.). These costs should account for shrink.
5. Subtract the total of your cost of goods sold from your gross sales to determine your gross margin (Sales – Cost of goods sold = Gross margin).
6. Divide the gross margin dollars into the total cost of goods sold to calculate your gross markup (Gross margin ÷ Cost of goods sold = Gross markup).

The gross margin is the profit before overhead costs and is calculated as a percentage of sales. Gross markup is the percentage of the cost of goods sold added to the item to calculate the price.

Multiplying inventory turns by the gross markup equals the inventory management index (Inventory turns x Gross markup = Inventory management index).
 

The inventory management index (IMI) provides a system for you to rank the different crops you produce based on their return to your gross margin.


Ranking crop profitability
The inventory management index (IMI) provides a system for you to rank the different crops you produce based on their return to your gross margin. If Crop A turns four times a year, and has a 50 percent markup, it has an IMI of 200. If Crop B turns eight times and has a 20 percent markup, it has an IMI of 160. Comparing the two crops, Crop A, even with slower turns, contributes a higher gross margin to the business.

This is an important distinction, especially when there are limits on the amount of funds available for investment in inventory. A $250,000 investment in Crop B will contribute $400,000 to gross margin over the sum of the eight turns. But that same $250,000 invested in Crop A will yield $500,000, even with only four turns. Which crop would you commit the production space to?

While determining the inventory management index can be done for the entire business, it is most effective if you can measure this by crop. Many growers keep records on a line-item basis for their tax returns rather than on a management basis.

If you maintain tax-based records, there are two options: complete an enterprise analysis to allocate production costs, or modify the record-keeping system to allocate these expenses to each crop as you go in the future. For the first time around, the enterprise analysis is the quickest and easiest method.


Keys to remember
Consistency. Variable production costs must be accounted for in the same manner for all categories you’re tracking. This is easier to do in a “buy and resell” situation since costs are easily stated from invoices and only requires some labor allocation, whereas it may take some work to get to the true cost of a crop if it’s one you grow.

A higher inventory management index (IMI) is better. There isn’t a set target to aim for (as in, “I will only produce crops with an IMI of 200 or better.”). Financial turns of the same crop vary from operation to operation based on production efficiency and gross margin achieved. What you do have is a method for deciding based on an objective financial measure, which crops contribute more to the profitability of your operation. Knowing this allows you to look at your systems to determine if it’s the gross margin or the physical turns (or both) that can be improved. Don’t forget that improving gross margin can happen either lowering costs or raising prices.


Making improvements.
Once you have started to track the inventory management index for your operation, use the information to determine where improvements can be made. Set SMART (specific, measurable, attainable, rewarding and timed) goals and share them with key employees so they are part of the process.

Knowing your production costs is key to making selling decisions. Knowing these costs allows you to make the decision to sell on the spot, hold out for a sale price that brings you a better return or sell when there’s still profit to be made instead of investing another week’s worth of labor into maintaining a crop that will only drop in value. Knowing which crops contribute the most dollars to your company’s gross margin helps with production decisions before you commit the space.


Erin S. Pirro is a farm business consultant, Farm Credit East, ACA, (860) 741-4376, Ext. 8173; www.farmcrediteast.com.