Columnists, Thom Finn, V2I6

Inventory Turns

So, I recently started with a new client who signed up for the short-term, three-month program. After asking him what must have seemed like an endless list of questions, he confirmed what I suspected: That our primary coaching goal would be to improve profitability.

In most cases I will ask to see the most recent financial reports, specifically the P&L and the B.S. I could tell by the tone in his voice that he wasn’t exactly sure what I meant by those terms, which is no problem, and I explained what profit and loss and balance sheets are. But, nonetheless, it was a slight red flag that the client probably didn’t know what important numbers are found on these reports.

What I got from his accountant was a little on the strange side. During our first paid session, I dove right in with questions I had about various entries on his financial reports. Just to be safe I backed up a few yards and explained what the different parts of the profit and loss were. And once again I was surprised and angry that yet another accountant was not providing their client with the basic education they needed.

Over the years, I’ve learned to accept that there are two types of accountants: The vast majority who are record-keeping accountants, and the stellar few who are true managerial accountants. In the cases like this one, where the client just has a record-keeping accountant, it’s my duty to step in and provide that management advice.

We were quickly able to see where the problem areas were and begin with strategies to improve upon them. We also started a cash-flow forecast that would predict what his next 12 months would look like.

I suppose every financial report reader has a few favorite measurements. I like to see the percentage of gross profit and the percentage of net profit. If I had to pick only two to look at, it would be these.

But if I were to select a third favorite, the competition gets stiffer.

Inventory Turns

In many cases the measurement called inventory turns ratio can be especially enlightening. I believe our nation’s economy changes like the seasons in the year. But, unlike the seasons we observe outside, these seasons don’t typically last for three months. I personally believe we are in the summer season; although, I’m not sure if we are in mid-summer or late-summer before fall and the inevitable winter season returns. But I digress.

Inventory turns is a favorite measurement tool of mine during the summer. As with all good statistics, this one measures two important figures at one time: How much you are selling, and how long it takes you. It shows me how effectively you are managing your inventory by looking at how many times each structure “turned.” A company with $1,000 of average inventory and sales of $10,000 effectively sold its inventory 10 times over.

In managerial accounting, the inventory turnover is a measure of the number of times inventory is sold or used in a time period such as a year. The equation for inventory turnover equals the sales (some formulas use the cost of goods sold) divided by the average inventory. Inventory turnover is also known as inventory turns, merchandise turnover, stock turn, stock turns, turns, and stock turnover. In the cases of the shed industry, I am really only interested in finished product inventory.

The formula is Inventory Turnover = Sales/Average Inventory, Or = Cost of Goods Sold/Average Inventory.

I prefer the first version. It is simpler and if we use it all the time, we can get good measurements comparing one month to the next, or one lot to the next.

Another formula to know is average inventory. The most basic formula for this is Average Inventory = (Your Beginning inventory + Your Ending Inventory)/2.

And an even simpler way is to just use your latest ending inventory.

Example

Fatty Sheds sold $1 million, to the penny, in structures last year. Fatty is lazy, so he just grabbed his ending inventory of finished products. And that was a whopping $3.5 million.

If you divide $1 million by $3.5 million, you come up with .285714. So Fatty’s inventory is .29. This means Fatty only sold 1/3 of his total inventory last year. It probably means it would take Fatty three years to go through all of his inventory. Fatty does not have a good turn.

Slim, on the other hand, also has $1 million for sales last year. He took the time to figure out his average inventory, which was $750,000. So Slim’s inventory turn is $1 million divided by his lean inventory of $750,000 or 1.333. Slim is turning his inventory 1 1/3 times each year.

Slim gets it. He is using this inventory turn ratio to make sure his production keeps up with his sales. Fatty isn’t and just keeps producing and producing and producing. His production far outpaces his sales and his inventory turn ratio is proving this. Fatty most likely has cash flow problems.

What is so interesting to me, is Fatty may not see this red flag if he just looks at his profit and loss. He could be running an amazing gross profit percentage, but his business will most likely die because it ran out of cash.

The industries that tend to have the highest inventory turnover are those with high number of sales by transactions and little margin, such as retail, grocery, and some clothing stores.

I find the grocery store industry particularly interesting. In this segment of the economy, it is normal to have very high inventory turnover. According to the experts, the grocery store industry has an average turnover of 18.56 which means the average grocery store replenishes its entire inventory close to 19 times a year. Which makes sense, as the store owners are trying to balance very low margin transactions but have high unit sales.

Even companies within the same industry can have wildly different turnovers because of their specific selling patterns. For example, a shed builder that sells customized sheds directly to consumers will have high inventory turnover because supplies are only ordered as needed. On the other hand, a shed company that sells through dealers must have stock on hand at any time so inventory turnover can be lower.

It seems to me that there is a correlation with inventory turnover and profit margin. Businesses with a low profit margin tend to have a higher inventory turnover vs. companies with a high profit margin that have lower inventory turnover. Your local high-traffic grocery store will have extremely high turnover ratios with items like bread and milk however the store also receives very low margins on these items because of their wide availability and high sales volume.

The Solution

“Thanks for scaring me Coach. Now what do I do about it?”

For management purposes the first step would be to start measuring your inventory turns. Maybe look at it every three months. When we measure it, we want it to go up. I would advise you to start to compete with yourself rather than compete with the inventory ratios of other shed builders and other industries. If you are disappointed with your inventory turns number, the solution is simple. Either grow the sales or cool it on the production.

If the goal is to raise your inventory turns number and because this is a two-part math formula, you have two choices. The first one is to increase your sales, which has been discussed in many previous Shed Builder Magazine articles. I could write a whole book on this subject. But let’s say you have decided to open a lot at the North Pole and the demand for your product is so small given the sparse population and that most folks up there can simply build an igloo and call that a storage shed. In this case, you are truly up against the wall with sales.

So, look at the other part of the formula. The solution is to curtail your production.

We sometimes forget the primary financial goal of a business is bottom-line profitability. If you can’t get it from growing sales, then the inventory turn ratio will show you to bring down production and the associated material and labor costs.

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