Knowing the real price of low inventory turnover is a critical piece of information for any business.
Inventory levels predict sales and earnings. That’s why it’s important to correctly manage your stock levels. When companies do not, they usually end up with extra inventory and that leads to roadblocks that prevent financial success.
Companies with excessive inventory typically:
- Experience costly production delays or downtime due to incorrect forecasts and overspending
- Increase carrying costs that prevent investments in equipment or other required resources
- Incur write-offs due to stockpiles of unsold products that are no longer in demand
- Damage relationships with vendors that expect just-in-time (JIT) delivery of finished goods
- Lose loyal customers who are frustrated with a lack of available products
There are ways to prevent these barriers for a smooth ride to profitability.
Identify inventory turnover ratios
To remain competitive, companies must accurately measure their inventory at every stop of the supply chain, whether they are a manufacturer that creates finished goods, a warehouse that stores inventory, a transporter that delivers packages, or a retailer that sells products.
Related Article: Increase Profit with Inventory Management SoftwareThe most common approach is to examine inventory turnover ratios, which are calculated by comparing the cost of goods sold with average inventory over a defined period (usually 12 months). This measures how many times a company sold its average inventory dollar amount during the year. For example, a company with $1,000 of average inventory and sales of $10,000 effectively sold its inventory 10 times.
Investors view inventory turnover ratios as solid indicators of an organization’s success because they:
- Demonstrate its ability to control merchandise
- Prove it can sell the inventory it produces or buys
- Reveal its liquidity
- Provide operational transparency
In general, higher inventory turnover ratios equate to strong inventory management practices and sales. These aren’t the only metric to consider when evaluating the impact of excessive inventory.
Consider additional metrics
The Harvard Business Review (HBR) suggests using adjusted inventory turns to measure changes in gross margin, fixed assets as a proportion of total assets, and the degree to which actual sales exceeds or falls short of forecasts. In support of this proposed benchmark, it cites a retail example that originated with Vishal Gaur of Cornell.
“Between 1995 and 2005, Wal-Mart’s inventory level surged from less than 5 to over 7, while Target’s inventory turns stayed reasonably flat around 6. Using inventory turns alone would suggest that Wal-Mart’s inventory productivity improved dramatically, and would also suggest that by 2005, Wal-Mart was substantially better than Target at managing its inventory. On the other hand, adjusted inventory turns during the same period provide a statistical dead heat between the two. In fact, the growth in Wal-Mart’s inventory turns was complemented by a reduction in its gross margin.”
Obviously, the inability to move inventory impacts earnings since turnover is a primary source of revenue.
Other metrics used to evaluate profitability are outlined in Forbes’ list of performance indicators, which includes:
- Monthly profits or losses. To calculate profit, identify fixed and variable operating costs, such as rent, utilities, insurance, and taxes. Then examine product prices. The difference between the cost and price is called margin. Profitable businesses typically enjoy average margins of 60% or more in part because they successfully manage their inventories by not incurring extra expenses.
- Gross margin. Gross margin reflects improvements in productivity. Higher percentages indicate higher earnings, which lower the cost per unit. To calculate gross margin, subtract the cost of goods sold from total sales and divide it by total sales revenue.
- Customer retention. Expert Fred Rechheld says that, “A 5% increase in customer retention rates will yield between a 25 to 100% increase in profits across a wide range of industries.” To identify customers’ expectations, use surveys, capture feedback at the point of sale (POS), and thoroughly analyze sales data. Knowing what customers want or need can prevent production of items that aren’t in demand.
- Customer acquisition. To calculate the cost to acquire a new customer, divide total acquisition expenses by the total number of new customers for a defined period. Over time, investments in marketing activities should go down as a company grows and its brand recognition increases. Less funds for acquisition means more money to invest on products people want.
- Overall productivity. What is a company’s best asset? Its employees. When they are unhappy, productivity drops. To determine productivity ratios, divide actual revenue by the number of sales people and compare the results to industry averages. Consider the price you’ll pay if employees don’t perform as expected when producing and selling inventory.
- Variable cost percentage. As demand increases, so do operating costs for things like raw materials, labor, and shipping. Track the “cost of goods sold” and compare against industry norms to determine the variable cost percentage. If it exceeds averages, profitability won’t increase, even if sales are up and inventory turnover ratios are strong.
Invest in an automated inventory system
It’s difficult to measure success when using a manual system to manage inventory. Errors prevail and efficiency decreases, while money walks out the door. Supply chain visibility is lost due to systems that can’t be integrated, leaving companies with costly overages that impact the bottom line.
It’s hard to mine sales data and turn it into actionable insight that leads to profitable decision-making with outdated inventory systems. All the metrics and turnover ratios in the world can’t overcome inefficient processes, inaccurate entries, and the lack of centralized data.
Are you tired of running into roadblocks when managing your inventory? Is excessive inventory digging into your profits? Do you still use a manual inventory system? Contact a System ID advisor at 888.648.4452. We can offer recommendations and demonstrate software so you can confidently invest in the right inventory system to increase performance and profitability in your organization.
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