Managing Inventory Turnover

February 10th, 2021

Efficient and effective inventory turnover is one of the secrets to improving cash flow and managing inventory investment. Businesses struggle with inventory management. Excess and obsolete inventories represent a major problem for most businesses, large or small. Effective inventory management and measurement is crucial.

First, inventory turnover is defined as the number of times turns over or cycles during the year. It is a measure of how well your inventory is working for you. The higher (or faster cycling) your inventory turns indicates a lower level of inventory investment and a more efficient leveraging of your investment to support your sales level.

Inventory turnover is a ratio of your average cost of sales to average cost of inventory. Cost of sales is used in order to compare inventory cost and not to company profit. Average inventory is a calculated number that should be based on the best possible assumption which is typically the sum of the extension of an item quantity times unit cost. I suggest using direct unit costs to avoid inclusion of allocated overhead.

The formula for the calculation is average cost of sales ÷ average inventory. When making this calculation the most accurate calculation is by using daily values and the next best option is to use monthly average costs and data. Using yearly averages provides least meaningful information.

Measurement should utilize data that includes cost of sales and inventory amounts broken down by product line. This shows what products are not selling so you adjust purchasing decisions or pricing decisions to correct the level of inventory investment.

Vendor relationships can be a major factor in managing inventory investments. This might involve the timing purchase orders or logistics with replenishment of stock. Your strategy might be to have vendors carry your inventory without impacting customer service. This is called vendor managed inventory. Personnel with purchasing responsibility need to understand the objectives for managing inventory investment and the optimum level of inventory by product, parts, or units.

If you can measure inventory turnover, you can more effectively manage it. This requires having the proper technology tools to perform accurate and timely measurement. Accurate sales forecasts combined with perpetual inventory management and customer relations management systems are critical.

Another tool is the ABC inventory approach, which splits inventory into three classes where A items are the highest priority and cost items (10 to 20 percent by number of items and 70 percent of dollar value) and receive more attention. Less focus and attention are given to B and C inventory items. This allows managers to place their focus on the higher dollar areas that matter the most. There are a number of other factors such as economic order quantities (EQO), lead times, inaccurate bills of material, and inaccurate yield quantities which can result in excess inventory.

My recommendation is to place emphasis on managing turnover and measuring it. Constant focus on inventory investment and turnover will produce awareness and lead to action that produce higher inventory turnover, increased cash flow, and reduced investment in inventory.