Daniel Fritsch August 10 2015 5 min read What's in this article? Inventory turnover ratio metrics and measurements 5 Inventory Turnover Challenges to Overcome Tools to use for better inventory turnover management Don’t Just Manage Inventory, Optimize it! Inventory turnover is an inventory and accounting ratio used to measure how many times stock is sold (or used) within a fixed period of time. It is often used to measure efficiency in the wholesale distribution of durable goods and is defined as the ratio of costs of goods sold to the average stock held. Inventory turnover ratio metrics and measurements The ratio is calculated by taking the total figure of costs of goods sold and dividing it by the average holdings during the period in question. Let us consider an example of how to calculate inventory turnover ratio or rate: Cost of goods sold / closing stock value = turns per year. Let’s look at an example for a company in the HVAC industry. The ACME Heating, Ventilation and Air Conditioning Company decided to examine its stock holdings and turnover for the last 12 months. The cost of goods sold in the past year was $815,000. At the end of this period, the stock was valued at $163,000. We use the inventory turnover formula: $815,000 cost of goods sold ———————————————- = 5.0 turns per year $163,000 closing inventory To calculate the average number of days it takes to sell the stock concerned, we divide 365 days by the 5.0 turns per year calculated in the above inventory turnover formula, obtaining the result of 73 days. 365 days in the year —————————————– = 73 days to turn inventory 5 inventory turns per year The inventory turnover ratio helps operations managers better understand how frequently their stock levels will turn and also helps financial advisors or buyers better understand how often replenishment stock should be ordered to avoid stock outs. 5 Inventory Turnover Challenges to Overcome Wholesalers and distributors of durable goods often face the following challenges when managing inventory turnover. Using these 5 indicators below can help wholesale distributors better track their inventory turnover and overcome the associate challenges for each factor. Inventory seasonality: Some goods carried by distributors will have higher customer demand that is predicated by certain weather conditions, which may be subject to exceptional variations such as unexpectedly wet or cool summers. For instance, the HVAC industry will often times see Heating and Cooling systems with completely opposite seasonal demand trends, which should be accounted for in inventory stocking policies and plans for the year. Obsolescence: Outdated stock often times cannot be sold and for most distributors, inventory that has sat for more than 12 months is likely an obsolete inventory item. Obsolescent inventory has a corresponding negative effect on the balance sheet, where it has to be written off or given away at a cost to the company. Tracking demand patterns of inventory items helps identify excess inventory and obsolete inventory over time. High carrying costs: If a business has excess inventory, either sales are lower than forecasted or stock holding levels have been poorly planned and managed by operations. Buying in bulk from suppliers can also tie up capital in stock and lead to too much inventory being on hard, which can lead to poor cash flow. Keeping inventory levels lean can off set unnecessary carrying costs. Carrying slow turning, high cost products: Having slow inventory turnover ratios for expensive stocked items will lead to more working capital committed to inventory costs and possibly a greater risk of inventory obsolescence. ABC Analysis or ABC Classification can be used to avoid carrying high cost, slower moving items. Many times, it is cheaper for wholesale distributors to rush order high cost items from the supplier compared to the cost of keeping these items in inventory. ABC Analysis: As known as, Pareto Analysis (the 80/20 rule) is inventory that is classified into A, B and C groups, with ‘A’ being the most frequently demanded items. Detailed attention is focused on these important items to ensure items with high customer demand are always in stock to avoid stock outs or back orders. ABC analysis is also used to help warehouse managers place inventories in the optimal location within the warehouse to ensure efficient order fulfillment saving labor costs. Floor Plan Layout for Warehouse ABC Classification Tools to use for better inventory turnover management When it comes to analyzing inventory turnover, or asset turnover as it is also sometimes called,every company should think of inventory turns as a measure of how well the company’s products are doing in the market and how well its inventory is managed. The inventory turnover ratio is one of the best indicators of how efficiently a company is turning its inventory into sales. Most operations and finance directors today leverage technology such as enterprise resource planning (ERP), warehouse management systems (WMS) or inventory optimization software to track inventory turnover at the item level. There are other strategies beyond just inventory turnover that should be used to ensure inventory levels are optimized. To keep service levels high and costs low, an inventory optimization solution should be in place to monitor the following: Demand Forecasting: Historical performance and item level demand can be used to calculate possible future trends, taking into account possible changes or demand variability. In vertical supply chains, supplier communication can be improved to ‘pull’ systems, which manufacture only on demand (and therefore need considerably less inventory). Since most wholesale distributors require inventory to be on hand, refining order-purchasing processes is the fastest way to reduce costs in the supply chain and to ensure demand forecasting accuracy. Inventory Redistribution: Redistribution helps company’s redistribute items to other stock locations that have greater demand for those items. This process eliminates the need to procure more inventories from the supplier and helps keep inventory item counts low and lean. When stock is moved from one warehouse location to another, a record still needs to be maintained across all systems to maintain accurate inventory analysis. Track Inventory Obsolescence: In the unfortunate event that items in inventory have reached the end of their product life cycle and are classified as “obsolete”, it is important for an organization to work backwards to identify why that item is still in stock without associated customer demand. Was it an issue with the forecasting plan, did operations carry too much excess stock or did finance order too much from the supplier to save on a bulk quantity discount? Addtionally, inventory items that are scrapped should be written off the balance sheet, to comply with prudent accounting conventions. Optimization systems today can alert managers when item level demand is falling off and large quantities of inventory are still in stock and are at risk of becoming obsolete. Data Integration: Inventory systems that are seamlessly integrated can easily gather records of items purchased for more advanced inventory control and turnover analysis. Advanced optimization software today is mostly offered as a cloud solution and can be dynamically integrated to almost all older ERP’s or legacy inventory tracking systems. Don’t Just Manage Inventory, Optimize it! The monitoring and control of inventory turnover is important to the profitability and performance of wholesale distribution companies because it helps to improve inventory optimization, while measuring how well the business is generating sales. In almost all cases, a higher turnover ratio is desired, as this tends to indicate that more sales are being generated by the business. Alternatively, for wholesale distributors that report constant sales figures, making efficiency improvements in the supply chain (speed of response, increased customer satisfaction, reducing supplier lead times, reducing supplier costs or delivery time scales etc.) will also improve the profitably of the supply chain. Many of these alternative cost savings methods can be implemented with inventory optimization software, such as EazyStock. The ideal inventory turnover ratio is different for every company and should be considered carefully based on relevant industry benchmarks in order to establish whether the company is managing stock levels and stocking policies successfully. Learn More: For a more in-depth look at how to optimize your inventory and fix common challenges, download your copy of our free white paper here! Share Daniel Fritsch August 10 2015 5 min read Sign up for the EazyStock Newsletter Stay on Top of the Latest News, Trends, Tips, and Best Practices for Supply Chain Management, Inventory Optimization, Replenishment & Purchasing, and Demand Forecasting with Our EazyStock Newsletter.