For years, operations managers have tried to manage inventories effectively to control costs, boost cash flow, and increase profitability. Too much inventory pushes up operating costs, and too little often results in lost sales because of canceled orders, backorders, and the erosion of customer loyalty. The care and maintenance of inventory place a heavy burden on cash flow, storage capacity, and associated carrying costs, so it is vital to stock the right merchandise in the right quantity at the right time - and move it at the right time.

Inventory management is so closely associated with numbers that the "people" aspect of it is often ignored. In any operation, there are a lot of people involved in handling inventory, and all of them must work together if the key goal of achieving optimal inventory turnover is to be realized.

Stock levels can be adversely affected in a limitless number of ways. Misplaced merchandise is hastily re-ordered for an upcoming promotion; after it arrives, the original shipment is discovered way back in an aisle of the warehouse. Or let's say the merchandising department decides to increase the number of toothpaste SKUs to include all brands, all flavors, and all sizes, based on a faulty sales forecast, leaving you stuck with a huge inventory and poor turnover. The examples are endless, but the solution is clear: Optimum inventory turns will occur only if the various business units within a company work together. Inventory management should be a joint effort of - among other divisions - merchandising, planning and forecasting, traffic and transportation, inventory control, quality assurance, distribution and fulfillment, and information technology. In addition, senior management must help to coordinate those responsible for managing inventories.

A crucial measure of management's ability to control inventory is annual inventory turnover, or the number of inventory turns. This figure is easy to calculate. Simply divide the annual cost of goods sold from stock by the value of your average inventory investment (in dollars) and you have determined your turns factor. Be sure to base your calculations on dollar cost and not on selling price, or you will erroneously overstate your inventory turns value. If you are cross-docking a part of your flow through your distribution, do not include the cross-docked goods in your calculation, because they have nothing to do with the goods carried in inventory.

Furthermore, be sure to do your calculations using average annual inventory and not a monthly snapshot of your inventory. SKU levels are in a constant state of flux, and are particularly sensitive to seasonal and demand variation. If you are in the pool supplies or toy business, your inventory levels are going to vary much more in the spring and summer months than they would in a non-seasonal business such as health and beauty aids.

So, what's a good number of inventory turns to shoot for? As it is to many other questions that we consultants are often asked, the answer to this one is "It depends." A lot depends on your industry, company, and corporate strategy. Quick response and manufacture-to-order techniques allow Dell Computer Corporation to turn its inventories 30-40 times a year. On the other hand, a distributor of rare classical music CDs would likely have a very low (fewer than three turns) inventory turn rate, but that is the nature of his business. Although the numbers vary widely among retail businesses, those consistently turning their inventories eight to ten times per year are above the norm. Companies at the lower end of the spectrum are likely to struggle just to turn their inventories three to four times a year.

Carry the burden

You know that low inventory turnover results in high carrying costs, but do you know precisely what influences those costs? The list is surprisingly long:

• Money. The higher the inventory level, the more capital is needed to own those goods.

• Taxes. Depending on the state in which you maintain your inventories and where you do your business, you owe taxes on the inventories you carry.

• Storage. The more inventory you carry (both "average" and "peak") the more space, equipment, and labor you need to spend on handling and storing those items.

• Insurance. What if the sprinkler pipe bursts or you have a fire? Maybe you should get some insurance!

• Obsolescence. What, the Razor scooters and Hula-Hoops aren't selling? Can we get our money back?

• Shrinkage and damage. "Hey boss, we had a problem with that pallet of fine crystal that was dropped on the dock, and by the way, we can't find the matching dinnerware anywhere." Better order more for next week's sale.

• Handling, relocation, disposal, and transportation. Periodically, inventories need to be moved around, transferred, and otherwise "massaged" to make room for incoming goods.

Accountants and scholars frequently debate exactly how each cost element should be calculated, but in general, the cost of inventory ownership is in the range of 30%-40% of the average inventory value.

See the table above for an illustration of the dramatic impact that turnover has on the cost of owning and caring for inventory. It is particularly interesting to note what happens to costs when the inventory turn rate is less than four times per year. Once you are out at eight to ten turns a year, the effect of improving the turn rate by one unit is less than that of improving from a five-turn rate ($21 million carrying cost) to a six-turn rate, wherein the annual carrying cost drops by $3.5 million!

The magnificent seven

Now that we understand the relationship between inventory turns, costs, and cash flow, let's review seven basic ways to improve your inventory turns:

1. Improve planning and forecasting

   In 1916, Henri Fayol first published his General and Industrial Management. His writings served as the basis for what has now become the "five functions of management." The first of Fayol's principles was "Planning." Failure to forecast demand accurately can result in excessive inventories as well as out-of-stock situations where demand was underestimated. The most difficult items to forecast are new products that have no history and for which market preferences are not clearly known. A combination of marketing data analysis and an Ouija board is a good tool to use in this case, but historically, we have continued to have problems with the Hula-Hoops, Razor scooters, and ceiling fans!

   Build your forecasts using sophisticated forecasting and replenishment algorithms to optimize inventory and customer service levels. Where possible, use current demand- and sales-driven data (e.g., point of sale) for replenishment instead of last month's forecasts. Also, collaborate with your suppliers and use their knowledge of current market conditions to influence your buying or re-buying patterns.

2. Streamline organization, systems, and decision-making

   Follow the lead of the best-of-breed companies in breaking down the silos that historically contained individual functions such as sales, marketing, or merchandising. The companies that have done a commendable job of controlling inventories are those that have found ways to integrate multiple, competing goals using cross-functional teams.

3. Leverage vendor relationships

   Vendor-managed inventory (VMI) is a means of optimizing supply chain performance in which the vendor or supplier is responsible for maintaining the customer's inventory levels. The vendor has access to the customer's inventory information through electronic data interchange (EDI) and is responsible for generating replenishment purchase orders and arranging the shipment to the customer. In some cases, vendors provide consignment inventories, placing the goods at the customer's location but retaining ownership of the items. Payment is not made until the goods are actually sold, and end-of-season return privileges are negotiated at the front end of the deal.

   Another way of keeping stocks off the books, thereby reducing average inventory investment, is by negotiating "dating" terms in the purchase agreement. In this situation, the customer agrees to accept delivery of the goods and maintain them in storage; however, more favorable payment terms are negotiated so as to defer payment to the vendor past the normal payment cycle.

4. Reduce lead time

   Decreasing the time from receipt of a customer order to the time of delivery at the specified destination is another valuable technique used to reduce inventories and accelerate inventory turnover. Shortening the lead-time cycle allows a leaner customer inventory level if a rapid replenishment shipment can be assured. In addition, shorter lead times boost sales by increasing the number of available "selling days" within the product's selling season. You can also cut lead times by using fast transportation channels such as air freight.

5. Improve information accuracy, timeliness, and availability

   If incoming goods are misidentified at the time of receipt, you will end up with inaccurate inventory records. If this misinformation then results in the apparent "loss" of SKUs within the DC, you may need to a re-order the stock that can't be found. In this situation, the inventory position on the misplaced goods is needlessly increased, and a portion of the duplicated inventory may become obsolete at a future date. Inventory turns suffer, capital is tied up in excess stock, and carrying costs soar. To avoid this quandary, maintain detailed records on each SKU: its current quantity, equivalent number of days on hand, and "last sold" information. Continuous monitoring of these records will allow your buyers and inventory managers to adjust order quantities and inventory positions to suit the company's objectives.

6. Monitor sales for profitability

   If a SKU is not selling, then any amount of inventory is too much. The foremost measure of the financial effectiveness of an inventoried item is the turn-and earn principle. If you turn a product four times a year and make a 25% gross profit margin, the product's turn-and-earn index is 1. This index is a measure that bridges asset management (turns) and profitability (gross margin percent) to assess a product's performance. If a product is low on the turn-and-earn index, you can improve the turns, the gross margin, or both; or, if those efforts fail, dispose of the item.

   Another useful technique is measuring a product's gross margin return on inventory (GMROI). Simply stated, GMROI relates gross profit dollars to inventory dollars to establish a ratio of return on inventory value. The lower the ratio, the more energy you should spend on reducing the inventory levels of those products that are tying up capital and cash flow with no commensurate contribution to margin.

7. Purge inventories aggressively

   To maintain frequent inventory turns, you must continually monitor each item with respect to its inventory level, current rate of sale, and contribution to profit. Each SKU must meet a minimum requirement in terms of gross margin ROI or another financial indicator of profitability. Eliminate obsolete and damaged goods immediately, and drastically cut the number of slow-moving items in stock. Mechanisms for disposing of such goods include returns to the vendor, markdowns and clearance sales, warehouse sales open to the public, sales to jobbers, and charitable donations.

Impact of Inventory Turns on Carrying Costs

Source: Keogh Consulting Inc

What's Included in Inventory Carrying Costs?