Attributes of Inventory Turnover

Inventory Turnover or "Turn" in short, is one of the critical pieces of the business metric that serve many purposes - measuring inventory productivity, evaluating operational efficiencies, driving inventory reduction and therefore freeing up cashflow for investment in other business opportunities. High inventory levels are unhealthy because they represent an investment with a low or zero return of investment (ROI). It also opens the company up to trouble should sales demand and material prices continue to fall.

Inventory Turns is a ratio showing how many times a company's inventory is sold and replaced over a period. Let me give you a simple illustration as shown in the table below. Considering the three options all have a fixed annual cost of goods sold. If you bought $100,000 worth of products at one time and sold all at the end of the year for a profit, you had only turnaround your inventory once in a year. In the second option you first bought $50,000 worth of products by implementing a Reorder trigger stock replenishment strategy so that replenishment would happen just before your inventories dip into safety stock level. The subsequent $50,000 replenishment investment you were able to finance from the revenue you received from selling the first $50,000 worth of products. You sold everything at end of the year and you were able to turnaround your inventory investment with only half of the amount of COGS. In the third option supplier was able to reduce lead time from 6 months to 3 months. You initially purchased $25,000 worth of products, and replenished your stock in every three months from the proceeds you received from selling the previous stock. When you later sold everything within a year, it means you were able to replace your inventory 4 times within a year, but with only a much lower capital outlay of $25,000, and that's it! The last option with a Turns ratio of 4 provides you a more profitable business result because you were able to achieve the same gross profit but with much smaller investment sum, and most of all, you can make use of your other $75,000 to be invested in other businesses.

The cost of goods sold is an integral component of the inventory turn formula. Important here to note that COGS appears on the income statement, while ending inventory appears on the balance sheet under current assets.

I want to point out a few important notes when you are applying the above Inventory Turns formula:

1) 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, or calculating your total inventory value on the first and fifteenth of every month, instead of using a 12-month averaging.

2) The use of average inventory is primarily to minimize seasonal factors. If you have an insignificant season for the period, you can choose to use the average inventory value. Sometimes people do use an average inventory figure in the denominator in order to avoid sudden changes in the inventory level that are likely to occur on any period-end date where inventories are kept unusually low, for example, to meet some corporate inventory targets when the month-end closing coincides with the quarterly closing calendar.

3) 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. "Annualize" means taking the period-end inventory, multiply by 12 months.

4) Inventory turn is a dynamic metric. As sales (and thus, cost of goods sold) and inventory levels fluctuate so 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. When you measure it monthly, make sure that you are consistently taking inventory value on the same day of every month. Also, you have to be consistent in using the same cost basis (standard cost, average cost, last cost, or replacement cost) in calculating both the cost of goods sold and average inventory investment. Otherwise, you won't be sure whether you have made effective comparison from period to period.

5) Inventory turnover is a measure of inventory productivity, and you should include only cost of goods sold from stock sales which are filled from warehouse inventory. Non-stock items such as direct shipments from supplier to customer should be excluded from the calculation.

6) COGS should also include those internal orders charging to departmental cost centers, or stock transferred to other branches whether it is for production, repairs or re-distributing to other depots.

Below is another Inventory Turns formula that is based on Net Sales for the period instead of using COGS. I have seen managers using this formula to evaluate the turnovers for a contractual list of parts stocked for some customers. However, the previous formula using COGS is preferred because in this formula sales are recorded at "Market Value", whereas inventories are recorded at "Cost". This formula is misleading and can not be used to effectively gauge the healthiness of your inventories, but at best, is only to measure the industry averages. A low ratio would means low turnover which implies poor sales, whereas a high ratio implies strong sales. Is it really strong sales? You have to think it twice because you are overstating the nominator value which is selling prices, but with your denominator's average inventory value are at costs.

After understanding from the above attributes of inventory turns, you know that you may be able to expand the inventory turns formula to evaluate on the many important areas of your inventory. In deed you can use it to measure the turns of your specific customer's lists of parts where company had signed a contractual agreement to keep the stock for a specified period and renew contract thereafter; or measure the turns of the specific product lines; or you can use it to measure the productivity of inventory being kept in the different depots (then transfer the slow-moving stock items to other depot or DC where there are more volume consumption); or use it to measure the productivity of inventory being differentiated by material classes, based up "80/20" rule pareto analysis or some other ratio of your choice. See my other example of measuring inventory turns by the top 80% of the inventory total value, using pareto analysis and ABC material classification codes, with a target of 5.0 Turns. Pareto analysis effectively shows you where the under-performing material classes are, so that planners can evaluate whether forecasted demand has been too aggressive or whether the safety stock level and re-order point are being set too high, and then take concrete action plans. The other end result is that you can also liquidate or eliminate overstocks of the non-performing inventory.

Problems with setting Target Inventory Turns

When reviewing your inventory plans, service levels agreement and setting inventory turns targets, there are some critical questions you must always continuously evaluate and making comparisons for. More often, I have seen managers continuously using the same turns targets for the same customer throughout the periods. They failed to evaluate on external economic factors like when customers are reducing corporate spending in certain quarters, which would credibly impact on the turns performance. You should never fail to answer these following questions before setting your inventory goals:

• Is your Turns target realistic? How do your planned inventories compare to last period’s actual performance?

• Were the last period’s inventories too little, too much, or just about right?

• Were there difference in the costing method or standard costs used in your current inventories compared to last period's?

• Are there stock items that have safety stock levels set excessively high because of global constrain factors, longer supply lead times, product high failure rates and other interim issues?

• Are there slow or average-moving stock items that should not even have been stocked in this period in the first place?

• Is the existing guideline and method for reviewing and setting safety stock levels efficient or too conservative in approach?

• Are there opportunities in this period to reduce supplier lead times, which would enable your inventories to be reduced compared to last period's?

• Are customers production plan or sales forecast likely to be softened in this quarter, which would enable a reduction in your safety stocks investment?

• Are you able to reduce some inventories by cutting back 3% or 4% in certain product lines, in expensive material categories, in certain depots or distribution outlets without negatively impacting sales volume in this period?

• Did you do a simulation program by taking in all the mentioned factors as above, base upon the best approximate sales forecast for the next period, to ascertain the appropriate yet realistic inventory turn target?

There must be a sense of urgency about identifying slow moving and non-performing inventory as quickly as possible and taking measures necessary to liquidate it. Slow moving and non-performing inventory add little to the bottom lines, and tie up valuable cash that could be used for other important business purposes.

Some words of caution with Cost of Goods Sold

The turnover ratio can be skewed by changes in the underlying costing methods used to allocate direct labor and especially overhead cost pools to the inventory. For example, if additional categories of costs are added to the overhead cost pool, then the allocation to inventory will increase, which will reduce the reported level of inventory turnover – even though the turnover level under the original calculation method has not changed at all. The problem can also arise if the method of allocating costs is changed; for example, it may be shifted from an allocation based on labor hours worked to one based on machine hours worked, which can alter the total amount of overhead costs assigned to inventory. The problem can also arise if the inventory valuation is based on standard costs, and the underlying standards are altered. In all three cases, the amount of inventory on hand has not changed, but the costing systems used have altered the reported level of inventory costs, which impacts the reported level of turnover ratio.

A separate issue is that the basic inventory turnover figure may not be sufficient evidence of exactly where an inventory overage problem may lie. Accordingly, you can subdivide the measurement, so that there are separate inventory value calculations for raw materials, work-in-process, finished goods in different product lines, and perhaps subdivide it further by storage locations or production factories. This approach allows for more precise management of inventory-related problems in cases where inventory turnover ratios have been consistently low and without success in improvement despite that different inventory control measures were being implemented.

Your next challenge

Lastly, here is a challenge for you. How do you combine Inventory Turns formula with your Customer Service Level Percentage monthly performance, differentiated by orders delivery according to the different customers' requirement, within 4 hours, >4<12 hours, >12<24 hours, >24<48 hours and so on? Try whether you can provide such hybrid performance analysis and work this out. I already have the answer. Write to me if you need help on this. I would be pleased to help. 

  
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