In this column we will try to answer common questions faced by companies and organizations trying to achieve effective inventory management. If you would like to submit a question, please email it to JonS@EffectiveInventory.com. If we use your question, you will receive an “I Believe in Effective Inventory Management” golf shirt.
This month’s question: Is inventory turnover the best measurement of inventory performance?
Many companies and organizations strive to maximize the turnover of their stock inventory investment. However, focusing on turnover may in fact be detrimental to your organization’s success. Let’s take a quick look at inventory turnover and the problems associated with this metric:
What is inventory turnover and how is it calculated?
Turnover measures the number of times you use or sell your average investment in inventory. It is calculated by dividing annualized cost of goods sold of inventory (i.e., what you paid for the material you sell) by your average investment in stock inventory (i.e., what you paid for the material in stock in your warehouse or store). For example, if your annual cost of goods sold is $6 million and your average inventory investment is $1 million, you would achieve six inventory turns. Keep in mind that every time you turn your inventory you have an opportunity to earn a profit. So, if you achieve six inventory turns, you experience six opportunities to earn a profit from every dollar invested in inventory.
What is wrong with basing performance evaluation solely on turnover?
Turnover measures opportunities to earn a profit, not actual profitability. Gross margin is a common measurement of profitability. It is calculated with the formula:
(Sales $ – Cost of Goods $) ÷ Sales $
Some businesses make an average 10% gross margin. Other businesses make an average 35% gross margin. If a business only makes a 10% margin they need high inventory turnover in order to generate enough profit dollars to pay their expenses and earn an acceptable profit. The company with an average 35% gross margin requires fewer turns to generate the same profit dollars. This concept is best illustrated with what we have found to be a better measure of inventory performance, the turn-earn index. The turn-earn index is calculated by multiplying inventory turnover by gross margin. For example, if the company with a 35% gross margin turns their inventory 4 times they would have a turn-earn index of 140 (4 x 35% = 140). The firm with the 10% margin would have to turn their inventory over 14 times to achieve the same return (10 turns x 10% = 140). We suggest that all of our clients strive to achieve a turn-earn index of at least 120.
Customer service is not considered. If you do not have the items in stock when your customers want them, you will drive those customers to your competitors. In order to obtain a comprehensive analysis of your inventory you must look at the percentage of customer requests you were able to completely fill from stock inventory (commonly referred as the customer service level) or the number of times you experienced a stock-out of a product you committed to have “on the shelf” for your customers.
A customer service measurement along with a turn-earn index will provide you with an accurate picture of how well you are doing in managing your investment in stock inventory.