Key Metrics to Measure Inventory Turnover
Last month we began our discussion of key inventory metrics with the customer service level. While the customer service level is probably the most important inventory measurement, inventory turnover is often the most misunderstood. Let’s clear up this misunderstanding and help all your employees realize the true value of inventory turnover.
Let’s take the phrase “inventory turnover” out of your vocabulary and replace it with the phrase “opportunities to earn a profit.” Why? Well, because that is another way of expressing inventory turnover. And, if you go into a sales meeting and talk about “opportunities to earn a profit,” salespeople suddenly sit up and give you their attention!
The concept of inventory turnover is best illustrated with an example. 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 the product on January 1st, at the end of the year you would have made a $2,500 gross profit on an investment of $10,000.
But do you have to buy the entire $10,000 worth of the product at one time? What if you bought $5,000 worth of the product on January 1st? Then, just before running out of stock, you bought an additional $5,000 worth of the product with part of the revenues received from selling the first shipment. At the end of the year, you’ve still sold $10,000 worth of the product, still made $2,500 gross profit, but at any one time you had a maximum of $5,000 invested in inventory.
Could you make the same gross profit on an even smaller investment? What if you were to buy $2,500 dollars’ worth of material? Sell most of it. Buy another $2,500 dollars’ worth of the product. Sell most of that shipment and then repeat the process two more times before the end of the year. The annual gross profit of $2,500 is now generated with a maximum of $2,500 invested in inventory at one time.
Which investment option is better? Selling $10,000 worth of a 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 that have the potential of generating 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 you have 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.
The following formula is used to calculate inventory turnover:
Cost of Goods Sold from Stock Sales during the Past 12 Months
Average Inventory Investment during the Past 12 Months
Be careful how you determine the cost of goods sold figure for the overall inventory turnover for your company. You only want to include the value of material actually delivered to customers. If you include the value of material transferred between locations or the value of inventory used to assemble or create other products, you will exaggerate your company’s overall inventory turnover.
The inventory turnover equation includes the average value of stocked inventory. To determine your average inventory investment:
- Calculate the total value of every product in inventory (quantity on-hand times cost) every month, on the last day of the month. Be sure to be consistent in using the same cost basis (average cost, last cost, replacement cost, etc.) in calculating both the cost of goods sold and average inventory investment used to determine inventory turnover.
- If your inventory value tends to fluctuate significantly throughout each month, calculate your total inventory value on the first and fifteenth of every month.
- Determine the average inventory value by averaging of all of inventory valuations recorded during the past 12 months.
- A turnover rate of six turns per year doesn’t mean that the stock of every item will turn six times. The stock of popular, fast moving items should turn more often (up to 12 or more times per year). The inventory of slow moving items may turn only once or not at all.
- It’s a good idea to calculate turnover separately for each vendor line in each warehouse every month. This allows you to identify situations in which your inventory is not providing an adequate return on your investment. You’ll see that inventory turnover will improve as you start buying the “best buy” quantity of each product and liquidate your inventory of dead stock and excess material.