Inventory Turnover is a prominent KPI in a lot of businesses. This post will give you some understanding on the concept. In another post I will give details on how the SAP report MC44 can be used to measure inventory turns and what data is used to calculate this ratio.
Inventory Turnover = Cost of Goods Sold (COGS) / Average Inventory at value
If you are not familiar with the term Cost of Goods Sold, this is the cost of your revenues.
Average Inventory is measured in value and not in volume.
If you divide both elements you know how often you sold you’re average inventory. “So what?” you ask. I will explain next.
Concept and use
I will present you with two business scenario’s to point out the significance of the Inventory Turnover ratio.
You sell one product. You invest 10.000 EUR as starting stock. You run your business for one year and at then end of the year you are completely sold out. Your revenue accumulates to 12.500 EUR. For simplicity sake your gross profit is 2.500 EUR (12.500 – 10.000).
Revenue = 12.500
COGS = 10.000
Average Inventory = 5.000 (10.000 starting stock + 0 end stock / 2 = 5.000 average stock)
Inventory Turnover = 2 (10.000 / 5.000)
ROI = 50% > 2.500 (R–C) earned out of 5.000 (A)
Again you sell one product. But this time you invest 5.000 EUR in starting stock. After 6 months you sold your stock and you replenish your stock again for 5.000 EUR. After another 6 months you’re sold out. Your revenue is again 12.500 EUR. Your gross profit is 2.500 EUR (12.500 – 5000 – 5000).
Revenue = 12.500
COGS = 10.000
Average Inventory = 2.500 (5.000 starting stock + 0 end stock / 2 = 2.500 average stock)
Inventory Turnover = 4 (10.000 / 2.500)
ROI = 100% > 2.500 (R–C) earned out of 2.500 (A)
Looking at the two scenarios the increased inventory turnover means increased operating efficiency: your ROI increased from 50% to 100%! Obviously you invested half the money in scenario 2 to achieve the same profits.
This doesn’t mean businesses should try to achieve a maximum inventory turnover per se. Achievable ratios differ per material type (finished goods, semi or raw), but also per moving speed (ABC class). Last but not least the type of industry very much determines what ratio you can achieve: process industries typically have higher inventory turns than, say, heavy equipment manufacturers.
You can find out what the industry standards are by purchasing metrics from data suppliers like Reuters or Gartner. This will give you an idea how well you are doing compared to your competitors. Or you can just use inventory turnover as an internal benchmark. In this case you periodically review the inventory turnover for different sets of materials and set targets that you wish to achieve.
Inventory turnover is typically a financial measurement (see relation to ROI). In order to improve the ratio, close cooperation with procurement/production planning is required, since they directly influence the stock levels.
Again, as with many KPIs and reports don’t judge based on this value alone, but use other stock controlling reports to minimize your inventory and still have a sound service level.
Finally you can read an interesting business case on how inventory turns made Dell a leader in it’s business.