Company executives, stockholders, lenders, and other interested parties all watch inventory turns levels like hawks because it is a financial measure of a firm’s health. Therefore, an inventory turns level is a much more meaningful number than just the amount of available inventory. But it is useless unless analyzed from the proper perspective.
First, let’s define inventory turns, also called inventory turnover. According to the APICS Dictionary, 14th Edition, inventory turnover is “the number of times an inventory cycles or ‘turns over’ during the year. [To compute,] divide the average inventory level into the annual cost of sales.” For example, if you have an average inventory of $3 million and divide that into an annual cost of sales of $21 million, your inventory will turn over seven times, the APICS Dictionary notes.
Now, it might be gratifying to know that your inventory turns measurement is seven, but what does that really mean? Basically, it shows that you have about seven or eight weeks’ worth of inventory on hand. Is this a good amount? To find out, you have to put these numbers into context.
Looking at the landscape
A good place to start is by examining companies similar to yours. Comparisons of your inventory turns level to theirs will give you clues about how your competitors manage assets and what they expect for future sales. Conversely, you might find that your competitors are unable to respond to recent changes in demand, which could open up a market opportunity for you.
For a better indication of your performance, compare your inventory turns to industry averages. You can compute these averages from United States Census Bureau data, which is available at census.gov/econ/ manufacturing.html.
It would also help to know how your inventory holdings have changed throughout the years. Are there more turns now than there were, say, two years ago? Generally speaking, a higher turns level means better performance because it indicates that you are supporting sales and production with a relatively smaller amount of inventory and therefore have a greater return on investment.
Don’t forget that you have inventory for a reason—several reasons, actually. Too much inventory is indeed wasteful. Too little leads to shortages, lost business, and plant disruptions. It’s naïve to think that a higher inventory turns level, and therefore less inventory, is always better. When inventory turns start to hurt customer service—for example, because of supply shortages—the inventory plan needs to be adjusted.
However, it is possible to raise your inventory turns level without increasing your risk of shortages. For example, if you already have more inventory than needed to deliver the desired service level, inventory reduction will boost efficiency. In addition, performance improvements that shorten lead times, change lot sizes, or lessen variability risk can reduce the need for inventory.
You should also keep an eye on turns by inventory type, such as finished goods (in relation to customer service achievement) and raw materials and components (relative to production disruptions caused by shortages). Each type of inventory has a different usage profile and therefore different service-level expectations and stocking guidelines.
An inventory turns level is a better measurement than raw inventory value because it puts the inventory level in the context of business volume or sales. When considered in combination with good business practices, historical performance, and inventory availability and shortages, the inventory turns level will give you a solid gauge of your company’s performance.