May 1998 • Volume 8 • Number 5
Dear APICS:
Analyzing Inventory Turnover
By George Johnson, CFPIM Dear Readers: Recently, we have had a number of
inquiries concerning the measure known as inventory
turnover.
These appear to be coming from relative newcomers to
the field, so I am devoting this month's column to the
subject. Let's begin with the basic concept.
The APICS Dictionary, Eighth Edition, defines
inventory turnover as "the number of times that an inventory cycles
or 'turns over' during the year." Traditionally, inventory
turnover is calculated as a ratio:
Annual cost of sales represents the rate, in cost dollars
per year, at which inventory flows through and out of the
organization. Average inventory represents the amount of
cost dollars that are tied up in inventory, on the average,
during the year. One could think of turnover as "how much
blood can be gotten from a turnip" in a given period. Cost of
sales is the outflow; average inventory is the size of the
turnip. More flow from a smaller turnip indicates more
productive use of the turnip.
Time periods other than a year may be used. It is
merely necessary to assure that the same time window is used
in both the numerator and the denominator. Some
companies watch turnover figures on a monthly basis and
actually stratify the inventory by categories that make sense for
control purposes, e.g., raw materials, work-in-process and
finished goods, to mention a few. The ratios could also
be calculated by plant, division, business unit, market
segment, manufacturing cell, etc. whatever serves a useful focus.
Generally, higher turnover ratios are seen as more
desirable. However, the risk of getting into trouble increases as
the inventory becomes leaner. A neighbor of mine with scar
tissue from experience expresses it well: JIT (Just-in-Time)
flow can become JTL (just-too-late), with its attendant
shortage costs. So the challenge is to determine how much
inventory really is needed to operate successfully and to
relentlessly work on improvements that increase the flow and
decrease the inventory pool without triggering shortages.
Ahrens (1997) explains how to distribute
responsibility for improving the productivity of inventory to various
units that impact the ratio's numerator or denominator.
We often receive inquiries requesting typical
turnover ratios for specific industries. Those who wish to obtain
such information on a regular basis may find it in public or
company libraries or may subscribe to it themselves.
Available information seems to come primarily from statistics
published periodically by the federal government or by a
business source, such as the "Annual Statement Studies."
This particular source is compiled/published by RMA (1
Liberty Place, Suite 2300, 1650 Market Street, Philadelphia,
PA 19013; 800-677-7621; www.rmahq.org).
The federal government provides inventory and sales
data which may be used for inventory/net sales ratio analysis
(not the same as classical inventory turnover, which is defined
as cost of sales/average inventory). One source is The
Federal Trade Commission's "Quarterly Financial Report for
Manufacturing, Mining and Trade Corporations," (U. S.
Government Bookstore, 26 Federal Plaza, Room 2-120, New
York, NY 10278; 212-264-3825). The inventory/net sales data
also are available quarterly in "Update: A Newsletter for
Supply Chain Management Professionals," available from the
Center for Inventory Management (900 Secret Cove Drive,
Sugar Hill, GA 30518; ). Data reported to
the IRS are available in "IRS Corporate Financial Ratios."
This publication can be obtained from Schonfeld & Associates
(1 Sherwood Drive, Lincolnshire, IL 60069; 847-948-8080).
Having provided some sources of inventory ratio
data, let's consider the usefulness of what you might obtain.
First, it is important to consider the comparability between
their numbers and your numbers. Whether the federal
government or some other intermediary collects the data, it is
virtually impossible to keep "noise" from creeping into
the figures. Different companies in the same industry use
different inventory systems and valuation techniques,
operate different processes under different strategies, have
different product mixes, calculate turnover differently (e.g.,
using average inventory vs. end-of-year value), etc. It is
virtually impossible to know the degree of comparability in
third-party figures. What do the numbers really mean? For
discussion of the uses and potential hazards of inventory
ratios, see the articles by Bonsack (1997) and Edelman (1997).
There are at least two ways to sidestep the difficulties
of "noisy" comparative ratios. One is to focus primarily
on your own company's figures and the other is to do
rigorous benchmarking. If you focus on your own firm's ratios
over time and watch for trends, at least you can be
consistent from period to period in the way you collect data and
make ratio calculations. The other inside-focused thing you
can do is perform an actual vs. theoretical analysis
(sometimes referred to as A-Delta-T) of inventory turnover. This
should reveal how much room for improvement there is
between current turnover performance and the theoretical
highest achievable turnover given your current resources and
operations. This challenging target figure is known as the
"entitlement" value (Thomas, 1990). It isn't the
highest theoretical figure possible (i.e., involving only pure
value-added activities), but starts with that figure and backs off
for realistic non-value-added activities and resources.
To elaborate, the total inventory presently in your
system is whatever amount it takes to operate under existing
conditions. To determine the theoretical minimum inventory
investment and work toward an entitlement figure, you
would include in the calculations only inventory that 1) serves
value-adding activities (i.e., runtime WIP and delivery
pipeline) or 2) legitimately helps avoid extra cost (e.g., truly
essential seasonal, buffer or lot-size inventory). After performing
this "inventory value engineering" task (Sirianni, 1982), the
denominator of the ratio should be at the entitlement
level. Assuming cost of sales remains constant, the now
smaller average inventory produces a higher inventory turnover
ratio. This new ratio is the entitlement (challenging
target). The gap between it and the present ratio is your
opportunity for improvement, given the present resources and
operating conditions.
Now, to the intercompany setting. It is possible to make
intercompany comparisons via well done benchmarking.
This is because the rigorous process assures comparability of
circumstance and measurement which yields credible metrics
as well as insights about related practices. For information
about benchmarking, see Camp (1989) and Balm (1992).
There is another issue that troubles me about
comparing third-party published ratios: usually they are averages
(e.g., average inventory turnover for the electronics industry).
Average performance just doesn't cut it today. Why use it as
a reference "standard?" A successful company has to be the
best or at least have rough parity with the leaders in
its industry and be able to beat the others on some important competitive
dimension. What if the current best performer in your
industry is able to learn from the best, regardless of industry?
Then where are you? The targets keep moving and the
benchmarks are not averages.
Two sources of information based on benchmarking are:
1) The International Benchmarking Clearinghouse
(maintained by the American Productivity and Quality Center, 123
North Post Oak Lane, Houston, TX 77024;
800-776-9676; www.apqc.org); and the firm Pittiglio, Rabin, Todd &
McGrath (9 Riverside Road, Weston, MA 02193;
617-647-2800; www.prtm.com). Only participants in the benchmarking
studies coordinated by this firm have access to the results. You
may wish to determine if your company is a participant.
Let's recap. Aggregate inventory ratio data are available
by broad industry classifications from public and private
sources. The aggregate data tend to be gathered and reported
in ways that undermine their precision and credibility. They
also tend to represent averages, which in today's highly
competitive environment are not terribly useful, maybe even
misleading. Well done benchmarking data are more useful and
credible because they are based on comparable conditions
and focus on the best rather than the average. Theoretical
and entitlement calculations help create a focus on how
much improvement is realistically possible with a given set of
resources and operating conditions. My preference is
obvious. I recommend downplaying industry averages and
emphasizing benchmarking and theoretical/entitlement figures.
These provide visibility of your real challenges and opportunities.
References
This department is provided to answer technical questions regarding problems in production and inventory control. Readers are invited
to contact George Johnson, APICS National Research Committee,
Rochester Institute of Technology
Turnover Ratio =
Average Inventory
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