Methods Matter: Calculating Inventory Turns

Hello Beets! My name is Helen King. I am the newest member of the Supply Chain Insights team. I am very excited to join the team. I look forward to interacting with the Beet Fusion community. I will be posting a Metrics Blog here weekly so be sure to come back each week to see what we have for you.

Before I get into all of the facts and figures of this post, allow me to give you a little background on myself. I am a recent graduate of Tuskegee University with a Bachelor’s degree in Sales and Marketing with an emphasis in Supply Chain. During my four years at Tuskegee, I developed an interest in supply chain management and took extra courses to get a better understanding of the vast field and how it works. I attended panel discussions, roundtables, and conferences that were hosted by my college and began networking in the supply chain world. In my senior year, I was introduced to Lora Cecere during her visit to Andrew F. Brimmer College of Business and Information Sciences. The rest is history.

A Closer Look at Inventory Turns: An Important Measurement

In any kind of research, it is important to understand the why and how of the measurement. In the past, at Supply Chain Insights, when calculating the Supply Chain Index rankings, we used financial information from YCharts. The methodology used by YCharts is to calculate inventory turns as Inventory Turnover = Revenue / Average Inventory where Average Inventory is equal to the average of the last two reported inventory levels of the specified frequency.

In an ideal world, companies want to turn inventory faster The faster the turns, the greater the contribution to market valuation.  

It was recently brought to our attention by an independent researcher in the pharmaceutical industry that the standard for calculating inventory turns is: Inventory Turnover = Cost of Goods Sold/Inventory. We find that it is calculated both ways in the industry. However, for companies the use of cost/goods methodology normalizes the data for a more supply chain-centric view.

As can be seen in Tables 1 and 2, the calculations yield very different results. It is for this reason, that we are adapting the Supply Chain Index methodology to use the cost of goods sold method.

Table 1: Inventory Turns Using Revenue/Average Inventory

All Industry Snapshot 2006-2015

Table 2: Inventory Turns Using Cost of Goods/Inventory

All Industry Snapshot 2006-2015

Looking at Trends

We use orbit charts to track and depict changes in year-over-year results at the intersection of certain metrics that we measure, below are two orbit charts which compare Operating Margin to Inventory turns. The first chart is a reflection of the calculation as Inventory Turnover = Revenue /Average Inventory and the second depicts Inventory Turnover = Cost of Goods Sold/Inventory.

 

Orbit Chart

Orbit Chart

As you can see, the difference in the number of inventory turns between the the observed timeframe (2006-2015) were 7.60 turns and in the new method, average inventory turns over the observed timeframe were 6.27.

 

Next Step for the Supply Chain Index and the Supply Chains to Admire

Pharmaceuticals is a unique industry in that compared to other industries margins are extremely high, so when the methodology for calculating industry turns was adjusted, we found the inventory turns were overstated when using YCharts data. This drastic change can explained by the difference in using revenue versus using cost of goods sold in calculating inventory turns because the large revenue margins that pharmaceutical companies are able to realize skew the ratios when cost is not taken into account.

In our countdown for the Supply Chain Insights Global Summit, we will be publishing a series of reports on the Supply Chain Metrics That Matter by industry. In this series, we will use the cost of goods definition for inventory turns.

Let us know what you think. I look forward to hearing from you.

 

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Comments (6)

  • Interesting article on Inventory Turns.  However, my turn (excuse the pun) on inventory turns is a little different. 

    Inventory turns are an indicator of how well your biggest cash asset is performing.  But are we getting a true picture. Many companies either manufacturer or distributor are ignoring the key word in the numerator of the formula....STOCK.   They are throwing in all sales into the equation.  Drop shipments have been included but did you invest your money to hold that item of inventory? How about non-stock specials? How about transfer that complete a customer order?

    I see no mention of these in the article.

    May 05, 2016
  • Helen, thanks for sharing this,  a good look at the difference between industries. I would like to add that if you're using the year end inventory to calculate this Kpi that will only show us the ability of the industry to down the inventory at the end of the period to show to the analysts a better performance than the year average. This practice is very common in some industries. Could be interesting to analyze the year average inventory as a better view of sustained performance. Is this the case?

    Your view?

     

    Regards

    May 06, 2016
  • Thank you Helen for this article - I have raised this concern with my team; Cost/ Goods approach does normalize the results and makes it a true supply chain metric.  Jose, your comment is also very important - taking the year end calculation does influence how organizations manage their inventory and if you manage high inventory through out the mammoth and take the snapshot of inventory at the end of the month/ art/ year than you are not truly measuring your supply chain. As you mention taking an average inventory vs end of year would be more Supply Chain centric. 

     

     

    Victor

    May 10, 2016
  • Helen, thanks for the article.  At one company that I worked for we completely changed the inventory performance metric because like most organizations everyone only focused on the YE number.  We moved to a concept that was called the 5 QTR average where we were measured on a rolling 5 qtrs.  It was also COGS based.  We had to project what the FISCAL YE inventory would be in dollars and days which included our Quarterly projections throughout the year.  Basically poor inventory management in Q2 would prevent one from meeting the Q4 target.  It heightened the awareness and accountability for everyone in the Supply Chain and Operations.

     

     

     

     

    May 12, 2016
  • These are all good points. The sad point is that too few people know the definitions and understand the points referenced above and how they tie to supply chain excellence.

    May 18, 2016
  • According to the APICS disctionary, Inventory turnover is defined as the Average Inventory divided into the Annual Cost of Goods sold. This is also the accepted method for banking comparisons and for finacial reporting (per the AICPA standards).  We can come up with many individualized methods to inform our internal management but any time we attempt to compare outside our own reporting units, we should stay with the accepted definition.

    Earl

    May 20, 2016