Inventory Turnover Ratio
The inventory turnover ratio provides a helpful overview of how effectively the company manages what may be its most valuable asset, its inventory. It describes the relationship between the cost of the product sold over the course of a year and the average inventory the company maintained to support those sales. The formula for the inventory turnover ratio is:
Cost of Goods Sold / Average Inventory = Inventory Turnover
The resulting inventory turnover is interpreted as follows:
- A turnover of 12 times translates to one month’s inventory on hand, on average.
- A turnover of 25 times translates to two weeks’ inventory on hand, on average.
- A turnover of 6 times translates to two months’ inventory on hand, on average.
Of course, determining the appropriate amount of inventory for a company is much more complex than calculating this ratio, however valuable the ratio may be.
The cost of inventory includes the following:
- Acquisition cost
- Transportation in and out
- Insurance
- Personal property taxes
- Warehouse overhead
- Labor expense
- Computer and related expenses
- Interest expense
- Physical deterioration
- Seasonal obsolescence
The cost of not having enough inventory or of having the wrong inventory includes:
- Unhappy customers
- Lost market share
- Higher production costs in the form of overtime or extra
- shifts
- Purchasing small quantities at short notice
- Paying extra for accelerated transportation
Finished Goods Inventory. Efficiency of Production. The more efficient the production operations are, the less finished product a company must maintain. If operations are inefficient, the company will have to have a safety stock of finished product to assure adequate customer service.
Made to Order/Made for Stock. A company that makes product without an order in hand will have to maintain extra inventory because of the uncertainty associated with what products customers will demand. A company that makes product in response to specific orders, especially custom-designed product, will require very little or no inventory on hand other than the inventory that is being accumulated for shipment.
Forecasting Sales. The more effectively a company can predict what its customers will want, the less finished product inventory it will require. If there is great uncertainty concerning the customers’ needs and/or the directions that the markets will take, the company will have to keep more product on hand to assure customer service.
Lead Times. The more notice that the customers give the company concerning their product requirements, the less extra inventory the company must maintain.
Low-value-added distributors must have adequate supplies of almost everything on hand in order to serve their customers and be competitive. In fact, their value added is precisely their having everything on hand, ready for immediate delivery or pickup. The ultimate low-value-added business is a supermarket. It changes the nature or content of the product very little; all it does is take crates of twelve or more items, open them, and put the contents on convenient shelves. Its value added is having 35,000 of these products in one large, clean, comfortable room.
And, a supermarket cannot run out of any essential items and hope to keep its customers happy.
Number of Warehouse Locations. Some companies serve their entire marketplace from a single warehouse. This is efficient if the marketplace is geographically concentrated and can be properly served from that one location. It can be effective even if the marketplace is national in scope if the product is very valuable or orders are very large, making transportation a small part of the total cost. It can also be effective if deliveries are not too time-sensitive, so that surface or ocean transportation can be used.
However, in the absence of any of these conditions, many businesses must use a network of warehouses, and perhaps even satellites of those warehouses, to serve their customers. If a company has warehouses at multiple locations, inventory levels relative to volumes sold will be higher than those of a business with a single warehouse. Safety stocks will also be higher to protect against transportation uncertainties. Minimum stocks of each product line must be stored in order to assure customer service. The offset to these higher costs and inventory levels should be more timely customer service and more efficient transportation, with products being transported in bulk over the long distances from the factory to each warehouse rather than being transported individually over the long distances from the central warehouse to each customer. A financial analysis of these alternatives should be provided to assure cost efficiency.
Raw Materials/Purchased Components. Product Diversity. The greater the variety of products that a company manufactures, the greater the amount of raw materials and components that it must keep on hand. For each type of product, the company needs to have a minimum stock of materials and components on hand. This is especially true when the company’s finished products have few if any components in common. Commonality of components contributes considerably to the minimization of inventory. An excellent example of this is the automobile industry. Many different models of cars actually have many components, including the frames, in common. In fact, there are many different models of cars that are actually the same car, despite different appearances and perceptions of quality.
Supply Chain Management. Technology has had a dramatic impact on inventory management and has resulted in drastic reductions in all forms of inventory. When a company goes online with its vendors, its product needs are automatically communicated to those vendors electronically. This shortens lead times, reduces mistakes, and accelerates the supply process. Greater competitive intensity forces suppliers to provide faster delivery of high-quality products. Safety stock can be reduced when quality problems are reduced.
Concentration/Diversity of Vendors. Technology, especially the business-to-business (B2B) capabilities of the Internet, has created both incredible supply chain turmoil and incredible opportunity at the same time. Internet hookups between vendor and customer give that vendor a considerable competitive advantage, assuming that the vendor’s performance remains at the highest quality levels. On the other hand, product web sites and transportation logistics have created a nationwide supply market. Companies used to buy product from relatively local vendors. Now they can access the Internet and locate suppliers all over the country. The intensity of the resulting competition, along with very dependable transportation support from companies like Federal Express and UPS, leads to lower purchase costs, shorter lead times, and less inventory.