Introduction
One of the methods of measuring how well a company is doing with its materials management is to measure how many times during the year the average inventory turns over. This is called the Inventory Turnover Ratio.
Technically, on a detailed level, each time a product is sold in an amount equal to the average amount of money you have invested in that product, you have turned your inventory. But in practical terms, the 'inventory turns ratio' is usually used to measure the number of times a company's inventory has turned over in the past twelve months (inventory 'turns' per year).
This calculation helps to judge how well the inventory investment is doing. It is really a measure of how hard your inventory dollars are working for you, more specifically, how often each invested inventory dollar is used per year to buy merchandise. However, when people think about turns it is easier to visualize how many times we have reordered certain merchandise than it is to visualize dollars being reused to buy that merchandise.
Low inventory turnover is a sign of inefficiency, since inventory usually has a monetary rate of return of zero. Inventory not moving doesn’t convert to cash to help pay bills or buy new inventory. In fact stagnant inventory contributes to costs by having to be kept in storage (taking up square footage), heated, sheltered, moved around, counted, managed, etc. Inventory doesn’t contribute to income until it "goes through the gate" so to speak, or more specifically, is sold and shipped off to a customer.
How Turns Are Calculated
There are some variations to how turns can be calculated, but the following formula is generally used and accepted in standard accounting practices for the vast majority of applications:
Cost of Goods Sold over 12 months ÷ Average Monthly Inventory Cost Value = Inventory Turnover (Turns)
Inventory turns are calculated using the average monthly value of the inventory rather than the average monthly quantity of inventory. This allows the warehouse manager to compare inventory turns for items with significantly different values. If quantity were used in the calculation rather than value, inventory turn rates could be misleading. For example, a company sells bolts and washers frequently and in large quantities; these bolts have a relatively low cost value. In contrast, this company also sells the odd power tool; these tools are high in cost value. If inventory turns were calculated using average quantity, the bolts and washers would have a much higher turn rate than the power tools. However, the method that is currently used for calculating inventory turns takes inventory value into account, thereby allowing items of different value to be compared and turns can be looked at objectively overall.
The measurement of turns is an important calculation. But like so many calculations, if the raw data is inaccurate, or the calculation is wrong or applied inconsistently, the result is useless. It’s the old "garbage in, garbage out" syndrome. In fact, the use of inaccurate information will often lead to decisions that are worse than decisions made by 'gut feel'.
Considering the seasonality of most businesses and that inventory count and valuation is generally done infrequently, the calculation of the cost of an average inventory can be difficult.
- If you take an inventory count at high season and another at low season, average the cost value of the two.
- If you take two inventory counts a year you can actually use three inventories:
- Last year's final year-end inventory
- The current year's mid-year inventory
- The final year-end inventory from this year Now divide by 3.
- If you take only one inventory a year be true to yourself. Don't use an inventory taken when you know the stock on hand is extremely low, which will result in an inaccurate, high number of turns. Don't discount your performance by using an unusually large inventory number resulting in a low number of turns. If you take only one inventory count a year; adjust that inventory number to reflect your best estimate of your average inventory.
- If you take only one inventory a year you can also take the ending inventory from the previous year and the most recent inventory and divide by two. This will give you a yearly snapshot average but might be a problem if both count times were during seasonal low or high points of your inventory cycle.
As with most things, inventory turns can also be generally assumed by real world observation. Inventory turns that are too low will be evidenced by stock rooms bulging with product, tired looking merchandise, large overstock areas, maybe lots of dust on things as if they have been sitting a long time, lots of neglected items. If the turns are too low, too much money is being tied up in inventory and the business may also begin to display cash flow shortages. Money supply issues begin to occur more frequently; at first when emergency purchases are required to be made and later when even normal day-to-day purchase needs arise.
Generally speaking, the higher the turns the better. High turns mean you are using your inventory dollars efficiently, your stock looks fresher, and you probably need less storage space.
On the other hand, rapid turnover can put a strain on personnel who need to process more purchase orders and receiving documents. There is also all the increased activity and wear-and-tear of equipment and facilities associated with frequent deliveries and physically processing the inventory. More importantly, if you do not keep up with the work and processes associated with high turnover, you can actually lose sales because there is a good chance some more popular items will risk being temporarily out of stock. High turnover is more desirable but requires greater attention to detail and demands more effort from the personnel involved.
Factors Affecting Calculation of Turns:
Another consideration in the calculation of your inventory turns is what type of inventory you are actually including in the calculation for cost of average inventory. This is an important but often overlooked factor. Eliminate possible skewing of the costs going into the calculation by observing the following information.
Inventory can be classified as follows:
- Relevant
Inventory required to support the throughput of the plant and to meet sales demands.
- Surplus
More relevant inventory on hand than required for any given item.
- Obsolete
Inventory that is on hand for which there are no requirements or no requirements after X amount of time as determined by company objectives. - Excess
Surplus plus obsolete inventory.
- Inactive
No inventories on hand, but active according to the bill of material and may still have possible use. May become visible in association with lost sale reports.
Programs to deal with the types of inventory beyond relevant inventory should be implemented so proper inventory valuation can be carried out at counting time. Thus the calculated turns number will be a more useable figure and can reflect actual material management activity separate from problems that belong to other material management issues dealing with surplus and obsolete stock reduction.
Inventory Reduction Program
- First set company objectives for inventory (number of turns & days of supply we’d like to see)
- Identification of all surplus inventory.
- Identification of all obsolete inventory.
- Disposition (including arrangement) of surplus and obsolete inventory.
- Optimizations of relevant inventory (systematic reduction, min/max review, just-in-time ordering).
Set up a separate stockroom for surplus inventory (physically and in computer system).
You need to:
- see the magnitude of the problem
- be able to account for it separately
- have it available for buyers and sellers
- obtain working space back for active relevant inventory in your main warehouse
We want this inventory to be seen by the MRP or Material Resource Planning system. It needs to be drawn on if shortages in the main warehouse require restocking. This area should be looked to before sources outside the business are sought. Perhaps you feel this goes without saying but it is surprising how often product that is in surplus quantities is often purchased for a working warehouse location before being drawn from overstock.
Do the same for inventory identified as obsolete as you did with the surplus by setting up a separate stockroom for these items as well (physically and in computer system).
Now turns can be calculated on the relevant "working" inventory and reflect actual material management. This gives personnel real numbers to help them make decisions.
Surplus and obsolete inventory, though stored in separate areas, is valued as stockroom inventory. We just now have the ability to separate these costs and mix them into or out of calculations at will. All the ways stock reduction is progressing or not, how it is affecting overall business health and growth can now be objectively analyzed. It is also easier to identify exactly what areas of the material management are giving the business problems. It is extremely difficult to deal with inventory problems when the mix quantities are high and composed of very many different part numbers and certainly if obsolete, surplus and relevant inventory is all located together in the same warehouse locations.
Days of Supply
Days of Supply is another way to describe inventory based upon activity. Days of Supply calculations are typically made by knowing supplier lead time (expected time between ordering and arrival of product) and expected sales movement of the item between ordering cycles.
Days of Supply relates directly to inventory turns.
As you can see in my table, 30 days of supply means that your inventory is turning once a month or twelve times a year. (Table assumes all months consist of 30 days for simplicity of example).
|
Days of Supply |
Turns per Year |
|
1 week |
52 |
|
30 |
12 |
|
60 |
6 |
|
90 |
4 |
The Days of Supply calculation is just another tool for the material manager to use to judge warehouse efficiencies.
MIN and MAX Calculation
The turns of a given product can be managed by assigning a MIN and MAX level to it based on the known or expected movement of that item in a given period. This MIN and MAX setting will help in the reorder process to provide the correct order quantity to maintain stock levels and eventual desired number of turns of this product at year-end.
Calculations can be based on days, weeks or months of the year. I will use 12 months consisting of 4 weeks each for the sake of simplicity of example. We will give an example that produces 6 turns of inventory a year. Once the theory is understood, it can be applied to any combination of days, weeks, months, lead times, order cycles, across any product group.
Expected or Known Item Movement Over a Given Period of Time
The first number you need to know is the actual or expected number of units to be moved (sold) per month. Let us assume, in this example, this product will sell in quantities of 40 per month or 10 per week.
MIN Reorder trigger
Quantity of item movement during lead-time (delivery period).
The MIN number is the trigger of the reordering process. When quantity on hand of this product reaches a stock level equal or below the MIN, it is time to reorder this product or risk running out of it.
If your supplier or vendor usually takes 1 week to get product to your door from the time of ordering it, look at how many of these units you move in this time period. In this example, as stated above, we see that we move (sell) 10 units per week. The MIN trigger should be set at 10. E.g. You’ll now place an order, it will take 1 week to arrive, and by then you’ll have none left in stock because you are moving 10 a week but your order will arrive on time and you’ll once again have enough stock to fill orders. (This is known as "just-in-time" ordering. You get fresh stock just in time, just as you are running out).
The remaining quantity on hand after the product hits its MIN quantity is part of the Days of Supply calculation. When MIN is reached we’d have a bit of stock left but when Days of Supply hits 0, so does stock quantity and we begin to lose sales on that product if called for.
MAX Guideline
Quantity of item movement between order dates + during lead-time (delivery period).
The MAX guideline calculation is made as follows. You determine the number of units you will be moving out of stock (selling) during the time between orders. In this example, lets assume we are ordering once every 2 months or every 8 weeks. In our example above, we stated we were selling 10 items per week so this equals 80 units in 8 weeks between stated order cycle. This is the first part of the MAX calculation. We add to this the lead-time (delivery time) of the vendor or supplier. Let us once again assume the delivery time is 1 week. In one week we sell 10 items. Add this 10 to 80 and set the MAX guideline to 90.
Calculating Reorder Quantity
MAX minus Quantity on Hand.
When the MIN trigger occurs, you (or the MRP system) will subtract the quantity of stock on hand for this product number from the set MAX guideline and order this difference. In this example, at 10 the MIN will trigger the reordering. The set MAX of 90 minus 10 (units on hand) tells us to reorder 80 units from the supplier. In one week we will have 0 on hand but the order (1 week lead time) will arrive just in time and we will immediately have replenished stock to 80 units. This will carry sales until the next reorder cycle which (in a perfect world) will fall on the day, coincidentally, that the MIN trigger will again occur because units are being sold at a rate of 10 per week.
The cycle repeats throughout the year.
Turns Calculation Example
At the end of the year, if you calculate cost of sales and cost of average inventory on hand, you will see 6 turns of inventory for this product.
In this on-going example let us also assume each unit costs $20 each.
We sold 40 per month X 12 months = 480 units for the year.
Cost of Sales is 480 X $20 = $9600 for the year
Since we reordered every 2 months, we normally ordered 2 months of stock to be on hand on average.
Average Cost of Inventory is 80 units X $20 = $1600
Inventory turnover = $9600 divided by $1600 = 6 turns per year
CHART SHOWING:
- MOVEMENT OF 40 UNITS per MONTH
- ORDER CYCLE EVERY 2 MONTHS or 8 WEEKS
- 1 WEEK LEAD TIME (delivery period)
- EQUALS SIX INVENTORY TURNS PER YEAR!
