MC44 – Inventory Turnover (1)

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.

Formula

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.

Scenario 1

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 (RC) earned out of 5.000 (A)

Scenario 2

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 (RC) earned out of 2.500 (A)

Conclusion

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.

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15 thoughts on “MC44 – Inventory Turnover (1)

  1. Pingback: SAP MM: Inventory Turnover Concept And Use with Real Life Scenarios (MC44)

  2. jeyana

    Yes, by the way, why do you calculate the average inventory as the arithmetic mean between starting and ending inventory balance? It should be more complicated, if the company purchases the inventory in unequal amounts or in unequal time periods, for example…

    Reply
    1. Kowboy Post author

      Jeyana, you are right when you say the example is oversimplified. That is my intention. I want everyone to be able to understand the concept that higher inventory turnover means higher ROI. I don’t want to give an elaborate scientific explanation on how to calculate average inventory in a real life situation. There are other sources for that PLUS in SAP MC44 transaction will do that for you.

      Reply
  3. Tommy J.

    If I am right, most of the times the Inventory Turns is measured over a period of one year (12 months rolling). In the Consumer Electronics industry we see a lot seasonality. Could this be a reason to change to a shorter period like 6, 3 or even 1 month turns? What do you recommend and why? Do you have any literature on this specific subject. Thanks in advance for your help.

    Reply
    1. Kowboy Post author

      Especially with seasonality stick to 12 months rolling. If your seasonal pattern is repeated each 6 months you could use 6 months rolling. By including the full season you cancel distorted results. Whenever your KPI is increasing you know you did better. If you exclude part of the season you’re not sure whether you did really better or that the increased inventory turns is part due to the start of season with higher demand. Also, in this case it could be possible that procurement is lagging demand and although the inventory turn increased your service levels may be under pressure as safety stock is consumed. So, stick to 12 months rolling and do not assume that a higher inventory turn is better per se. Analyze major deviations from the historical average.

      Reply
  4. Eric

    Hi Kowboy,
    Here you show turnover for complete inventory, but can we do the same for inventory split by RM, Wip and FG to explain the differente part of the turnover? Thanks in advance

    Reply
    1. Kowboy Post author

      Yes, absolutely. Although with RM and WIP you wouldn’t use COGS, but Cost of Goods “Processed”. For the obvious reasons that raw materials and components are not sold. In case you are an SAP user: Since I do not work with SAP anymore I am not sure how SAP handles these material types in MC44. MC44 does offer the ability to filter on material types (see my other post on inventory turnover).

      Reply
  5. Franklin

    In a general sense, could a product’s market share be a factor on it’s inventory turn (given that the product is competiviely priced)?

    Put another way, is it common to see high inventory turn products (if competitively priced) have high market share?

    Reply
  6. ps

    how do you define a baseline or target inventory turnover for a business which has both slow and fast moving goods? what is the target the business should be aiming for?

    Reply

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