Inventory Turnover: Is your Annual Bonus Sitting on the Shelf?
By Dr Paul E Adams | December 31, 2002
Prosperity is the fruit of labor, it begins with saving money. Abraham Lincoln
If your business is struggling with paltry profits, a checking account with phantom balances, and you have more sleepless nights than pleasant dreams, here is a tool of the pros — check your inventory turnover.
It is easy to accumulate slow moving dead merchandise that hangs around your business. Items that your customers no longer want. Or that latest fashion a glib salesperson promised your customers would stand in line for but never did. The dollars you have invested in these overstocks that may have appeared incidental at the moment, add up — really add up.
Every dollar in inventory gathering dust is a dollar less in your checking account. Perhaps that bonus you planned on giving yourself at year end is still sitting on the shelf.
Calculating your Inventory Turnover
What do you know about inventory turnover ratios? Here is a simple example of the impact of inventory turnover.
Assume on January 1, you buy $10,000 worth of the fabled widgets, which you mark up 100%, and proceed to sell over the year-total sales revenue of $20,000. Not bad, you doubled your investment, but as you ordered only once during the year, your inventory turnover was 1 time. Your $10,000 dollar investment earned you a $10,000 gross profit. Or a 100% return.
However, if on January 1 your ordered $5000 worth of widgets and on July 1 you re-ordered another $5000 — the dollars invested in your widget inventory at any one time was only $5000 — half your former investment. Again, with the same sales volume of $20,000, and a gross profit of $10,000 — wham! A 200% return on your investment. And if you turned your inventory four times, you do the math — a startling 400%. Do I make my point?
Check your turnover. Grab you latest income statement and balance sheet and do a simple analysis.
Divide the inventory amount in the current assets section of your balance sheet into the total cost of goods that appears on your income statement.
Here is an example. Assume you show $150,000 in inventory and $450,000 as your cost of goods, the math shows a turn of 3 times. If you double your turnover rate to 6 times — inventory of $75,000 will do the job for you. The $75,000 saving will make a nice addition to your checking account. It is simple management — the more you turn your inventory the better your cash flow.
Mass merchants understand; most strive to stock only fast moving merchandise leaving the dogs to specialty stores. The problems of K Mart stem from poor inventory management. The success of Wal Mart, starting with Sam in Arkansas, is based on superior inventory control — control always on the edge of technology. Sam understood a dollar sitting on the shelf collecting dust was a dollar that could not pay bills.
With bar codes, and computerized checkout systems, inventory control today is simple compared to managing a business 30 years ago with error-prone manual systems. I remember well, as my parents owned an auto parts business where control was limited to hand entered inventory cards — a lot of detail and many mistakes. If you go to any AutoZone auto parts store today, the clerk enters a part number into his computerized work station and in an instant he or she knows the inventory of the item. So easy!
Inventory Turnover Analysis: A closer look
Back to your turnover analysis. Let me be more accurate than the simple procedure I outlined before someone writes that I am misleading my readers.
Assuming you have been in business a few years, dig out your last two year-end fiscal reports. From your most recent report, copy the inventory figure from your balance sheet and the cost of goods from your income statement. From the prior year copy the inventory figure.
Average the two inventory amounts and divide your most recent cost of goods by the average of the two inventory sums. Your average inventory is a more accurate measurement than relying on your year-end balance. The answer is your turnover.
Ideal rates vary by business type
What should it be?
If you are a retailer, 8 turns is an achievable goal. If yours is more than 8, congratulations!
If you are a wholesaler, a ratio of 4 to 6 is the norm.
Extremes are always a problem. If your turnover is high, too high, you may be missing sales, if too low; your dollars are frozen in dead stock. Your turnover ratio is only the beginning.