The five components of benchmarking inventory turnover

Inventory turnover benchmarking is used to drive efficiency and increase business performance

Many companies are focused on inventory management and ways to measure and to improve business performance. Inventory includes all goods, both raw and finished that an organisation has in stock, with the intent to sell. Inventory turnover refers to the rate that inventory stock is sold, used, or replaced.

Inventory is core to any company with a supply chain, since it ties up cash invested in stock and often has high cost of holding and operational costs. Many companies use inventory turnover as a ratio to measure the efficiency of the business looking to increase the turn rate and hence improve the company’s performance.

The most common inventory KPI after SKU availability, is inventory turnover, and being common across companies makes it an obvious choice for benchmarking and making comparisons. It is not uncommon for business leaders to benchmark inventory turn performance against their competitors.

As, the turnover rate can be used to gauge operational efficiency, turnover rates that meet benchmark numbers are a prime sales objective.

Whilst there are several ways to measure turns, this is considered a universal calculation:

Annual Cost of Goods Sold (COGS) / Average Inventory Value (AIV) = Inventory Turn

This simple ratio demonstrates the efficiency of a business by highlighting its ability to manage stock levels relative to demand, and as a function of sales, monitor that effectiveness over time as demand changes.

Whilst the inventory turn calculation is a function of just sales and inventory value, the reality is that many more variables impact the turn number that are not evident when benchmarking.

Determining what good inventory turn looks like differs by industry

It is common when talking about inventory metrics for companies to have an inventory turn target. Admirably, this is often a bold, continuous improvement target linked to staff objectives as a means to increase business efficiency and maximise ROI.

Ultimately, what someone considers a “good” turn number will depend on the industry.

For instance, the tech industry has very high turns where Dell, Apple and Samsung report annual turns around 100, that are often converted into measures of a few days. On the other side of the spectrum, spare parts logistics for the automotive industry requires high stock availability for 100’s of 1,000’s of SKU’s, so turns of 3, 4, 5 are annual measures. And companies producing industrial equipment for mining and construction might have an annual turn of less than 1.

Five components to consider when setting up inventory turn benchmarking:

Assuming for a moment that the demand variable within the turn calculation is unchanging allows us to consider only factors within the control of the inventory planning team – Average Inventory Value. What determines how much inventory to hold? Why does a company hold any inventory at all?

1. Use product lifecycle and availability measures to improve accuracy.

Inventory turns change as items move through the product lifecycle, typically increasing during the product’s introduction and growth phase and gradually declining again at market saturation or a shift in consumer preference.

In the case of say cars or even construction equipment, the investments can be large and maintaining the usefulness of the item is essential i.e. commuting to work, running a warehouse, keeping a large construction project on plan. Repair parts and accessories allow customers to maintain their purchase for many years to best utilise their investment.

In the case of construction equipment, the liability of these products to breakdown and the urgent need to repair quickly requires that spare parts are available globally at relatively short notice. Until 3D printing allows producing replacement parts at the time and place of demand, holding spare parts inventory to cover the forecasted demand provides a level of service to the customers.

On the other hand, for a fast-moving retailer where competition is widespread, 98% fill rate might be essential to maintaining profitable market share. For a smaller, younger specialist retailer with minimal competition, <80% fill rate might be acceptable and keep customers happy.

It therefore follows that if a company is planning to meet 98% or 80% of its customers’ demands within customer order lead-time, the amount and mix of inventory required to be available in stock will vary dramatically.

2. Production lead times can dramatically impact the inventory turns calculation.

The time taken from creation of a purchase order upon a supplier until receiving the order into stock is the replenishment lead-time (RLT), another variable with multitude impacting factors.

There are several questions to consider when developing the optimal lead time such as:

• Where is the supplier located?
• How long does it take to manufacture the SKU/item?
• How much does the item cost?
• What is the method of transporting the item?
• What are the commercial arrangements with the supplier?
• Does the supplier hold stock?
• What is the order frequency?
• Does the part require packaging?
• Does it have to clear customs?

Again, fast-moving competitive items might have short RLT’s of only a few days, but large, costly specialist items such as machinery parts could have an RLT of up to 1 year. Every part is likely to have its own RLT, which in turn could be different at every stock location within the network.

In addition, the number of pieces forecasted to be ordered over those days/months needs to be covered by inventory in stock – demand over lead time. The RLT mix across the parts range is unique to the organisation and the inventory in stock is consequently unique.

3. The impact of demand including planning for seasonality fluctuations

We have assumptions about sales in terms of the inventory turns calculation, but demand factors into the AIV (Average Inventory Value) as well. A product might be subject to seasonality, it might be growing or declining rapidly in demand, or it might just be very slow moving and subject to occasional, lumpy orders.

The nature of the business including the size/scale, distribution channels, customer incentives, number of common parts and the level of competition for the product all factor into the order patterns of customers and therefore have a direct impact on AIV.

When considering seasonal products, significant time-based fluctuations can have a major impact on inventory turnover rates and should be carefully factored into planning. Most organisations experience an influx of seasonal demand during the holiday season and may even stock holiday-specific items that are not sold at other times of the year.

However, seasonal demand creates two challenges for organisations, either to pay for unused storage and fulfilment during the “off season” or keep operations tight during the year and over-extend resources during peak seasons. If out of season items are stored, it may affect the turn rate for that particular SKU or product category.

Leaders should compare the previous year’s sales and average inventory requirements, so seasonality can be considered, and year-on-year figures compared.

4. Business disruptions and the impact on safety stock levels as well as your benchmark calculation.

Maintaining inventory levels is essential when considering consumer demand, to avoid the potential dilemma of running out of stock. Considering that issues can occur at any point during the supply chain i.e., manufacturing, shipping, distribution or any other point, it’s important to have preventative measures in place.

Safety stock, for instance, serves as a buffer against hazards (such as production problems) and risks (sudden shifts in demand). Whenever there is uncertain supply, keeping extra SKUs in stock is wise to prevent a stockout situation. However, increasing inventory reduces the inventory turn making it less efficient.

Also, it is costly to maintain by tying up capital and running the risk of holding obsolete products. So, a solid understanding of safety stock and stockouts is vital for any business or supply chain leader, balanced against service level agreements.

It’s worth considering if safety stock is required for every SKU, identifying the hazards and likelihood of them occurring as well as defining what level of service to offer customers (and the potential impact on revenue of a stockout situation). The process should be carried out for each product line in order to prioritise the products and establishment of safety stock levels.

Supply chain shortages can lead to over-ordering, paired with shifts in consumer demand also create challenges for organisations. So, to combat this, leaders should consider re-allocating slow moving inventory, prioritising demand forecasting and liquidating obsolete inventory ahead of any upcoming peak seasons.

5. Product mix greatly affects the turn rate.

A young company with a narrow product mix, high percentage of common, low-cost items and reliable products is going to have very different demand patterns requiring appropriately different safety stock levels to that of a long established, global business supporting legacy products.

So it’s worth exploring a few questions to help quantify how the product mix affects the turn rate, for instance:

• How long has the company been in existence?
• Is the market regional or global?
• When did it reach the current scale?
• How many different products has it sold over time?
• How many products are still in use?
• How reliable are the products?
• Has there been a product design focus to use common parts across the range?

Decision makers should also consider the same questions about the closest competitor. Especially as the answers to those questions may alter their turn rate quite dramatically, compared to your results.

Finally, avoid comparing yourself to competitors when developing your benchmark.

The components and variables of Average Inventory Value (AIV) are many, but many more exist, such as budget for example. However, when considering each of these variables as a whole, the effect is an outcome particular to one business:

Product mix x # SKUs x Availability target x Lead Time x Demand Patterns x …etc. etc. = Unique and specifically optimised Average Inventory Value

Which means, your inventory value is unique to you and considers of all the variables affecting it. So, comparing your turn rates with your competitor(s) and benchmarking their inventory turn alone is worthless.

There is greater value in monitoring their turn number over time to see if they are improving in efficiency or not and aim to at least better that rate of improvement, but to pick an inventory turn target with the aim of “beating” your competitor without information on all supporting variables creates an unrealistic target.

Using inventory/demand profiles and similar characteristics from multiple businesses is the only way to properly match companies and deduce appropriate benchmark results related to inventory management i.e. fill rate, inventory investment and, of course, inventory turn.

In fact, if done properly, this method is so accurate that it is even appropriate to benchmark businesses and draw conclusions across differing industries where the profiles statistically match.

It may well be that the closest competitor manages the business entirely differently and would therefore not be a good benchmark, so you need to seek out statistical matches, appropriate benchmarks and truly meaningful targets that will drive real value for your company.

Conclusion

There are factors both inside and out of the organisation’s control that can affect inventory turns. But, regardless of origin, it all points to the need for effective inventory management planning.

A slow turn rate could indicate decreased market demand for certain product lines. So it’s important to track changes over time to explore options such as incentives to deplete inventory faster or even adapt the mix of products offered aligned to customer demand.

Regardless of what process is followed, inventory management software is critical to support omnichannel fulfilment and improve the customer experience, protect costs, and support organisational growth.

To find out more read our blog the “Five elements of inventory optimisation” here.