Inventory Turnover Rate is very simply your company sales (in terms of
the cost to the company) divided by the average cost of the carried
inventory. This number is a broadly used method of determining how
efficient an organization is at inventory management.
The reasons to use inventory turnover rate as an efficiency benchmark is simple: product costs capital, both directly and indirectly. The direct costs are the price of inventory and the order processing fees, including shipping costs.
The indirect costs include handling labor from receipt through shipment, the rental cost of storage space, the capital investment in storage systems such as racking and material handling equipment, and taxes on both property and, in some regions, on the inventory value itself.
An inventory turnover rate of one or greater is generally carried by current year capital expenses. Anything under one generally is leveraged inventory, which can greatly increase the carrying cost of inventory for the company. Over-leveraged companies tend not to handle the rigors of economic uncertainty, so this inventory metric is used by investors as well.
Calculating inventory turnover rate relies on certain set assumptions.
Inventory turnover rate can be calculated at virtually any interval. Some organizations only calculate it annually, while others will do a valuation twice monthly because inventory levels vary so widely over time.
The key is to select a date or day of the month and consistently use that date. Most organizations choose the first or the fifteenth of every month. By averaging these monthly values, accurate inventory valuation is attainable.
It is critical to pick one type of inventory cost: average cost, last cost or replacement cost to ensure consistent valuation of the inventory. Setting your goal for inventory turns depends on the gross margins in your industry.
For high-margin stock, one turn annually may be adequate to successful business operations. In industries with a more standard 20-30% margin, most organizations strive for 5-6 inventory turns annually. Using inventory turnover in a predictive fashion can help you leverage your revenue as operating capital instead of borrowing to support & manage inventory.
An inventory turn can be calculated for any period pertinent to your business. The most commonly used time periods are a month or a year, but sometimes a single inventory turn may be defined in a number of days for fast-moving inventory.
Another set of costs associated with cost of goods are waste and shrinkage. Depending on the industry, these two factors can significantly impact these calculations. In manufacturing environments, flawed final products or scrap produced represent a material loss to the overall value of product sold.
The tricky part is that scrap and shrinkage from theft or sales incentives are sometimes difficult to track. It is critical to have processes in place to record values and then include them in the inventory turns calculation. Instead of the standard:
COGS = beginning inventory cost + purchase cost - end inventory cost
A proper COGS reads as:
COGS = beginning inventory cost + purchase cost + scrap/shrink cost – end inventory cost.
By including that proper COGS valuation in the formula for calculating your inventory turn rate, there is more operational analysis credibility to the result of:
Inventory turn rate = COGS / Cost of average inventory level
Once accurately determined for the whole inventory, it is critical to identify where the areas of opportunity are in your inventory population. Inventory turn rate can be artificially elevated or deflated by certain inventory items. A high cost, high margin item may conceal the presence of many slow-moving items.
Top 100 and Bottom 100 items can both carry significant impact of the frequency of an inventory turn. Digging into the details of inventory turns can be the critical analysis necessary to take your inventory management to the next level of efficiency.
Top 100 and Bottom 100 items can be viewed from a number of different measures. These can be calculated in terms of:
By actively managing the Top and Bottom 100 items, this can impact you rate the most significantly with the least amount of analysis.
In a perfect company, inventory turnover approaches an infinite number because nothing sits on the shelves, ever. In a real but lean inventory management environment, inventory turnover is balanced with other inventory control factors such as Economic Order Quantity and Safety Stock calculations to protect both profitability and customer service.
Balancing inventory turnover starts with accurate demand forecasting. Actively engaging customers in predicting their future demands, particularly in a business to business supplier environment can help determine the optimum stocking levels versus supplier lead time and ordering costs.
If customers cannot or will not provide this data, then historical data can provide a starting point for stock turnover trends. Using historical data cannot be a blind process. Experienced analysts must view it in terms of trends and also consider the impact of new products coming to market.
Because they lack a history, new products are generally the most difficult ones to predict demand. Having accurately collected data on similar product performance in various economic times can mitigate the unknowns in new product demand forecasting. It is critical to have a plan in place to either address demand spikes or overstocks with new products.
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