Why is inventory turnover important?
It measures how hard your inventory investment is working.
by Jon Schreibfeder
How hard is the money you have invested working for you? You've probably been asked that question several times by stock brokers or "investment counselors." No, I'm not going to try to sell you mutual funds. This article isn't about how you are managing your personal investments. Instead, we are going to look at the performance of your company's largest asset: inventory.
The concept of inventory turnover
Say you sell $10,000 worth of a product (at cost) each year. Total revenue received from sales of the product is $12,500. If you bought the entire $10,000 worth of product on January 1, at the end of the year, you would have made a $2,500 gross profit.
But do you have to buy the entire $10,000 of product at one time? What if you bought $5,000 worth on January 1. Then, just before running out of stock, you bought an additional $5,000 worth of the product using part of the revenues received from selling the first shipment. At the end of the year, you still sold $10,000 of product and still made $2,500 gross profit, but on a $5,000 investment.
Could you make the same gross profit on an even smaller investment? What if you bought $2,500 of material. Sell most of it. Buy another $2,500 worth of product. Sell most of that shipment and then repeat the process two more times before the end of the year. You generated an annual $2,500 gross profit with an investment of about $2,500.
Which investment option is better? Selling $10,000 worth of product (and making $2,500 gross profit) with an investment of $10,000, $5,000 or $2,500? The best option is $2,500. Investing $2,500 (rather than $10,000) frees up $7,500 that can be used for other purposes, such as stocking other products with potential to generate additional profits.
Every time you sell an amount of a product, product line, or other group of items equal to the average amount of money invested in those items, you have "turned" your inventory. The inventory turnover rate measures the number of times you have turned your inventory during the past 12 months. Here is a list of the turnover rates from our example:
Inventory turnover is calculated with the following formula:
Cost of Goods Sold from Stock Sales during the Past 12 Months
Average Inventory Investment during the Past 12 Months
There are several things to keep in mind when calculating turnover rates:
1) Only consider cost of goods sold from stock sales filled from warehouse inventory. Do not include non-stock items and direct shipments. Sure, these sales are important, but don't involve your warehouse stock (your investment in inventory).
2) The cost of goods sold figure in the formula includes transfers of stocked products to other branches and quantities of these products used for internal purposes such as repairs and assemblies.
3) Inventory turnover is based on the cost of items (what you paid for them) not sales dollars (what you sold them for).
Inventory turnover depends on the average value of stocked inventory. To determine your average inventory investment:
1) Calculate the total value of every product in inventory (quantity on hand times cost) every month, on the same day of the month. Be consistent in using the same cost basis (average cost, last cost, replacement cost, etc.) to calculate both the cost of goods sold and average inventory investment.
2) If your inventory levels fluctuate throughout the month, calculate your total inventory value on the first and 15th of every month.
3) Determine the average inventory value by averaging all inventory valuations recorded during the past 12 months.
As you determine your inventory turnover goals, consider the average gross margin you receive on the sale of products. Most distributors with 20 percent to 30 percent gross margins should strive to achieve an overall turnover rate of five to six turns per year. Distributors with lower margins require higher stock turnover. If your company enjoys high gross margins, you can afford to turn your inventory less often.
A turnover rate of six turns per year doesn't mean the stock of every item turns six times. The stock of popular, fast-moving items should turn more often (up to 12 times per year). Slow moving items may turn only once, or not at all.
Finally, calculate inventory turnover separately for every product line in every warehouse. This allows you to identify situations where your inventory does not provide an adequate return on your investment. To improve inventory turnover, consider reducing the quantity you normally buy from the supplier. Inventory turns improve when you buy less product, more often.
You have limited funds available to invest in inventory. You cannot stock a lifetime supply of every item. In order to generate the cash necessary to pay your bills and return a profit, you must sell the material you've bought. The inventory turnover rate measures how quickly you move inventory through your warehouse. Combined with other measurements, such as customer service level and return on investment, inventory turnover can provide an accurate barometer of your success.
Jon Schreibfeder is president of Effective Inventory Management Inc., 116 Spyglass Drive, Coppell Texas 75019. (972) 304-3325
Fax: (972) 393-1310. E-mail him at email@example.com or visit his Web site: www.effectiveinventory.com.