||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.
- Jacob J. Bierley, Jr., MBA
Your Business's Inventory Turnover
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.
|| 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.
|| Phantom sales – Sales made to a customer
with the understanding that they will be returned for credit before payment
||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.
|| 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.
|| 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.
|| 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
|| 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.
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.
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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