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Inventory Turnover
The Dollars and Cents of Inventory Turn Inventory turn can be a powerful metric for freeing up vital dollars and cents for more productive purposes.
by Ted Hurlbut Hurlbut & Associates
Introduction As a business metric, inventory turn is understood to be the key starting point for measuring inventory productivity. Inventory turn is the critical first piece of data for evaluating operational efficiencies and the freshness of the inventory. But underlying the concept of inventory turn is the fact that there is real money involved, and that inventory turn is a powerful metric for driving inventory reduction and freeing up those dollars and cents for more productive purposes.
There’s no such thing as standing still in a dynamic business and economic environment. If you’re not going forward, you’re most likely going backward. It’s especially true in inventory management. Those companies that are not continually seeking to improve the productivity of their inventory by increasing inventory turnover are likely to see more and more of their dollars and cents tied up in an increasingly unproductive inventory.
The Inventory Turn Formula To begin to understand the power of inventory turn, it is important to review how inventory turn is calculated.
The basic inventory turnover calculation is as follows:
Cost of Goods Sold during the past 12 months Average Inventory at Cost during the past 12 months .
A couple of quick notes regarding this formula:
1. Inventory turnover is a measure of inventory productivity, thus the cost of sales made from other than inventory on hand, such as special orders, needs to be excluded from the cost of goods sold.
2. Inventory turnover is stated as an annual turnover. However, the period being measured does not necessarily have to be a 12 month period. In certain situations, particularly for seasonal items, inventory turn may be measured for a period of a few months, with the result being “annualized” for comparison purposes.
3. Average inventory at cost is usually calculated by averaging the ending inventories for the past 12 months. However, if inventory fluctuates greatly from month to month, or even within months, it may be necessary to calculate the average inventory using weekly or bi-weekly ending inventory values.
4. Inventory turn is a dynamic metric. As sales (and thus, cost of goods sold) and inventory levels fluctuate so to does inventory turn. It is not enough to measure inventory turn for each year or quarter. At a minimum, in order to properly utilize inventory turn as a tool it is necessary to measure it monthly on a rolling basis.
The Power of Inventory Turn To fully illustrate the power of inventory turnover to identify opportunities to free up cash for other purposes, there is a basic assumption which needs to be explicitly stated. The cost of goods sold is an integral component of the inventory turn formula. In illustrating the power of inventory turnover, the cost of goods sold will be held constant over a range of inventory levels.
In a real world situation, this assumption is obvious. As inventory is reduced, those reductions will not have the effect of reducing sales, or, by extension, cost of goods sold (an implicit secondary assumption is that gross profit margins remain constant, as well). The point of inventory reduction is to liquidate non performing inventory and eliminate overstocks of on-going items, not to create out-of-stocks which will directly impact sales.
To illustrate the power of inventory turnover, let’s consider a fictitious company, XYZ Corp. Let’s start by assuming that XYZ’s annual cost of goods sold is $25.0 million, and hold that constant. Let’s also start by assuming that XYZ’s average annual inventory is $10.0 million. That will yield an annual inventory turnover of 2.5 times. Translated into average weeks of supply on hand, an annual inventory turnover of 2.5 times is equal to 20.8 weeks of supply on hand (52 weeks/2.5 turns).
Now let’s examine the impact if XYZ were to plan to reduce inventory without impacting sales (or cost of goods sold). If XYZ were able to plan the inventory to turn 0.1 turns faster it would equate to a reduction in inventory of $384,615, or 3.8%. From an inventory management perspective, XYZ would be planning a reduction in the average weeks of supply of 0.8 weeks, from 20.8 weeks to 20.0 weeks.
If XYZ were able to increase the turn over a six month period, for example, from 2.5 turns to 2.8 turns, it would have the impact of reducing average inventory on hand from $10.0 million to $8.9 million, a savings of $1.1 million in average inventory! An increase in turn from 2.5 times to 2.8 times translates into a reduction in the average weeks of supply on hand from 20.8 to 18.6 weeks.
Let’s restate this: In our example a reduction in average weeks of supply on hand from 4.8 months (20.8 weeks/4.33) to 4.3 months (18.6 weeks/4.33) from an inventory base of $10.0 million, frees up over one million dollars in cash over a six month period for other important uses!
How can this be done???
Drilling Down In our example, we’ve examined inventory turnover on a company-wide basis. To fully utilize inventory turn as a tool, however, it is critical to continually drill down and measure turn at the division or department level, the product line or category level, and at the item or SKU level.
Within any company’s business, there are product lines, categories and items which, by their nature, turn faster than others. Core items, with high sales volumes and that sell frequently, will turn more quickly than other complementary items which may be rounding out assortments or are offered as a convenience for customers. Only by evaluating the full range of product lines, categories and items, and understanding their sales patterns and inventory requirements can a full picture of inventory turnover be developed.
For example, in a pet supply business, pet food might be expected both to represent a significant percentage of both the sales volume and transaction count. Customer demand is highly predictable, so strategies can be developed to shorten lead times and increased the frequency of replenishment to minimize the inventory investment at any given moment. Feeding supplies and dietary supplements might not sell as frequently or generate as much volume as food, but customers expect that those items will be in stock whenever they need them. Other categories such as grooming supplies, feeding supplies or toys might be expected to represent a less significant percentage of sales, and their sales pattern might be more volatile, requiring a relatively greater level of inventory.
It is only after fully understanding the sales patterns and inventory requirements within a business that concrete action plans can be developed by product line, category and item to improve inventory turn and reduce the average inventory investment. Plan Inventory Levels and Inventory Turnover In order to reduce inventory levels, increase turnover inventory productivity, inventory levels must be planned, from the bottom up, by product line, category and item. This process begins with a reliable sales forecast, built from the bottom up, which takes into account unique sales patterns and characteristics of individual product lines, categories and items. From these individual sales forecasts, broken down by week or by month, ending inventory levels can be developed for each period.
When reviewing inventory plans, critical questions must continually be asked for each and every product line, category and item. How do planned inventories compare to last year’s actual inventories? Were last year’s inventories too little, too much, or just about right? Are there opportunities this year to reduce lead times, which would enable inventories to be reduced compared to last years levels? Were sales less volatile than anticipated, which would enable a reduction in safety stocks? Were sales in a given category spread out over too great an assortment, enabling a narrowing of assortments and a reduction in inventory? Can inventories be cut back by 2% or 3% or 5% in this product line, category or item without negatively impacting sales volume?
At the same time, there must be a real sense of urgency about identifying slow moving and non performing inventory as quickly as possible and taking the hard measures necessary to liquidate it. Slow moving and non performing inventory add little to the top line, deflect company and customer attention away from highly productive product lines, categories and items, and tie up valuable cash that could be used for other important purposes. As part of the inventory planning process, it is important to plan the steps necessary to get rid of slow moving and non performing inventory as quickly as possible.
Conclusion Inventory turn can be a powerful metric for freeing up vital dollars and cents for more productive purposes. Measuring inventory turn from the bottom up, at the product line, category or item level, is the first step in building an inventory plan which eliminates unnecessary inventory and frees up cash.
This bottom up approach to inventory planning, using inventory turnover as the critical metric to drive the analysis, can help companies assure that they are continually pushing the inventory envelope, keeping inventory levels lean and inventory productivity high.
© 2004 Hurlbut & Associates All Rights Reserved
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