Inventory Turnover

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	Editors Note: This is the one in a series of articles that explains different financial indicators used to measure how efficiently a company is operating from a Lean perspective. Each article will explain the metric, its use, how to calculate it, what good performance on the metric is (or where you can locate current information on good performance), and what the pitfalls are in using the metric. We look forward to your feedback on these articles and to your suggestions for which metrics we should address next.

Inventory Turnover - Jacob J. Bierley, Jr., MBA

	Contents
	Introduction
	How to Compute Inventory Turnover
	Turnover for Different Types of Inventory
	Desired State of Turnover
	Interpreting Inventory Turnover
	Dangers
	How to Improve Inventory Turnover
	About the Author
	Feedback Please

Introduction


Improve Your Business's Inventory Turnover W ith Kaizen!

Inventory turnover reflects how frequently a company flushes inventory from its system within a given financial reporting period. The measure can be computed for any type of inventory—materials and supplies used in manufacturing or service delivery, work in progress (WIP), finished products, or all inventory combined. With the exception of finished product inventory, the measure applies to service and manufacturing businesses. The guidance below addresses whatever type of inventory you choose to measure—however, the benchmarks for good performance will vary by type of inventory and industry.

How to Compute Inventory Turnover

Calculate Inventory Turnover by dividing the cost of goods sold (COGS) for the reporting period by average value of inventory on hand during the period. The reporting period can be any time interval you select—monthly, quarterly, or annually, for example.

Inventory Turnover = COGS / Average Dollar Value of Inventory On-hand

If your cost of goods sold ¹ during the period is $100 and your average finished products inventory during the month is $10, then your finished products inventory turnover ratio is 10 ($100 / $10 = 10). This implies that you are able to sell out your inventory ten times during the reporting period.

Counting the units sold and multiplying them by the cost to produce one unit could compute COGS. However, accountants may compute COGS in a different manner that approximates the same result but is simpler to execute. They take the dollar value of inventory on hand at the beginning of the period, add purchases of production materials and supplies, and subtract the dollar value of inventory remaining at the end of the period.

Turnover for Different Types of Inventory

As you know, inventory may consist of raw materials and supplies used in production, work in progress (WIP), and finished goods. We recommend the same approach to calculating turnover for each of these. Always compute the average dollar values of the type of inventory whose turnover you seek to measure and divide it into COGS. Some people use total sales, not COGS to measure turnover in WIP. We recommend against that. In our opinion, sales can distort ratios due to the profit margin built into the selling price. The inclusion of profit in the value of sales inflates the size of the numerator in your ratio. That means that you can get a larger turnover rate based on how large your profit margin is, not how rapidly you flush inventory from your system. Whenever computing turnover on a dollar basis, use COGS as your numerator, not sales.

Desired State of Turnover

In a truly Lean system, there is no inventory as raw materials flow in and through the production system to produce finished products that are flushed continuously—meaning that as a product is produced, a customer buys it. This outcome is consistent with a production system that produces outputs to takt time, the rate at which a customer demands them. Given this understanding, what then is the ideal inventory turnover rate?

If we assume that the average inventory is zero, then the average dollar value of inventory is zero dollars ($0). When zero divides any number, the result is infinity (bigger than big!). Since turnover is the result of COGS (any number) divided by the average dollar value of inventory (zero), inventory turns in a truly Lean Enterprise are infinite. This would mean that each day, all raw materials are transformed into finished products that are bought by a customer. According to the Industry Week/Manufacturing Performance Institutes 2003 Census of Manufacturers, the top 25% of all manufacturers achieved only 25 inventory turns for finished product inventory in a year. Clearly, there is a very long way to go before any company claims to be truly Lean. Also, as you will read later, there are ways you can get high inventory turnover that would not be considered waste free. Perhaps the best way to state goal for this measure is:

To achieve infinite inventory turnover in a business that is waste free and profitable.

Interpreting Inventory Turnover

Generally, a higher inventory turnover ratio is considered a positive indicator of operating efficiency, since inventory that remains in place produces no revenue and increases the cost associated with maintaining those inventories. However, a higher inventory turnover ratio does not always mean better performance. You need to analyze it in conjunction with other trends within the financial statements to ensure that operations are truly business beneficial.

Dangers

1.	Advanced sales – An increase in sales in a given reporting period usually results in increased inventory turnover, but that increase in sales (and turnover) may be due to a temporary factor. If it were, then you would be wrong to conclude that the increase in inventory turnover means you are operating more leanly. For example, a sales jump in one period may reflect advanced purchase of items that are usually bought in the next reporting period.
	*Failsafe:* Check several reporting periods to be sure that the increase in turnover resulting from increased sales is not due to advance sales or some other temporary factor. If the increased sales and improved turnover rate hold over several reporting periods, then it is probably not due to advance sales.

2.	Phantom sales – Sales made to a customer with the understanding that they will be returned for credit before payment is due.
	Failsafe: To avoid this danger, you need to take two steps. First, check several reporting periods to be sure that the increase in turnover is not due to phantom sales. Also look for improvements in turnover in one period that are offset by a decrease in turnover in a subsequent reporting period as goods sold in the prior period are returned and re-entered into inventory. In addition to abnormal inventory turnover fluctuations, these phantom sales will typically result in an increase in accounts receivable as a percentage of sales. Thus, the improved inventory turnover will be offset by a decrease in accounts receivable turnover or the ratio of accounts receivable to sales.

3.	Discount-driven sales - Offering large discounts may also generate a boost in sales. Such discounts erode the company’s profit margins, but will boost revenue and rate of inventory turnover. The company might look like it is becoming more Lean, when in fact it may simply be pushing products into the marketplace using artificially low pricing.
	Failsafe: Watch the gross margins reported by the business. Gross margin is the difference between the dollar value of sales and cost of goods sold (also termed cost of sales). If inventory turnover is increasing, but gross margins as a percentage of sales are decreasing, then this may indicate a problem.

4.	Supplier-financed inventory – It is possible to reduce materials and supplies inventory and show improved inventory turnover by forcing your supplier to carry the inventory for you. The supplier assumes the cost of maintaining inventory and passes that cost on. Or, you may reduce inventory by use of express shipment or other costly means of delivery to ensure the availability of materials and supplies when you need them. Improved materials and supplies inventory turnover, in these cases, would not mean that you were operating more leanly.
	Failsafe: To detect this shift of cost to suppliers, monitor changes in the unit cost of products that result from the increased cost of materials and supplies. Solutions to maintaining inventory that simply shift cost to suppliers return the cost in added mark-ups to the materials and supplies you purchase. This results in a rise in your product's unit cost.

5.	Customer financed inventory solutions – Depending on your marketplace, it is possible to maintain low finished product inventory at the expense of your customer. In many marketplaces, competition is still not keen. You can survive— even grow, based on not being worse than your competitors. You can, for example, maintain low finished product inventory by having your customer wait for products forcing your customer to maintain higher inventory so he or she can sustain operations while waiting for your deliveries. In essence, you produce to order, not to need. When you are done, the product ships.
	Failsafe: Use information on customer satisfaction with the availability of products and timeliness of delivery to balance your judgment about whether improving inventory turnover reflect true lean operations. If it is leanness that has produced the improvement, then customer satisfaction with availability and timeliness will remain high.

6.	Waste inflated COGS – The cost of goods sold can increase due to total sales or because of increased rework or scrap. In other words, the same number of sales occurs but the cost associated with producing the products sold increases due to waste (defects, scrap, spoilage). When finished products are discarded because defects are discovered, the cost associated with that waste is captured in COGS. Consequently, the numerator of the Inventory Turnover ratio increases. Since the defective products are not in inventory, this waste also decreases the average cost of inventory, the denominator of the Turnover ratio. As the numerator increases and the denominator decreases, the ratio goes higher. It looks like you are operating more Lean— yet, you are actually operating LESS Lean.
	Failsafe: A remedy for this distortion is to extract from the COGS any expense due to manufacturing wastage. The formula would be as follow: (Cost of Goods Sold – Cost of scrapped and damaged items due to manufacturing) / average dollar value of inventory.

How to Improve Inventory Turnover

First, take an end-to-end view in addressing inventory. You need to optimize your supply chain, make your production processes lean, and optimize your relationship to your customers. When you solve the inventory turnover issue correctly from a Lean perspective, everyone benefits in real terms. Your supplier is enabled to produce and deliver materials in a timely, low cost fashion that allows you to minimize your inventory and cost of materials while elevating your supplier’s competitiveness as a business. When you establish partnering relationships with your customers, you can enable them to make their demand for products more predictable thereby allowing you to minimize finished product inventory without failing to meet their needs for volume and timeliness.

Second, perfect your value stream operation by following the precepts of Lean. Define value from your customer’s perspective, map your value stream, flow the process, establish pull by the customer, and perfect all operations by eliminating waste from the value stream. These steps shrink lead-time, minimize inventory at every point, and drive wastage out. Margins improve, not shrink, as unit cost is reduced. If you follow these guidelines, your improvements in inventory turnover will truly reflect efficient management and the emergence of a Lean enterprise.

About the Author

Jacob J. Bierley, Jr. received both his MBA in Finance and BS in Accounting from Indiana University's Kelley School of Business. He has 14 years in auditing and accounting management. Mr. Bierley is currently the Controller for Bunge Oils for Bunge North America where he coordinates all aspects of accounting controls, practices, processes, and policies in support of Bunge Oils. Bunge North America is a primary supplier of high-quality agricultural commodities and value-added, specialized food and feed ingredients and food products to the global marketplace.

Footnotes

¹You compute the cost of goods sold (COGS) using the following formula: COGS = Dollar Value of Inventory at the Beginning of the Reporting Period + Dollar Value of Purchases During the Reporting Period - Dollar Value of Inventory at the End of the Reporting Period. "Purchases" refers to materials and supplies bought for producing new outputs.

Revised February 2008

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