"Xero for Dummies" author Heather Smith is back again, giving awesome advice on inventory management for businesses. In this post, she's focused on those all-important KPIs, and advises on KPI and inventory ratio calculations to measure and track business performance.
Advisors and business owners can adopt a number of universally accepted ratios and key performance indicators (KPIs) to help them monitor business. Extracting, analysing, monitoring and reacting to relevant inventory ratios can help the business improve its performance, cash flow and profitability.
Ratios and KPIs can be compared to external industry standards, where available; however, finding suitable comparisons can frequently be difficult. Many small- to medium-size businesses will need to rely on defining their own ratio and KPIs goals, and using these to monitor ongoing performance. Further to this, they will benefit from categorising inventory, and analysing group performance. For example, a shop that has both fast-moving (such as fresh food) and slow-moving goods (such as notepads) will have a richer understanding of their inventory performance if they define and analyse inventory by their performance within their category.
Here I explore five inventory ratios and KPIs, explaining what they are, how to calculate them, what they indicate, and how they can assist in managing the businesses inventory.
1. Inventory Turnover
Inventory Turnover is a measure of the number of times inventory is sold and replaced in a time period. This ratio is calculated by dividing Sales by Inventory. The time period is typically a year, but can be shorter.
Analysing inventory churn helps a business to plan at all levels of their income statement. It allows one to better forecast the cash likely to be required to reinvest in inventory in the coming months based on past performance. It allows one to identify underperforming sales lines and products so that those products can be moved more quickly, either via specials or a focus on those products which may have previously been neglected. This in turn will free up cash flow and shelf space for higher volume or better performing products. It can also improve inventory logistics and supplier relationships. The cost of transportation can be reduced if proper attention is paid to this ratio and, finally, it allows one to consider inventory storage capacity requirements as the business expands.
-Andrew Mobbs, Managing Director, The Hatchery Limited
2. Inventory Write-Off
Inventory Write-Off represents inventory that no longer has any value in the business (as opposed to write down, where the inventory value has been reduced). Inventory could be written off due to technological obsolesce, theft or damage. Inventory Write-off is simply the dollar value of the stock to be written off. It can be allocated to the Cost of Goods Sold account, but this will distort Gross Margin percentage. My preference is to isolate it by allocating it to a Write-Off account.
The Inventory Write-Off value reflects how much writing off inventory is costing the business. If the level is concerning, further investigation into why the write-off is necessary and corrective action may need to be undertaken.
Every growing business should have a process to identify slow-moving or non-saleable products, and consider scrapping or writing off some of those items to create room for more profitable products.
-Dan Schmidt, founder and CEO, The Emerging Business CFO
It’s important to have a process in place to do this periodically. The last thing you want is to find out, sometime in the future, that your inventory is not the value recorded in the Balance Sheet, meaning you must incur a major write-off in the Profit and Loss Statement. [Tweet this]
3. Holding Costs
Holding Costs (sometimes referred to as carrying costs) are costs incurred in storing and maintaining inventory. They could include insurances, costs associated with the space housing the stock, security, and associated equipment and labour costs. An example of a holding cost could be a forklift truck required to move stock in the warehouse. Holding costs are simply the cumulative dollar value of these various costs. Typically, they’re accounted for separately but, when reporting, may be grouped together.
The Holding Costs indicate the additional costs involved in managing the businesses inventory. Although they can be easily overlooked, they are an important cost to monitor when making decisions about inventory. If, for example, inventory levels drop due to seasonal fluctuations, hiring out excess storage space to assist in covering the holding costs may be worth considering.
You can engage a business to manage inventory for you, and understanding your holding costs will assist you in evaluating your options and deciding on a suitable business model for inventory management.
4. Average Inventory
Average Inventory is the median value of inventory, over a defined time period. The Average Inventory ratio evens out seasonal fluctuations, effectively normalising the data. It is an indicator of how fast inventory is selling, and the average volume kept on hand. A fluctuation may highlight issues with purchasing or sales.
5. Average Days to Sell Inventory
The Average Days to Sell Inventory is a measure of how long it takes a company to buy or create inventory and turn it into a sale. Average Days to Sell Inventory is calculated as (Inventory divided by Cost of Sales) multiplied by the number of days in the year.
The Average Days to Sell Inventory ratio alerts the business owner to how long on average, in days, it takes to sell each item of inventory.
The old adage ‘time is money’ is why analysis of this report is so important. When businesses tie up capital in holding inventory items, there is an opportunity cost to do so. Consider the following example... A car dealership purchases a car to be displayed in the yard. The cost of the car is $20,000. The business’s cost of capital is 6%. Therefore, for every month the car sits in the yard, the business has an opportunity cost of 6% × 20,000 ÷ 12 = $100. If the average time it takes the business to sell each car is 180 days, the business should research to see if the car might sell in a faster amount of time should the retail price be reduced. If the car sold 30 days faster once the price was $100 less, the business would be indifferent, but if the car sold 30 days faster once the price was $90 less, the business would in fact be ahead financially by $10. The case is even more compelling when retail price is considered in place of item cost.
-Tracey Newman, Director, CloudCounting Pty Ltd
Many other ratios and KPIs relate to the movement of inventory, such as order accuracy, fulfilment cycle time, on-time delivery and cost per order. With respect to your business model, embrace the optimal combination of ratios and KPIs to analyse. Work with your accounting and inventory solution so you can easily extract the key data required to calculate this information. Monitoring and understanding key inventory ratios can enhance the overall inventory management of the business, and improve performance, cash flow and profitability.
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