The Monthly Metric: Inventory Insights

Throughout its four years in this little corner of cyberspace, The Monthly Metric has often discussed measurements that help supply managers keep tabs on their inventories. However, procurement organizations can put so much emphasis on sourcing and category-management metrics that inventory analytics are neglected by comparison, says Jim Fleming, CPSM, CPSD, Program Manager, Learning Solutions at Institute for Supply Management^® (ISM^®).

That is, at least, until recent events necessitated extra attention on inventories. First, the trade war between the U.S. and China caused organizations to change buying patterns to avoid or minimize tariffs. And the coronavirus outbreak that has paralyzed Chinese manufacturing has impacted the inventories and supply chains of even the world’s biggest behemoth companies.

“Supply reliability is an issue right now,” Fleming says. “That plays into your inventory turnover ratio. If your company has supply chains coming from China, you probably have a lot of significant portions of China where you can’t get any (products or supplies) out. And if you don’t have supply and you don’t carry inventory, you’re going to be in trouble.”

A Ratio For Company Health

Inventory turnover ratio was covered by The Monthly Metric in 2017, but it’s worth revisiting amid the trade turbulence, as many companies purposely slowed their turns by buying additional inventory to avoid tariffs. That decision comes with the additional costs associated with larger orders and longer storage, and warehouse space has been at a premium in the U.S. in recent years. There are also potential unintended consequences, including parts becoming obsolete and a product life cycle running out.

The 2017 blog post states, “The ratio — determined by dividing annual cost of goods sold by average annual inventory — indicates how many times a company’s inventory is sold and replaced during an interval, usually within a fiscal year. If a company’s annual cost of goods sold is US$1.2 million and its average annual inventory is $300,000, its inventory turnover ratio is 4.0. The ratio can be used to determine the average time it takes for inventory to be replenished; 365 divided by four equates to stock being sold and replaced every 91.25 days.”

Benchmark ratios vary by industry, but generally, the higher, the better. Fleming says the ideal ratio for most companies is between 4 and 6. Amazon’s recent quarterly ratios have been between 8 and 9, as it isn’t fiscally advantageous for the e-commerce giant to carry excess inventory.

Inventory turnover ratio is a key indicator of company health, used by Wall Street investors and the annual Supply Chain Top 25 rankings by Gartner, the Stamford, Connecticut-based global business research and advisory firm. “Company revenues are looked at, but efficiency as a function of the inventory is also taken into account,” Fleming says. “Investor confidence has many aspects, but supply management — especially how well it handles inventory — has a significant role in how well the company performs.”

Risks for Smaller Businesses

While large companies have the resources to adjust to inventory strains, small and midsize organizations with typically tactical, not strategic, supply management operations are more vulnerable, Fleming says. He recalls consulting with a company that became so focused on buying supplies at a volume discount that it wound up with unused, obsolete inventory that wiped out its profit margin.

The imposing odds of a small business succeeding over time have been long- and well-documented. Half of all small businesses fail within five years, and 20 percent fail to last one year. While “insufficient cash flow” is often the epitaph for a small business, one of the biggest symptoms of that is inventory mismanagement. According to the U.S. Small Business Administration, inventory issues are among the 10 biggest reasons small businesses fail.

“Those companies are at a greater risk of failure because they didn’t put any science into the way they manage inventory,” Fleming says. “They may look good on paper, but because of inefficient buying practices, they are actually at the point of breaking even or losing money. (Supply managers) think about getting the best price for the company, but one of the unintended consequences of that is that they get more inventory that they’ll ever need.”

Inventory Metric Resources

Among the other inventory-related measurements covered by The Monthly Metric are demand variability, supplier delivery time, gross margin return on investment and cash-to-cash cycle time. The ISM^® Report On Business^® is a valuable resource, as the monthly manufacturing and non-manufacturing indexes contain benchmark data on inventories, supplier deliveries and lead times that can help a company determine how its performance compares to the rest of its industry.

Other indicators, Fleming says, to monitor inventory health include:

•Total cost of ownership: How much is being spent to store additional inventory?

•On-time delivery: How reliable is the supply source?

•Lost sales stock outs: How often does a depleted item hinder the business?

•Capital equipment/expenditures availability percentage: Does the inventory balance enable the use of capital equipment and/or expenditures?

Recent events have resulted in a greater emphasis on inventory management, but the metrics that gauge it have always been vital information for practitioners. “In supply management, we sometimes get into too many other indicators to measure our success that we can be blindsided,” Fleming says. “Those inventory metrics have a critical impact on the business.”

To suggest a metric to be covered in the future, leave a comment on this page or email me at dzeiger@instituteforsupplymanagement.org.