Inventory Management: measuring the right things
Efficient inventory management is essential for optimising profitability, reducing costs, and maintaining customer satisfaction.
By tracking the most relevant metrics, businesses can focus on inventory performance, enabling them to make informed decisions. These metrics should measure both effectiveness and efficiency of holding stock.
Here are the top five metrics that can significantly enhance your inventory management.
1. Inventory Turnover Ratio / Inventory Days
The inventory turnover ratio, a key indicator of how frequently inventory is sold and replenished within a year, reflects inventory management effectiveness. A high ratio suggests good management and lower holding costs, while a lower ratio could indicate excess stock or sluggish sales.
Formula: Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Although a higher turnover is usually favourable, indicating efficient operations, it's vital to maintain a balance to prevent stockouts and potential sales losses.
Days Inventory Outstanding (DIO) shows Inventory Turnover in a form that is often easier to understand - the average duration that items remain in stock. It's an excellent measure of how swiftly a business converts its inventory into sales.
Formula: DIO = (Average Inventory / Cost of Goods Sold) x 365
A lower DIO is preferable as it points to efficient inventory management. However, a very low DIO might suggest a risk of running out of stock and failing to meet customer demand. Again, you need to balance both these.
2. Gross Margin Return on Investment (GMROI)
This is one of the most important concepts to understand about holding stock:
Inventory is an investment.
Just like any other investment, you need to know that the money you're investing into inventory will give you a decent return. You calculate that return by assessing the profitability of inventory investments by comparing the gross profit from sales against the average inventory investment (GMROI).
Formula: GMROI = (Gross Profit / Average Inventory Investment) x 100%
A higher GMROI indicates that the business is managing its inventory effectively, yielding higher profits from each dollar invested in inventory. This metric is crucial for deciding how to allocate inventory and set pricing strategies.
3. Fill Rate
This efficiency metric calculates the percentage of customer orders fulfilled from stock without backorders or delays.
Formula: Fill Rate = (Number of Orders Filled Completely / Total Number of Orders) x 100%
A high fill rate suggests that inventory levels are well-matched to customer demand, enhancing customer satisfaction and reducing the likelihood of lost sales.
4. Inventory Carrying Cost
Inventory carrying cost includes all expenses associated with holding inventory, such as storage, handling, insurance, and opportunity costs. It's unfortunately often overlooked in small businesses, but measuring it can actually help you to uncover which SKU's are actually making a real loss, by quantifying the cost of stocking them versus alternatives:
Formula: Inventory Carrying Cost = (Storage Costs + Handling Costs + Insurance Costs + Opportunity Costs) / Average Inventory Value
5. Inventory investment compared to Sales
Generating sales means holding stock - but how much?
Calculating Inventory as a percentage of Sales is a forward-looking measure that explains how much you need to invest in holding stock for every dollar of sales you expect to make in future.
Formula: Inventory / Sales = Average Inventory value / Sales Revenue
This metric is especially useful in planning forward. Let's say your sales are predicted to increase by 25% next year - you can easily calculate how much inventory you'll need to hold. Is that too much? Then use the other metrics to track improvement plans to get your Inventory/Sales figure down.
Summary
Inventory is often the largest single investment in a goods-related business. It's also often the worst managed, especially in small businesses - mainly because Owners / Managers don't know what to look for.
Monitoring these costs helps businesses pinpoint ways to reduce the expenses tied to unsold inventory, optimizing overall inventory levels.
By analysing these metrics in the context of your specific industry and operational goals, you can refine your inventory management practices, ultimately enhancing profitability.
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