ERP systems provide many metrics to track inventory performance such as inventory turnover.
Inventory turnover is essential but isn’t always the best indicator of success for inventory managers. Inventory turnover is frequently used in accounting and is calculated for a fiscal period (usually a year). While accountants tend to focus on a period (or fiscal year), many business operations are performed across multiple periods. Also, successful companies have long-term strategies that include inventory planning and optimization for periods longer than one year.
To better understand the benefits and challenges of using inventory turnover as a key performance indicator (KPI), let’s take a look at what it means and how it’s calculated.
What is inventory turnover?
It’s common knowledge that companies need to sell the products they have in inventory for a few main reasons: to make money and to lower storage costs.
Inventory turnover is calculated as a ratio between the cost of goods sold (COGS) and the average inventory.
How to calculate inventory turnover
The formula for calculating inventory turn over is cost of goods sold (COGS) divided by the the average inventory.
COGS is how much you spend to make or buy the products you sold during the period. You calculate cost of goods sold by adding your beginning inventory costs with any additional inventory costs, then subtracting your ending inventory.
The average inventory refers to the value of all products in stock; since the value can vary significantly during a fiscal period, it is essential to use an average, not the value at the end of the period.
For instance, if the value of your inventory was $1 million at the beginning of the fiscal year and $3 million at the end, the average inventory value will be $2 million. If the cost of goods sold was $3 million, the inventory turnover ratio will be 1.5.
The higher the inventory turnover ratio, the better. When the ratio is high, it means that you’re able to sell goods quickly. A low ratio indicates weak sales. The ratio can also help you understand changes in demand: A high rate indicates high demand, and a low inventory turnover may mean that the demand for your products is declining. Inventory turnover can further show you how well sales and purchasing departments work together. If the two departments are well synchronized, you’ll sell more, faster, so the inventory turnover ratio will be higher.
Factors impacting inventory turnover calculation
Many factors can impact the efficiency of your inventory operations. Some may impact inventory turnover directly, while others that don’t might be critical to take into account when optimizing inventory.
Here are the most important:
Costs of raw materials
It makes sense to buy more than you need to get a lower price for raw materials and components. However, this also means that you will have to store those products for long periods, sometimes more than anticipated. In this case, your inventory turnover will be low in the period when you acquired the raw materials but should increase in the next periods. Using the example above, the inventory acquired in one period can be used in the next, so the inventory value will decrease, and COGS will increase because you can manufacture more products. The fact that you can sell more without investing a lot in new inventory will increase your turnover ratio.
Price of finished products
Discounted products sell better, but you make less money. Your costs won’t change, so lower prices mean less profit. In some cases, it makes sense to get rid of slow-moving inventory, and the only way to achieve this is to significantly lower the price. Alternatively, you can give significant discounts to new customers, or lower prices to enter a new market. You may also want to take advantage of some of the busiest shopping days of the year such as Black Friday.
When choosing to or being forced to discount products, you can sell your inventory quickly but not efficiently. When it comes to slow-moving inventory, you may be selling products that you manufactured or bought years ago. Since demand can fluctuate, the value of the products sold also changes. One of the most common causes of market fluctuation is seasonality.
When your market depends on seasonality, you need to buy in advance, and you can’t sell until buyers need what you’re making. For instance, Christmas decorations are usually manufactured in the first half of the year, bought by retailers in the third quarter and sold during the holidays. As a consequence, your inventory will fluctuate a lot during the year.
In this case, you probably won’t know how much you sell until the holidays are over, so you will only be able to calculate the COGS in January, which may be in the next fiscal period. Customers also may return products after the holidays, which complicates things even further.
When customers return products, they end up back in your inventory, and you can try to sell them again or dispose of them if they are defective. Either way, your inventory value will change. The trickiest part is the fact that you may sell the same product twice, even though you only manufacture it once. This means that COGS and the inventory value will change.
Manufacturers waste a part of the raw materials or ingredients used in production. This is a characteristic of the industry, and there isn’t much companies can do about it. That being said, you need to track losses such as scrap, defective products, or samples and prototypes that you send to prospects for free. All these loses cost you money but don’t bring direct revenue. Their value is included in the average inventory calculations but isn’t always accounted for in COGS.
While companies should ideally track losses in real time, it often takes months to determine their amount. To account for losses, companies usually use an estimated loss percentage which is added to the unit cost of the product. For accurate costing, pricing and to determine actual profits, companies need to track the real losses, compare with estimates and reflect the difference in the total cost. Since this may take time and even transfer to a new fiscal period, inventory turnover calculations may be off.
More Inventory KPIs for performance monitoring
As a rule, no business metrics or KPIs are used in isolation. To get an accurate overview of the performance or a department or company, you always need to combine multiple metrics. When it comes to inventory management, here are some critical KPIs that are related to inventory turnover:
Order filling accuracy measures how well you fulfill sales orders. In other words: Are you shipping the right products to the right customers? Are they delivered on time?
Order cycle time refers to the time between the moment when a sales order is placed and when it’s shipped.
The cost of carrying inventory tells you how much you spend on inventory storage.
Most inventory control software products include these KPIs (and more). I recommend you take a look at various products to understand better how they can help you track the performance of your inventory.