Just by improving one turn, a typical wholesale distributor can save hundreds of thousands of dollars. The less money you have tied up in inventory, the more money you will to accomplish other things in your business. Here’s an explanation of why it’s important to optimize your inventory.
Improving inventory turns is one of the most prudent things a distributor can do. While it is a given that some segments of your product line naturally move faster than others, actively optimizing your inventory as a whole for rapid turns can make or break your distribution business. Given two similar companies, with two similar product lines competing in the same market, the one with the better inventory management system is the one that will grow faster. Poor inventory turn is a bottleneck for growth and a drain on profitability.
“Turns” refers to the number of times your inventory is flushed through your sytem per year, per month, or over any desired reporting period. Inventory turn rate can be calculated for your entire inventory or just a segment of it, such as a product grouping or particular SKU family, and gives you a picture of how you are doing relative to last week, last month, or last year, or even compared to your competitors. Our last blog talked about ABC inventory stratification; classifying your inventory this way allows you to drill-down and calculate turns on each stratum.
Aside from improved ROI, what are the other benefits of high turns? With any distribution business, the less money you have tied up in the inventory you need for order fulfillment, the more money you will have for working capital to do all the other things a company needs to grow — marketing, advertising, research and development, consulting, acquisitions, expansions, and other investments that fuel your business. Caveats of poorly buffered safety stock aside, the higher your number of turns, the better, and the harder your investment in inventory is working for you (aka ROI).
Calculating Inventory Turns
The “official” calculation to figure out how you are turning inventory, is to take your Cost of Goods Sold (COGS) and divide by your average cost of inventory during that period. For example, if your COGS during the month is $10,000, and the cost of your inventory for that period was $1,000, then your inventory turnover rate is 10 (which would be very good!). If you are evaluating turns over a longer period of time, or if your inventory costs fluctuates during your reporting period, it might be more accurate to calcualte your average inventory cost, using:
(Beginning Inventory Balance + Ending Inventory Balance) / 2
Don’t make the mistake of using the “Retail Method of Accounting”, which adds the beginning RETAIL value of your inventory to the RETAIL value of your purchases then subtracting the RETAIL value of the ending inventory, then divided that value by your total sales. This method has been used in the past because some distributors, on the advice of their accountants, used retail values because it was too difficult to calculate costs manually. But that assumes that everything you sell will be at the retail value. With a good inventory control system like ADS Soltuions Advantage distribution software, you will obtain a true Cost of Goods Sold. Hence, you should use the COST instead of Retail to produce an accurate picture of your inventory turns:
((Beg.Inv.at Cost) + (Purchases at Cost) – (Ending Inv. at Cost)) / (Cost of Sales)
If your inventory management system also has a method of tracking adjustments for shrink or scrapped items, then the more accurate formula would be: ((Beg.Inv) + (Purchases) – (Ending Inv.) – (Cost of Scrapped and Lost items)) / (Cost of Sales).
There is a fine line between a high number of turns and running out of product because your inventory quantity is too close to what you are actually selling AND having too much inventory in relation to your sales. Every distributor’s dream is to get their inventory to the correct levels so they have achieved “Just-in-Time Inventory”. Find that perfect balancing point where your amount of inventory on hand earns the best return. If this balance point, invest in a good software system, and it will become clear.
For example, if you had $500,000 in inventory, and you only had sales of $50,000 in a month, you would have too much inventory and paltry turns. On the other hand, if you had $5,000 in inventory and $50,000 in sales, you would be buying too often and wasting money on shipping, receiving, and labor required to process frequent purchasing. The ideal point is to turn inventory 5-6 times, and it is many companies have used their ERP software to help them turn 10-12 times.
Your goal is to keep your inventory investment at target levels with as wide a selection as possible, and avoid both finished goods sitting in your warehouse, and lost sales opportunities due to insufficient safety stock.
Leading ERP Vendor ADS Solutions Is Here to Help
Although ADS Solutions competes as leading ERP vendor of wholesale distribution software, we are always happy to discuss your questions about inventory optimization and inventory stratification. Please feel free to call our staff at 800-423-8268 ext. 835: we’re here to help.