Having a solid handle on your inventory is the best way to guarantee you’ll always have enough stock on hand to meet demand. Having excess inventory or the wrong product can slow your cash flow and reduce profits if you’re forced to mark items down. At the same time, under buying a product can result in missed sales opportunities, hurt your profit, and damage the customer experience.
But creating an open-to-buy (OTB) plan can help retailers selling multiple brands — as well as direct-to-consumer brands — decide how much inventory to buy or manufacture while keeping cash flow positive.
FURTHER READING: Learn how to create an inventory management system that scales with your retail business.
Defining Open-to-Buy: Breaking Down a Crucial Formula
An open-to-buy plan is a purchasing budget for future inventory orders that a retailer creates for a specific period. An OTB plan helps a retailer stock the right amount of the right products at the right time by showing the difference between how much inventory is needed and how much is available. This includes physical inventory on hand and in transit, as well as any outstanding orders.
OTB not only helps you better plan inventory purchases, but it’s also a budget that can help you tighten your belt. For example, you might have a total of $100,000 tied up currently in your inventory. Creating an OTB plan can help you carefully manage merchandise across your business for the year. As a result, this kind of planning can help you find “slack” in your inventory budget — even a 10% cost-savings in this example means you’d have an extra $10,000 to invest elsewhere.
An OTB can be calculated in units or dollars, but is usually calculated in terms of cash as there are variations in costs between products. OTB plans are also incredibly flexible — apply it to a single product category, a department, or across your entire retail business.
In some cases, retailers hold back some of their OTB dollars instead of spending their entire budget at one time. Some retailers strategically spend only a part of their OTB budget so they can take advantage of special buys during the selling season or add new products throughout the season.
Now that you have a better grasp of the concept behind an OTB plan, here’s a look at how to calculate OTB along with definitions of some of the terminology involved.
What is Inventory Turnover?
Part of creating an OTB budget involves planning inventory turnover. Turnover is a calculation that measures how fast you sell through inventory and need to replace it. The quicker a retailer “turns” their inventory, the more they’ll need to buy or make in a year.
Inventory turnover is calculated during a given timeframe using the following formula:
Sales / Inventory= Turnover Rate
For example, if you sold $50,000 worth of product and had $25,000 worth of inventory, then your inventory turn would be $50,000 / $25,000 = 2. Meaning you turned over your inventory two times during the given time period.
Most retailers don’t set turns at the same level for every product or category since it's common for products to sell at different speeds. With the right open-to-buy plan, you can manage your product categories and stock levels by planning inventory turns for each.
The Open-To-Buy Formula
The open-to-buy formula will help you create forecasts for your OTB plan. The values in your open-to-buy are projections, so they may not be perfectly accurate. But a sensible way to check your numbers is if your actual month-end inventory is within 5% of your prediction.
Here are definitions of terms used in the OTB formula:
Planned Beginning of Month Inventory: How much inventory (in dollars) you expect to have at the beginning of the month
Planned Sales: How much in sales (in dollars) you forecast during a given month
Planned Markdowns: A projection of product markdowns (in dollars)
Planned Open-To-Buy Dollars: The dollar amount that you have available to buy more inventory at the end of the month
Planned End-Of-Month Inventory: A forecast of balance inventory (in dollars) at the end of the month. End-of-month inventory carries over to become the beginning-of-month inventory for the next month.
Planned Sales + Planned Markdowns + Planned End of Month Inventory - Planned Beginning of Month Inventory = Open-to-Buy
Here’s an example of an open-to-buy plan for a single month, October 1–31:
$15,000 (Planned Sales) + $350 (Planned Markdowns) + $25,000 (Planned End-of-Month Inventory, October 31) - $30,000 (Planned Beginning-of-month Inventory, October 1) = $10,350 (Open-to-Buy at Retail)
Calculate Your Open-To-Buy at Cost
Initial markup (IMU) is the calculation used to determine the retail price of an item in your store. For example, if you have a wallet that costs you $15 to make or to purchase at wholesale, then the IMU is the measurement of how much you mark up the wallet when you sell it to the customer.
If your IMU is 75%, you would use this calculation to determine your retail price:
Cost or Wholesale Price / (1 - IMU %) = Retail Price
- Convert the markup percent into a decimal: 75% = .75
- Subtract it from 1 (to get the inverse): 1 - .75 = .25
- Divide the wholesale price by .25
- The answer is your retail price
$15 Cost or Wholesale Price / (1 - .75) = $60 Retail Price
Your initial retail price must cover the cost of the product and the selling expenses that are associated with the item. You'll also want it to cover a portion of your business's day-to-day overhead such as the cost of your website each month and marketing — you want to be left with some profit.
To figure out your OTB at cost, multiply the OTB value by the initial markup. For example, using the one-month calculations from above, if your markup is 75%, your open-to-buy at cost for those wallets you want to stock in your store is $10,350 x .75 = $7,762.50.
FURTHER READING: Open-to-buy plans are just one tool retailers can use to keep their inventory in check. Read our article on other tactics to better manage your inventory.
Creating Your Open-To-Buy Plan
You can start by creating a six-month open-to-buy plan that takes the form of a spreadsheet. Many small- to medium-sized retailers plan their OTB month-to-month, but for businesses with high spikes in seasonal sales, try creating a weekly OTB plan.
Over time, you will learn and adapt your OTB plan each season or year based on your unique business’ sales and markdown history.
Before you put your OTB plan into operation, make sure you carefully review each number and ask yourself if it's realistic.
Moving Forward With Your Open-to-Buy Plan
Each year, countless retailers have to close up shop due to mismanaged inventory. It doesn't have to be complicated, and a retail POS system like Shopify POS can help you streamline inventory management. Most importantly, start some version of an OTB plan for your retail store. You can use the chart illustrated above as a starting point to build the perfect OTB plan for your retail business.