For many companies, inventory represents the largest single investment of their total assets. Holding inventory is expensive for a variety of reasons. Inventory itself is expensive. Think about the car dealership you pass by everyday when you go to work or the grocery store you visit every week. How much money do you think they have to pay to stock their lot/shelf? These are not the only expenses. To hold that inventory, companies need to pay for storage, security, picking and handling, insurance, and so on and so forth. Thus, measuring and controlling investment in your inventory is of utmost importance in achieving a profitable business operation.
What is Inventory Turnover?
In plain English, inventory turnover measures how many times your average inventory is sold in a specific period of time. The most common way to calculate the inventory turnover is to use the following formula.
Inventory Turnover = Cost of Goods Sold / Average Inventory
To illustrate, Dealership A carries an average inventory of $2M, and the cost of the goods sold is $24M. Using the formula above, we get an inventory turnover of 12. This means Dealership A sold its average inventory 12 times per year. If Dealership B across the street can achieve the same sales target, with cost of the goods sold of $24M, with $1M, that is half the inventory, then Dealership B’s inventory turnover is 24, and this will result in lower inventory cost, higher profit margin, and a more competitive business model than Dealership A.
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Pitfalls of the Inventory Turnover
There are several things to watch out when using inventory turnover as a key performance indicator (KPI).
- Understand the definition – This is a very common mistake. Many resources explain inventory turnover as the actual number of times a physical stock of goods is bought and sold during a specific period of time. This is conceptually incorrect. For example, if a company can only replenish its inventory at the beginning of the year, the year-beginning inventory is $10M, and the year-ending inventory is $0. The average inventory is $5M, which will result in an inventory turnover of 2. An inventory turnover of 2 is different than the actual number of times a physical stock of goods is bought and sold in that year, which is 1.
- Use the right number for cost of goods sold – do not include any cost of goods sold for non-stock items. If you are not including those non-stock items in the inventory, why should you include them in the cost of goods sold? This will skew the inventory turnover and make you think your inventory is turning faster than it really is.
- Use the right number for average inventory – For example, a costume company’s sales peaks at certain periods of the year. Based on the inventory data below, the average inventory is the average of the year-beginning inventory and year-ending inventory, (4,600 + 2,200)/2=3,400. If the annual cost of goods sold is $40,000, then inventory turnover is 11.76, 40,000/3,400. This calculation did not take month-to-month inventory fluctuations into account. If we use the average of the average monthly inventory, 4,877, inventory turnover drops down to 8.2, 40,000/4,877. The second method is more accurate than the first because it takes into account the inventory fluctuation at monthly intervals which the first method ignored. Of course, the calculation will be more accurate if we take the average of daily inventory instead of monthly. In practice, the average monthly inventory value is sufficient for most industries.
- One inventory turnover fits all – Using a single inventory turnover to indicate all inventory performance can result in a misleading inventory turnover ratio. To accurately represent inventory performance, you have to calculate inventory turnover separately for every product category in each production facility and warehouse. For example, if a department store sells a diamond ring, a couture dress, a pair of jeans, and a T-shirt, using the data provided in the table below, the department store’s inventory turnover would be 5.03. However, using the same data, we see that each product category shows a different inventory turnover ratio. We can see that the inventory turnover for a diamond ring is very different from inventory turnover for a T-shirt. Thus, it is important to calculate inventory turnover separately for each product category.A higher inventory turnover is better – low inventory turnovers suggest that a compnay might have too much inventory due to overstocking, obsolescence, or deficiencies of product lines. Low inventory turnover means there is room for improvement. However, if the company has too high an inventory turnover, this may also suggest concerns. For instance, the company has inadequate inventory levels or incorrect positioning of the inventory acrossi the tiers of its supply chain. These could result in loss of sales, decrease in customer loyalty, and eventually a hit on the company’s brand value.
How Can I Improve My Inventory Turnover?
There are three ways to increase your inventory turnover based on the inventory turnover formula.
- Increase sales without increasing the inventory
- Decrease inventory without decreasing sales
- Increase sales and decrease inventory at the same timeUnderstanding what drives your inventory and supply chain costs is the key to making the right decision. It is possible to decrease cost and improve service levels at the same time through end-to-end supply chain optimization. Using advanced analytics, we are able to identify the optimal level of inventory to satisfy your current demand and identify the optimal inventory positions throughout your supply chain. In many cases, we can successfully decrease inventory levels while improving product availability.
Click below to download one of our case studies on end-to-end optimization.
Written by Billy Hou, a consultant at OPS Rules Management Consultants