| A temporary cash shortfall can be a death sentence for a small business. The small business owner's limited access to capital leaves little room for error. That's why it is critical to understand how to manage your cash cycle. In this series, we will take a close look at the cycle's three components: accounts receivable, inventory and accounts payable. We'll examine common errors in management and we'll review cost-effective strategies that can shorten your cash cycle. Advice about inventory management is not hard to come by. In fact, accounting and finance textbooks are full of elaborate formulas to calculate economic order quantities, reorder points,safety stock levels, and stockout probabilities. But all the advice has one virtually universal characteristic: it relates to how and when to purchase inventory. The inventory purchase and reorder decision is certainly of concern to businesses large and small. And the quantitative methods employed to assist purchase and reorder decisions have real value under limited circumstances (particularly with non-seasonal items maintained in a product line for lengthy periods of time with relatively constant rates of sale). But the critical inventory decision faced by most small businesses is not when and how often to buy; rather it is when and at what price to sell. As we have seen before, the problem can he framed in terms of the firm's cash cycle. But we'll get to that in a moment. First, it will be helpful to review just what inventory is and why business organizations bother with maintaining it in the first place. What are inventories? In formal terms, inventories are finished goods, work-in-progress, or raw materials stockpiled by a company against anticipated use or demand. In practice, inventories are the lubricant that enables the business engine to run without friction between its moving parts. Every manufacturing or distribution (wholesale or retail) business has a sequence of operations associated with its purpose. For a manufacturing firm, that sequence involves the processing of raw materials, interim production steps, producing a finished good available for sale, and shipping or delivering it to a customer. For a distributor, sequence involves purchasing finished goods, possibly repackaging and repricing those goods, and delivering them to the customer either at the point of sale or at the customer's home or place of business. Maintaining inventories enables the business to separate these sequential functions so that each can be managed independently of the other. Raw materials are available so that the production line can plan its activities and function on a daily basis independent of incoming freight problems; finished goods inventories are maintained so that selling, shipping and delivery functions of the firm can operate independently of variations in production schedules. Firms base their inventory level plans on two primary factors: the anticipation of transaction volume and the need to take precautions against interruptions in their normal processing sequence. The "transactions" motive for maintaining inventory is a response to the anticipated level of demand for the firm's finished products (and the necessary amount of "lubricant" to keep the machine running at the required speed). The "precautionary" motive is a response to the potential for unanticipated demand or emergency (a precaution against stockouts and the cost of lost sales that result). (see footnote 1 at end of article) For the small-business owner, inventories may well represent the major portion of the investment that has been made in the business. Even for large business, inventories represent a sizeable portion of total assets. The U.S. Chamber of Commerce reports, for instance, that for all U.S. businesses, inventories represented an average of 14.3 percent of assets in 1990. Interestingly. however, that figure has been declining steadily for almost 30 years. In 1960, inventories represented 23.6 percent of U.S. business assets. By 1970 the figure had fallen to 23.0 percent, by 1980 to 19.7 percent, and by 1985 to 16.5 percent.Large businesses have been getting more efficient in their management of inventories. Small businesses, however, have not achieved the same reductions in inventory levels (relative to either total assets or total sales) that large businesses have achieved. Since 1965, in fact, the figure has hovered in the 25 percent to 27 percent range with no recognizable trend other than stability. (see footnote 2 at end of article) Part of the reason may be that large business has the resources to utilize modern technology to manage inventories, where much of that same technology is beyond the financial reach of small business. But, just as we found that there are some right and wrong things that small business can do to more effectively manage receivables, we will also find that there are many tools available to the small business manager to more effectively manage inventories as well. Let's quickly review the importance of inventory management to the company's cash position. After all, what does inventory have to do with cash? The answer is simple: it takes cash to buy inventories. The less cash the business spends on inventories, the more is available for other purposes (or the less that has to be borrowed, which means less interest to pay). Remember that the cash cycle of the firm is determined by the Average Age of Inventory (the average inventory holding period) plus the Average Age of Receivables (how long it takes to get your money back from your customers) minus the Average Age of Payables (how long your suppliers will wait for their money). The average inventory holding period is in turn affected by two underlying numbers: the average size of the inventory and the frequency with which it is sold (also known as the inventory turnover). Understanding the relationship between inventory turnover and average age of inventory is essential to good inventory management. The longer the business owner allows inventory to sit unsold in the warehouse or on the shelf, the longer the average age of the inventory as a whole. The longer the average age of the inventory, the smaller the number of inventory turns in a given period of time. And the smaller the number of inventory turns, the smaller is the return the owner is getting on the money invested in inventory. Imagine for a moment a small business with just one item in inventory. Every time the business sells the one item, their entire stock is sold out. If the item is sold just once each year (one inventory turn) for twice what it costs, then a 100 percent return has been yielded on the investment in that item. What was the average age of the item held in inventory? Since we sold it just once in a year's time, its average age must have been half that period of time, or six months. Now imagine that the item is sold not once, but twice in a year's time. What is the return on the owner's investment in the inventory now? Obviously 200 percent. And what was the average age of the inventory during the year's period? Well, since we sold it twice during the year (every six months) and resupplied immediately each time, the average age of the item must now have been three months (half of the six month sales cycle). When we doubled inventory turnover, we halved the average age of our inventory and doubled the return on investment in inventory. Inventory turnover is a critical analytical tool to monitor inventory, and the primary strategic approach to increasing it will be to affect the average age of the inventory. More on that later. On the facing page is an explanation of how to calculate the average inventory age (holding period) as well as the average inventory turnover. The objective of good inventory management should be to reduce the average age of the inventory (or in other words to increase the average number of times the inventory is turned over each year). Reducing the average age of inventory reduces the length of the cash cycle, which reduces the time that money is out of the business owner's hands, which in turn reduces the need for borrowing and the cost of interest. Are you in the junk business?
Not that there is anything wrong with being in the junk business, of course, but many small business owners would be insulted at the suggestion that they are. Nevertheless, even a casual stroll through many small-business warehouses convinces this author that many small-business owners are, at heart, junk dealers. How else to explain their obsession with hanging on to obsolete merchandise that their customers long ago gave to Goodwill? The real explanation, of course, is not that business owners are all frustrated junk dealers, but that they have been misled by their reading of accounting reports. The confusion is between economic losses and accounting losses. Too many small-business owners are unwilling to recognize on their accounting statements the economic loss that has, in fact, already taken place. The result is that, thinking the loss isn't real until it shows up on their accounting reports, they delay an inevitable decision and incur still further losses as a result. The number one error that small business owners make in managing their inventory is not getting rid of the junk. The result is an ever-growing, ever-older inventory with ever-fewer turns per year and decreasing return on the working capital invested. The primary reason for the "junk dealer" phenomenon is a misunderstanding of the nature of losses and when they occur. Focusing on accounting statements as being reflective of real value—and tied to original purchase price ("book" value) as the "cost" of selling an item because, after all, that is what will be reflected as "Cost of Goods Sold" on the operating statement—the business manager is unwilling to "take a loss" on the item by selling it for less than was paid for it. Sometimes the phenomenon even extends to being unwilling to sell for less than normal margins, not wanting to reduce average gross margins and thus "reduce profit." The major misunderstanding here is in recognizing when losses on inventory occur. They do not occur when the item is sold and the accounting entry is made. Accounting losses are merely the act of recording a loss on the books. The real loss occurred when the item became worthless to the market (in this case the customer). This is a difficult mental transition to make. No one likes losses. The psychological and practical pressures to avoid recognizing losses are very real and often difficult to avoid. The local bankers do not want to see negative numbers on the operating statement and, moreover, they require a certain "book value" for the inventories to justify the company's line of credit. The firm's accountant says something must be wrong with any decision that reduces gross margins. And besides it just doesn't feel good to sell the item off "at a loss." We are dealing here with two of the fundamental concepts in the field of finance. Moreover, these are concepts that accounting systems do not recognize and tend to misrepresent, namely sunk costs and opportunity costs. An example may help to clarify each of them. Consider a local plumbing supply wholesaler, Paul's Plumbing Products (PPP, Inc.). As a wholesaler, one of Paul's goals is to provide a ready source of plumbing supplies and fixtures to the local construction and retail trades. Each year, Paul must make a variety of purchasing decisions. Driven by both the "transactions" and "precautionary" motives, Paul will purchase plumbing supplies and maintain an inventory based on his extrapolation of previous years' figures, his interpretation of local economic conditions and construction plans, and his current supply of items on hand. In addition, many of Paul's decisions will depend on his perception of the tastes of the local market. Will architects, builders and interior designers prefer oval or round sink bowls? Will rounded or squared faucet handles be in demand? Which will be the most popular colors for toilet stools and seats? Relying on the advice of suppliers' sales representatives, his own perceptions of taste, and his sister-in- law's infallible wisdom on the subject, Paul will make his choices and build an inventory for the season. (see footnote 3 at end of article) And Paul will make several mistakes not because Paul is incompetent, but because Paul is human. Paul, in fact, seriously misjudged the market for purple toilet seats and stocked up on them heavily. He paid $7.50 per seat, listed them at $15.00 wholesale (a keystone, 100 percent markup resulting in a 50 percent gross profit margin), and sold not one. At the end of the building season, Paul knows that he made a purchasing error and must now decide what to do with his supply of purple toilet seats. Let's consider what the accounting record looks like at this point. Paul bought 100 seats and sold none of them. When he purchased them (and paid for them soon afterwards), they were placed on his balance sheet at $7.50 each for a total value of $750. They are still there. From the accounting system's point of view, they are still worth $750. No accounting loss has occurred. But a real economic loss HAS ALREADY TAKEN PLACE. That concept, that the real loss has already occurred is central to understanding both the problem and the solution. By recognizing the loss as having already occurred, the cost of the loss is placed in the past and becomes a "sunk cost." Why sunk costs are irrelevant
Sunk costs, having already occurred, should not influence our decisions about the future. This is a central concept in finance: costs already incurred do not affect decisions about the future. They become irrelevant, because no future decision can affect them. We all know about this way of thinking. In fact, our mothers taught it to us as children (They said "Don't cry over spilt milk," but the idea was the same). Somehow, however, we tend to lose track of Mom's superior business judgment when we grow up and acquire a business of our own. All right, the concept of "sunk costs" makes sense: but what are "opportunity costs" andhow do they figure in this decision? Suppose, for instance, that Paul has the opportunity to sell his entire stock of purple toilet seats to a close-out retailer for $3.00/seat. Should he do it? Theanswer is not yet clear (it will be in a moment), but here is "wrong thinking" about the problem:"I can't sell for $3.00! I would have to take a $450 loss on the seats!" WRONG! Paul hasalready taken a loss on the seats. The loss just hasn't yet been recognized in the accounting records. The question must be reframed not in terms of the loss, which has already occurred, but rather in terms of the opportunity cost associated with not selling the seats. Opportunity cost is another financial concept that accounting records are not capable of reflecting. What are Paul's opportunity costs under this circumstance? Let's suppose two possible futures: If Paul does not sell the seats now for $3 each, he believes that he can sell them off gradually over the next two years (average time to sale = one year) for $9.00. The opportunity cost of selling the seats, therefore, is $9 (average wholesale sale price expected) - $3 (close-out price) = $6 (times 100 for the number of seats) = $600. Sounds like Paul shouldn't sell, right? He comes out $600 better off if he holds on to the seats. But what if Paul has already fully used his line of credit at the bank, is out of equity capital, or is otherwise restricted from further expanding his inventory in relationship to sales?(see footnote 4 at end of article) What, then, is the opportunity cost of not selling? Paul's average inventory turnover is six times per year (see Figure 1 to calculate this number), and his average gross profit margin is 40 percent (on a standard markup of 100 percent). That means that $1 invested in new inventory will result in (1 x .4) x 6 = $2.40 in gross profit. If Paul sells his purple toilet seats for $300 and reinvests the capital in new inventory for which he has a ready market, he can expect to yield gross profit of $300 x 2.40 = $720. The opportunity cost of not selling the toilet seats is $720. But what makes this a difficult decision for many small-business owners is the combination of the psychological and accounting effects of taking what shows up on the books as a loss. When Paul sells the seats for $3, he must show an accounting loss of $450. And the offsetting gain is never explicitly recognized as relating to the sale of the assets at a loss. For all the world it is recorded that Paul made a mistake. The accounting system has no way of recording the benefit derived from the tough choice to sell cheap. Paul's Plumbing Products is not an exaggeration. It is, in fact, based on a real case. About five years ago this author was negotiating the purchase of a mid-sized wholesale plumbing ;supply firm in Nebraska. The company had sale totaling just over $5 million per year, an average gross profit margin of just over 40 percent, and an average inventory on the books of just over $1 million. The seller had in fact purchased a large number of colored fixtures years earlier, among which were a significant supply of purple toilet seats! The toilet seats were sitting on the books at original book value, and the owner's resistance to selling them below what he paid for them extended to the valuation of his entire business. He just couldn't understand why we valued his inventory so low when "the books show what it's worth!" (see footnote 5 at end of article) The challenge of inventory management in fact extends beyond the problem of strictly obsolete inventory. The same essential decision affects any distributor (wholesaler or retailer) of seasonal merchandise left with excess inventory at the end of the selling season. The inventory may still have good market value, and may even be able to be stored and sold at close to full markup nine months or a year later. But, if the business owner is faced with capital constraints, is he or she better off selling the inventory at a loss or putting the inventory aside for sale at full markup at a later date? The problem is well illustrated by the example of a retail shop that this author patronizes in central Nebraska. The retailer runs a small combination Golf and Ski shop, specializing in ski equipment and apparel for the winter season and golf equipment in the summer. The big ski selling season extends from mid-November for two and one- half months to the end of January. The big golf season is a bit more lengthy, lasting three and one-half months from mid-April to the end of July. In between is slow sales time devoted to restocking and seasonal changeovers. Seasonal changeover for the owner, however, involves more than simply changing the window displays. It also means the redeployment of capital into inventory that will turn rapidly during the upcoming strong season. Your author, being the incurable bargain hunter and haggler that he is (the result of observing his father in negotiations with the merchants at the West Side farmers' market in Cleveland, mostly conducted in Yiddish), approached the shop's owner at the end of last winter's ski season and attempted to outfit his family (all six of them) with new ski ensembles. While the negotiations themselves were occasionally spirited (a joy to all involved), the result was a classic win-win situation dear to the hearts of business owners throughout the universe. Afterward, intrigued by the shop owner's willingness to sell substantially under list price, your author ferreted out the following illustrative data:- The shop owner operates entirely with equity capital. Given the high-risk nature of his inventory and the lack of imaginative local bankers, he must rely on his own relatively small financial resources to finance his inventory and operations.
- Average markup in the shop is a 100 percent keystone, yielding a projected gross profit margin of 50 percent.
- Actual average gross profit margins during the previous year after markdowns and season-end sell-offs (the point of this part of our discussion) was approximately 40 percent.
- Total sales volume during the previous year was approximately $250,000. Average inventory during the previous year (calculated by averaging 12 month-end inventories; variation was extreme because of the seasonal nature of the business) was $25,000.
- Your author purchased ski outfits for each member of his family for $75 apiece that had originally been marked at $200 each!
Calculating Opportunity Cost
It is probably obvious how your author came out ahead. But how in the world, you ask, could the owner have come out ahead too? The answer lies in the correct calculation of the owner's opportunity cost of not selling his inventory at the end of his season. Here is how that calculation proceeds: There are three basic parts to the process: (A) Forget what you bought the junk for in the first place, (B) Determine the opportunity cost of selling the inventory now, and (C) Calculate the opportunity cost of not selling the inventory now. The following series of calculations may look intimidating, but it's just those three steps in action. Here is how the calculation proceeds:- Identify the relevant inventory (obsolete or seasonal) and determine what you believe you can sell it for now. In this case, let us assume the $75 that the author paid and determine if that sale price will be beneficial to the owner.
- Totally ignore the accounting cost of the inventory involved. This is the hard part psychologically. But there is no need to determine the inventory's book value because it is a sunk cost and therefore irrelevant. Don't even burden your mind with the information.
- Determine how long it will take you to sell the item at some higher price. In this case, the ski outfits could likely have been sold in nine months for 75 percent of full markup ($200 x .75 = $150). The owner would not have been able to sell last season's ski fashions at full price, but would have been able to sell them for substantially more than he could get for them now at the end of the season. In the case of obsolete inventory, take your best guess at how long you will have to carry the item in inventory to find a willing buyer at some higher price. (see footnote 6 at end of article) Convert this period of time into a number representing a portion of a year. Thus, nine months = .75. This figure we will call our Opportunity Cost Delay Factor.
- Calculate the opportunity cost of selling the inventory now. Subtract what you could sell it for now from what you believe you could sell it for in the future. The result ($150 - $75 = $75) is the standard against which you will judge the opportunity cost of not selling the item now.
- Calculate your inventory turnover rate. Figure 1 reviews that procedure. In this case, the business owner's inventory turnover rate is ($250,000 x .6)/$25,000 = 6. Be sure to use the gross profit margins from the operating statement, not those represented by the markup given to new inventory.
- Calculate your actual gross profit margins on sales for the past year. Once again, be sure this figure is based on operating statement numbers, not on markups put on new inventory purchased. In this case, that figure is 40 percent.
- Multiply the actual gross profit margin by the designated inventory's (the obsolete or seasonal inventory's) actual sales value right now. For this shop owner, that is $75 x .4 = $30.
- Multiply the annual inventory turnover rate by the Opportunity Cost Delay Factor calculated in #3. This converts the annual turnover rate into the expected inventory turnover during the period of time between now and when the inventory might otherwise be sold. 6 x .75 = 4. Call this figure the Delay Period Turnover Rate.
- Multiply the resulting Delay Period Turnover Rate by the gross profit for the inventory value calculated in #6. The result (4 x $30 = $120) is the total gross profit that can be expected as a result of reallocating the capital otherwise tied up in the inventory. This figure is the actual opportunity cost of NOT selling the inventory now.
- Compare the opportunity cost of NOT selling now (item #9 = $120) to the opportunity cost of SELLING now (item #4 = $75 ). The comparison, in this case, yields the obvious conclusion that the shop owner is $45 wealthier to sell the ski outfits now for $75 each.
- What if the comparison had been close? Which decision is the safer (more conservative) one? Surprise! The more conservative decision is to sell now at a loss. Your historical inventory turnover rate is a known quantity and can be expected to be maintained in the future. The opportunity to sell now is certain and the price is certain. The value of the obsolete or seasonal merchandise in the future is an unknown and risky. In addition, those with some finance training will recognize a slight time value associated with a sequence of inventory resales on the new inventory purchased versus the average time to sale of the old inventory (a refinement ignored above for the sake of simplicity). (see footnote 7 at end of article) The result is that the conservative decision in case of a close call is to sell now at an accounting loss! (see footnote 8 at end of article)
Of course, the accounting entries appear somewhat grim. The $75 sale results in a credit to Sales of $75 and a debit to Cost of Goods Sold of ($200 x .5) = 100 for a net accounting loss of $25. But the store owner gets an A+ in Practical Finance 101. All right, you say. You're convinced and are now converted from your evil ways. No more will you hang on to junk for sentimental or irrational reasons. Never again will you look at the accounting records and ignore opportunity costs for unreallocated capital. You will be the first in line to declare your purchase errors and get rid of them as quickly as possible. Seasonal capital will be reinvested in productive merchandise that will do more in the off season than sit in the back room. All that will do much to reduce your average age of inventory (and thus increase turns, reduce overall investment in inventory relative to sales, and increase return on working capital invested). But you're still not satisfied! Once converted, you are now a fanatic: an inventory turnover junkie. What else, you say, can you do to reduce average age of inventory and increase returns? Three modest suggestions follow. The whole is the sum of the parts
If the objective is to lower the average age of inventory, then inventory must be seen not as a monolithic structure but as a brick wall. Traditional financial accounting records are inadequate to track inventory turnover, because they provide just a single inventory figure and a single sales figure against which to compare it. Each brick in the wall needs to be evaluated separately to see that it is adding value to the whole. Suppose you identify an aging inventory as a problem and want to know how to solve it. Where do you begin? Of course you can walk the aisles of your store and try to pick out moldy product, but a systematic approach may be more helpful. What is more, you want to try to catch a trend before it becomes a problem. Your inventory must be categorized into product classes and tracked separately by class. If you have an automated inventory control system—a computerized inventory control system that charges off Cost of Goods Sold by individual item number and records sales volume by multiple categorizations—the task is, of course, made much more simple. If you are already computerized for your general ledger operations but have in the past rejected the Inventory Control module offered by your software company or have not yet gotten around to installing it, reconsider your decision. Investing in the clerical and data entry time to fire up that portion of the system will pay off a thousand times over. For those who have initiated inventory tracking by product classes, be sure that you go beyond the obvious tracking of sales by class to determine gross profit, cost of loss and loss prevention, and the costs of obsolescence and dumping by calculating turnover rates by product class. First, an explanation of what tracking by category means. The idea here is to develop a separate inventory turnover rate for a subset of your total inventory. Just because the inventory is getting gradually older (with turns going down, of course) does not mean that the problem is with the whole inventory. In fact, it is unlikely that such is the case. The problem is much more likely confined to a portion of the inventory. But which portion? That is what a tracking system by component is all about. Over time, you should be seeking to identify categories of inventory that work for you and your market and categories of inventory that do not. You should be constantly identifying marginal inventory categories, testing new categories of items, and, when you identify a test group that outperforms a standard group, upgrading your inventory mix. Over time, of course, you are reducing the average age of the inventory as a whole. How should your inventory be categorized for tracking? The categorization systems possible are, of course, infinite and depend on the nature of your business. At the fashion accessory wholesale company this author managed for several years, we broke our inventories down by size, color, shape, price range, composition (woods, metals, ceramics, leathers, stones, beads, shells), designer group, item type (necklaces versus post earrings versus clip earrings versus French hooks versus belts versus pins versus scarves versus hair goods), and even by vendor. And of course how many different tracking categories you identify depends on the capacity of your system to maintain the data. An individual item of inventory can belong to many different categories at once. A book valuation is maintained for each category (the total of which valuations far exceed the actual total valuation of your inventory because of counting items in multiple categories), and an inventory turnover rate is maintained for each category. Monitoring the inventory and upgrading it over time becomes a simple matter of reviewing category turnover rates. An automated system such as we had is a luxury that some very small businesses cannot afford (though it may surprise you how relatively inexpensive it is). Most of the cost involved is data entry, and most of that cost is incurred only once at the installation of the system. But even without the joys of computer automation, the small business can do much to categorize inventory and track it separately. Multiple categorization schemes (assigning inventory items to more than one category at once to track according to several parameters) is difficult without automation. But one-dimensional tracking is still possible and even easy. Suppose, for instance, that you are a retailer running a small shop (the Ski and Golf shop would be a good example). Your inventory is not tracked item by item except in your own memory. You reorder when you notice that you are getting low on an item. The COGS figure you enter into the monthly accounting records is an average figure based on your standard markups, and you adjust it to the physical inventory count that you take twice a year at the end of each season. What can you do to categorize your inventory and track it for turnover upgrading? Categorize and Track Inventory
The clear implication is that early payment discounts are a poor way to reduce the length of the Cash Cycle. There are three circumstances, however, where the small business owner should view early payment discounts with favor. But none of them have the objective of reducing the cash cycle. First, the business owner should see discount terms offered as an opportunity to reduce the effective cost of goods. Second, there may be marketing opportunities that can best be realized by offering discounted sales terms. And third, the creative combination of early-payment discounts and seasonal production and warehousing cost-reduction techniques can yield an effective sales tool. First, you must choose the most important tracking "dimension" because you will be limited to just one without automation. The most important dimension will depend on your business and for that you must employ your own judgment. It may be size, color, style, source, price range, or something else. You may want to change the dimension tracked every year or two. Once you have optimized the inventory by size, spend the next year or two tracking it by style or price range to spot weaknesses and improve. Next, you must determine some means of physically identifying items by category at the point of sale. Colored price tags are one possibility, for instance. The idea here is that the sale must be recorded as applying to the proper category in order to update the accounting records appropriately. Finally, you must have some mechanism to record and maintain the two essential figures necessary for inventory turnover calculation by category. Those two figures are, of course, inventory value and sales. Whether your general ledger is computerized or not, it is not difficult to split your inventory valuation into even as many as a dozen different accounts. When inventory is purchased, the invoices must be coded by category account number (the best time to do this is when the inventory is being checked against the packing slip and matched to the invoice). Since you are likely checking the shipment item-by-item against damage or shortage anyway, it is only a small additional step to break it down by your standard one dimensional categories. Likewise, sales figures must be tracked by category. The easiest way to do this is with a cash register with multiple keys. Modern electronic cash registers, with up to a dozen or more different keys for accumulation of daily sales by category, are readily available on the market today for under $500. If items are marked (color-tagged) by category, the sale is recorded by category, and inventory valuation is maintained by category, then it becomes a relatively simple procedure with a hand-calculator to track inventory turnover rates by category. Be sure to reserve one category for test items. Periodically, bring in a new category of merchandise to test the turnover against your standard merchandise mix. When you find a winner (and now you have a quantitative standard of what constitutes a "winner" by measuring new categories of merchandise against your old), replace your weakest group with the new merchandise and start a new test. And, of course, don't forget to sell off the old merchandise from the discontinued group. That's junk, remember? Work to cut inventory order lead times
Totally ignored by the accounting records, and in fact operating outside the standard data accumulated by many businesses, is the lead time for ordering factor. It may seem an unlikely place to find a savings in the Cash Cycle, in fact, because it seems at first glance that lead times cannot affect your inventory. After all, if it takes longer to get, you just need to order it earlier, right? What's the difference to your inventory? In fact, however, there exists a subtle mathematical relationship between lead times in your purchase order system and the average inventory held in stock. By cutting lead times, average inventory size is reduced, inventory turnover increases, and the average age of inventory is reduced (with return on investment results that we have already discussed). Why should this be so? The relationship between lead time for reordering and required inventory levels can be seen if you start with a simple example. Suppose, for instance, that you operated a retail outlet that happened to be right down the street from a company that manufactures the items you sell. You can replace anything you sell the next day just by walking down the street after a sale and buying another (the manufacturer presumably will not sell directly to the public). How much inventory do you need? Clearly just one day's worth, since by tomorrow you can always get more. But what if the factory were in the next county and it took two days to get the replacement merchandise? Clearly, you would now need two days' supply of stock on hand or you would be losing half your sales to stockouts. Of course you could always simply order a day earlier to assure a continuous stream of incoming merchandise. But how will you know today what you will sell tomorrow? The answer is that we must provide a sufficient "safety stock" for all the items we carry so that, regardless of which one sells, we will have a sufficient volume to maintain our business until more merchandise comes in. We must strike a careful balance between overstocking our inventory to avoid stockouts, and understocking it to maintain high turnover. And here is the problem: the longer the period of time until the new merchandise comes in, the greater is the uncertainty concerning what future sales will be and therefore the greater amount of inventory necessary to maintain a desired stockout policy. (see footnote 9 at end of article) Reducing lead times ultimately means reducing average inventories. A lot has been written in recent years, in fact, about the ultimate in lead time reduction: "Just-in-Time" inventory systems. Essentially, the firm above with the manufacturer just down the street has a "Just-in-Time" system in place. Just-in-Time systems (also sometimes referred to as "continuous flow manufacturing systems," "zero inventory systems," and "materials as needed" systems) are designed such that the materials needed for the next step in the production or distribution process arrive exactly before they are needed. The engine runs without lubricant. Of course, when tolerances are so fine to allow the system to work without lubrication, even a minor bit of grit in the system can cause a mighty large amount of damage! Most of the "Just-in-Time" systems created by large businesses involve streamlining setup times for manufacturing production cycles. The smaller the costs associated with setup (or ordering), the smaller the production run (order volume) that is economical. By reducing setup times, smaller production runs requiring less inventory are possible. Such systems and their specifics are beyond the scope of this article, and are frequently beyond the technical capability of many small businesses in any case. Eight Strategies to Reduce Lead Times
There are other practical strategies that can be employed by small businesses to reduce lead times for ordering materials:- It may seem obvious, but before you can reduce lead times you first have to know what they are. Many small companies (and some large ones) do not track orders and delivery times by vendor. You should do so.
- Don't simply write "RUSH" on all your purchase orders. That will accomplish nothing. Crying WOLF! on every order just leads to the supplier ignoring it on every order, with the result being that when you really do need something in a hurry that will be ignored as well.
- Order from the smallest company that can provide you with quality product at a competitive price. The larger your orders are, relative to the overall size of the company, the more important you are to them and the greater attention your orders will receive.
- Always try to find multiple sources of supply for critical and large-volume materials and components. First, of course, you want to insure yourself against an interruption in supply that could arise from technical or financial problems a single supplier might have. In addition, without at least two sources of supply, how can you measure the delivery performance of any single supplier?
- Let your suppliers know what your delivery standards are. It may seem too simple to be true, but your suppliers may think time is unimportant to you simply because you have never mentioned it.
- Call every supplier and talk to the office responsible for entering your orders into their system. Don't talk to the salesrep that services your account; he or she probably doesn't know a thing about how their order entry system works but will never admit it. If you want your orders to go directly into their system with minimum delay, then you need to find out what their system is and how you can use it to advantage. Are you using the correct item numbers according to their inventory system (if not, your orders are going to the bottom of the data entry stack until the clerk has time to recode them). Are they being sent to the correct address, correct department, correct mail stop? Are the item descriptions sufficiently clear and unambiguous that they don't need interpretation or translation on the other end?
- If you don't already have one, install a fax machine tomorrow! Sending purchase orders through the mail is ancient history. Fax it in and get it into their system TODAY! Fax machines have come down to the $200 to $300 price range within the last year.
- Other things being equal, prefer suppliers within your own state to out-of-state, nearer to further away, those in large cities to those in rural areas. UPS ships faster within state and faster from major metropolitan areas.
Calculating inventory benefits
Making decisions about implementing new inventory management techniques is made difficult by the complex nature of the costs associated with inventory maintenance. When presented with a new inventory management concept that will demand initial investment, ongoing costs or both, how does the small business owner decide whether the innovation is worth the expenditure or not? Suppose, for instance, that you are the C.E.O. of the MiniMegaMaxi Manufacturing Company (4M, Inc.), and are considering going to a continuous count, real-time inventory control system for your business. Such systems, increasingly common for large business organizations, tie the point-of-sale transaction to the inventory control system and maintain instantaneous, up-to-date inventory counts and reorder reporting. (At the end of this section we'll also mention how a small, unautomated business can use the same concept in a low-tech way). 4M has an annual sales volume of $7 million per year, an actual gross profit margin on a "clean" (no junk) inventory of 35 percent, and an average inventory value of $760,000 on 2,000 SKUs (Stock Keeping Units). Average inventory count per SKU is nine items. 4M finances its inventory with a working capital loan from a regional bank, for which it pays 1.5 percent over the prime rate and the prime rate of interest in that region of the country right now is 8.5 percent. You have listened to the salesrep, your warehouse manager has spent time at other installations with similar systems, you have studied the matter thoroughly and you are convinced that the installation of the system will reduce your average inventory by 10 percent. You know what the system will cost and you know how to compare that cost to the savings that will result. (see footnote 10 at end of article) But what are those savings? The savings that result from a permanent reduction in inventory levels result from a reduction in the cost of "carrying" the inventory (maintaining it available for use). Inventory "carrying costs" are themselves of two varieties: the costs of physically maintaining the inventory on hand (called "holding costs" ) and the cost of financing the inventory that has been purchased (called "opportunity capital costs," or just "capital costs"). In order to calculate the overall savings in carrying costs of an inventory reduction, we-must calculate the underlying holding costs and capital costs that will be avoided. Holding costs come in a wide variety of forms, depending on the type of inventory being held and its peculiar needs. Examples of holding costs include the space necessary to contain the inventory (including utilities, lease costs, maintenance), inventory insurance, special security costs, spoilage for perishable items, inventory "leakage" if internal security is a problem, special handling costs (refrigeration, humidity control), and others. Obviously, such holding costs can be unique for certain types of inventory. Almost certainly your company's inventory holding costs are different from any other company's. Business owners tend to make two kinds of mistakes when they calculate inventory holding costs saved by management changes: First, they tend to count certain costs that are not relevant to the decision under consideration. Here is an important financial concept: the only relevant costs are those that are actually affected by the decision being made. Suppose, for instance, that the inventory reduction involved will save space, but that the space you have available is not able to be reallocated to other uses and the lease costs will remain unchanged. The result will be empty space. The costs involved are real, but they are not relevant holding costs for this decision because they will be unaffected by it. The only holding costs that should be considered are those that can actually be saved as a result of the decision being considered. The second error many managers make is to assume that holding costs are the same for all types of inventory. If the inventory reduction that is going to be achieved cuts across every inventory category held by the firm, then an average relevant holding cost per item can be calculated and utilized for the decision. But if the inventory affected is only one class of items, it may well be that that subset of the whole carries greater or lesser costs than average. Particularly susceptible to variation are special storage costs such as refrigeration, spoilage costs, and "leakage" costs due to pilfering. Capital costs are simpler. Here we are talking about the costs of short-term financing for the working capital necessary to purchase inventory, expressed as a rate per day to carry the inventory in stock. Suppose, for instance, that the firm's line of credit at the bank is charged at 14 percent annual rate. Simply divide .14 by 365 to get a daily equivalent rate (.14/365 = .000384). Capital costs are the same regardless of the type of inventory involved. Let's find out what 4M can save by installing the new continuous count system: Step 1: Calculate the holding costs per unit per day of an average item
For this example, we will assume that all inventory is equally affected by the across-the-board reduction in inventory levels. To calculate these holding costs, we will simply add up all the independent relevant annual costs (Let's arbitrarily set those at $34,500) and divide the total by the number of items held and the number of days in the year: $34,500/(2000 * 9)/365 = $0.0053 per item per day. Had the group of inventory affected been a subset of the whole with unique holding cost characteristics, we would use the total annual costs for that subset alone, divided by the number of items in the subset and the number of days in the year. Step 2: Calculate the capital costs per item per day
Since 4M pays 1.5 percent over prime, its annual capital cost for working capital loans is 8.5 percent + 1.5 percent = 10.0 percent or .10. To get a daily equivalent, we will divide that number by 365 = .000027. (see footnote 11 at end of article) To calculate the capital cost per item, multiply the result by the average cost per item. For 4M, the average cost per item is the total inventory divided by the number of items ($760,000/18,000) = $42.22. That average cost per item is then multiplied by the cost of capital per day ($42.22 x .000027) = a capital cost per item per day of $0.0011399. Of course, once again, if the subset of items affected is on the average more or less expensive than the average inventory item held in stock, then the capital rate per day should be applied to the average value of the item actually affected. Step 3: Calculate the Average Age of Inventory
You already know how to do this, of course. For 4M, the calculation will be $7,000,000 x (1-.35) = $4,550,000/$760,000 = $5.98; 365/5.98 = 61 days. Step 4: Determine the number of items to be reduced in average inventory as a result of the decision being considered
4M believes that it can effect a 10 percent across-the-board reduction in inventory, resulting in a total reduction of 10 percent x 18,000 items = 1800 items. Step 5: Calculate the total carrying costs of inventory per item per day (holding costs plus capital costs)
Add the cost per day calculated in Steps 1 and 2: 0.0053 + .00114 = $0.00644 per item per day. Step 6: Determine the daily savings that will result from the project and annualize it
Multiply the daily carrying cost per item by the number of items affected and by 365: .00644 x 1800 x 365 = $4,231. The 4M company can expect to realize an annual savings of $4,231 in expenses indefinitely. Should they make the decision to proceed with the project? That, of course, depends on how expensive the project is and a number of other factors (including marginal tax rates, depreciation schedules, and the firm's overall cost of capital, distinct from the cost of short-term working capital) that are beyond the scope of this article. But the correct calculation of the savings from an inventory reduction goes a long way to guiding the business manager toward a correct decision. The same series of calculations should be used for any project that will affect inventory levels permanently, including those which will increase average inventory levels. In addition, projects whose major impact can be measured or projected in terms of reductions in the average age of the firm's inventory (perhaps as a result of a change in production techniques, for instance) can be easily translated into actual inventory carrying cost savings for the company. Oh, and one more thing: there is a relatively simple way to get some of the benefits of continuous-count inventory systems in even a very small business setting. Why, after all, do most small businesses stop everything for three days once or twice a year to take count of their stock? Such a system loses sales (for the days closed for counting), costs a lot of money (have you ever managed to complete an inventory count without having to pay someone some overtime to finish on schedule?), and provides only periodic information. Why not institute a "continuous count" by counting a portion of your inventory every day (or at least every week?). Cycle through the entire inventory on the same schedule that you used to conduct your periodic counts, but skip around the warehouse or sales floor so that there is no observable pattern to what is being counted this week. The benefits of continuous counting are several: more accurate interim inventory counts, early problem identification and loss prevention (identifying inventory "leakage" is also easier when the staff cannot anticipate what will be counted this week), and the avoidance of inventory down times. Summary
Inventories exist primarily to keep a business operation's separate components running smoothly and relatively independently of each other. Increases in inventory turnover result from lowering the average age of the inventory and yield improved return on the working capital invested. A common error that small-business managers make in managing their inventories is in confusing accounting losses with real economic losses. Real economic losses occur long before the company gets around to reporting losses on accountings statements. There are many circumstances where the business owner can realize a greater increase in wealth over time by selling for a loss now and reinvesting the freed-up capital in new inventory. This is particularly true with seasonal businesses that must wait for a significant period of time before a new season begins and that redeploys limited capital in alternative merchandise during the off season.Three inventory management tools were discussed in depth. Inventory tracking by class allows the small-business owner to continually upgrade inventory and improve return on investment as a result. Improving ordering lead times can reduce average inventory and thus shorten average inventory age. And knowing how to properly calculate the cost benefit of changes in inventory policy or the implementation of new inventory control systems can assist the manager to make rational decisions. In the next article, the last in this three part series dealing with issues in Cash Cycle management, the Accounts Payable system will be discussed. Footnotes
1 There are, in fact, two other motives for the accumulation of inventory: speculative and contractual. Speculative motives arise when the business owner purchases inventories based on a belief that prices will rise in the future, either due to an increase in demand or an interruption in supply. Such purchases are actually investments in the commodities market; business owners who make such investments may win or lose, but they are frequently operating outside their expertise and have forgotten what their real business is. Commodities speculation, in the form of inventory buildups against changes in prices, is almost never a good idea for small businesses. Contractual motives for inventory buildups arise as a result of legal, marketing or regulatory requirements for a business to carry a specified amount of inventory. Being designated as a sole distributor within a market area may carry with it, for instance, the requirement from the manufacturer to maintain a particular inventory level. Such a requirement should be measured as a cost against the benefit of the exclusive marketing provision. The cost of the requirement is calculated by comparing the average investment in inventory that would be necessary under the terms of the contract to the requirement itself. Suppose, for instance, that a firm with $1 million in sales has an inventory turnover rate (based on COGS) of five times per year and gross margins of 50 percent. Average inventories are therefore ($1,000,000 x.5)/5 = $100,000 . An exclusive marketing agreement from the manufacturer of a specialty product is available and your sales manager estimates the agreement will be worth an additional $20,000/year in sales, but it carries with it the requirement to maintain a total inventory that will average $175,000 in cost. Should you accept the marketing agreement? The answer is calculated using a concept called "marginal analysis." The only facts that are relevant to the decision are those that arise directly out of the decision itself. What are the changes in costs and benefits associated with the decision? The change in costs is the cost of the additional investment in inventory required: $75,000. If the firm's short-term cost of funds is, say, 14 percent, that additional investment in inventory will cost an additional (.14 x 75,000) = $10,500. We will assume here too that you have plenty of warehouse space and that the administrative costs associated with carrying the additional items is negligible. In practice, you may want to add an estimate of the additional "carrying costs" for the extra inventory. Remember, however, that increases in interest expense are offset by the tax deductibility of the interest payments. After all, if you don't pay an additional $10,500 in interest, that $10,500 will be taxed and you will only have (at a 40 percent tax rate) .60 x $10,500 = $6,300 left anyway. The real additional cost of maintaining $75,000 in additional inventory for a year is therefore $6,300. What about the benefit of the additional sales? You will realize a $20,000 increase in sales which at a 50 percent gross profit margin means $10,000 in extra gross profits. If you pay a 5 percent sales commission to your sales force, then $9,500 will be added to operating profits. But, you must pay out 40 percent of that increase in operating earnings in additional taxes, which leaves just .6 x $9,500 = $5,700 in increased after-tax profits. Compare the $5,700 marginal benefit with the $6,300 in marginal costs and the result is a loss. 2 The source for all these statistics is the Quarterly Financial Report for Manufacturing, Mining, and Trade Corporations, published by the U.S. Department of Commerce. Unfortunately, changes in the reporting categories in 1975 and again in 1985 make comparisons of large and small corporations difficult, but it is clear from the numbers that virtually all the gains in average investments in inventories for U.S. corporations have come from corporations with total assets over $25 million. 3 Paul will get very little help in this process from the complex and frequently arcane mathematical wisdom enshrined in most finance textbooks. EOQ formulas are of little help for seasonal businesses (such as the construction trade), and of virtually no help at all when dealing with "fashion sensitive" items, which comprise a good portion of Paul's inventory. What is more, most finance and accounting texts concentrate on the question of how much to buy and when, not how much to sell for and when. The inventory management problem, however, is just as much the question of when and how much to sell as when and how much to buy. Business owners know full well what academicians frequently ignore: not all inventory sells. 4 Paul may have a restriction on his line based on a percentage of total inventory plus a percentage of total eligible receivables, a not-uncommon requirement for a banker to place on a working capital line. Nor is it uncommon for small business to be operating at the maximum extension of the line. Under those circumstances, the relevant opportunity cost of not freeing up capital that can be reinvested in new inventory is not the cost of the capital itself (based on the rate of interest charged by the bank), but rather the return that can be expected from the reinvested capital. Are matters any different if Paul has no line of credit, but rather is a 100 percent equity-financed firm? Not at all. Once again, assuming that Paul has some capital constraints (Paul is not General Motors, with virtually infinite access to the equity markets), he must make decisions about how to invest his limited capital. The opportunity cost of not freeing up capital is its most productive alternative use. 5 Note, too, the effect of the bad inventory on inventory turnover rates. The inventory turnover rate for this firm is ($5,000,000 x .6)/ $1,000,000 = 3 (in an industry with an average inventory turnover of 6.4 according to Robert Morris Associates, 1990), and the average age of the inventory is 360/3 = 120 days. But do these figures really represent the value of the firm in the future or the ability of the firm to provide a reasonable return on investment in assets? Of course not. The real numbers are being obscured by the effect of the portion of the inventory that is, in fact, junk. The result is not uncommon: what may be an otherwise well-functioning operation appears in the accounting records as a sickly firm because of the effect of accounting statements that do not reflect real values. 6 This may seem like a very big assumption, but we are dealing here, after all, with the future. Anything we do is based on our assumptions about what the future holds. What is important is that, given our assumptions about the future, we operate in a wealth-maximizing manner. Our assumptions may prove to be either accurate or inaccurate, but we can only know what we know; no more. 7 Use this analysis if the average time to sale for the old inventory is one year or less. Beyond that, the time value of the opportunity cost of not selling becomes ever more significant and the risk associated with holding onto the old merchandise climbs substantially. Inventory is like a hot potato taken out of the oven. It loses heat rapidly and sits cold and uneaten before long. If you cannot reasonably anticipate selling off the old inventory in an average of one year's time, then the opportunity cost financial advantage shown for not selling must be substantial to offset the increased price risk and lost time value of the interim cash flows associated with inventory turnover. 8 Some readers may be wondering why taxes were left out of this calculation. The question of whether to include an adjustment for the effect of corporate taxes is a difficult one for financial analysis in a small-business environment. Taxes only matter if you pay them, and many small businesses pay no corporate taxes at all. Earnings simply accrue to the owner through an increase in "management" salaries. In that case, it is the owner's personal tax rate that will apply to adjust the numbers, not the corporate tax rate. In this article, the effect of taxes were included in the earlier PPP, Inc. example because the company used in the example was large enough that corporate taxes were likely paid. In the Golf and Ski shop example, corporate taxes were left out of the calculations because most owners of a small shop of that size would probably pay none. Personal tax circumstances can vary so much (depending on family size, home loans, gross income and a variety of other factors) that little meaningful advice can be given here. What if, however, the Golf and Ski shop did pay corporate taxes. How, you ask, would that affect the "sell now—sell later" inventory decision? Two adjustments would need to be made: First, any accounting loss that goes on the books as a result of selling now (or later; this same calculation would be used to adjust the effect of selling at a loss later if the future sales price expected is still below accounting cost) would be lessened by the tax shield it creates. If you sell the ski outfit now for $75, that is $25 under book value and shelters $25 of other sales from taxes. If the firm is paying out, say, 40 percent of net earnings in state and federal taxes then the cash benefit of an accounting loss of $25 is found by multiplying the $25 by the marginal tax rate. $25 x . 4 = $10. Ten dollars would be added to the opportunity cost of not selling now (you get the $10 advantage only if you do sell now). Second, the gross profit placed on the books as a result of selling (now or later) above accounting cost will generate taxes at the corporate rate. In this case, both the future gross profits generated by the future inventory turnover from reinvested capital, and the future gross profit generated by holding the ski equipment and not selling now, would have to be adjusted. Both are done simply: To adjust the opportunity cost of not selling (the benefit derived from the inventory turnover on capital reinvested in new merchandise), multiply the gross profit margin used in Step 7 by 1 minus the marginal tax rate (1 - t). In this case, the gross profit margin is 40 percent and (1 - t) is 60 percent. 60 percent of 40 percent is 24 percent. Now use 24 percent as the effective after tax gross profit margin and proceed according to the steps given. In Step 7, the $75 is now multiplied by 24 percent to yield a GPM on each "turn" of $18. In Step 9 that $18 is multiplied by the Delay Period Turnover Rate to yield an opportunity cost of not selling of 4 x 18 = $72. Added to the $10 tax shield above, the total opportunity cost of not selling is $82. To adjust the opportunity cost of selling (the figure derived in Step 4 in the example) if that future sales price is above book cost, multiply the accounting gross profit anticipated from the sale (sales price - accounting cost) by the marginal tax rate. In this case, the future anticipated sales price ($150) minus the book cost ($100) yields a gross margin of $50 times 40 percent = $30. That is the amount of additional taxes that will be paid as a result of the sale and must be subtracted from the cash opportunity cost of selling (it lowers the benefit of not selling now). The result is a final opportunity cost of selling of $75 (calculated in Step 4) - $30 = $45. The result, you will note, is the same: the opportunity cost of not selling is still higher than the opportunity cost of selling, so we still want to sell now rather than later. The difference is in the relative values associated with the two alternative courses of action. 9 A firm needs to plan its desired stockout policy. Having no stockouts at all is rarely optimal inventory planning. One hundred percent "fill" rates are almost always a sign of "loose" inventory management. But stockouts are expensive (in lost sales, especially in "fill-and-kill"—no backorder—operations; in customer relations; and in administrative costs if backorders are tracked and shipped). 10 The actual comparison of the costs and benefits is itself a rather complex process that is beyond the subject of this article. The technique used is a "Capital Budgeting" process that compares the initial cost to the expected benefits over time based on the firm's weighted average cost of capital (a combination of both debt and equity). Here we are going to ask the interim question: What are the benefits of a reduction in inventory? and then use a somewhat simplistic technique to compare those benefits to the costs. 11 Readers of the first article in this series will remember that rates were annualized by dividing by the more convenient 360 days, which is the convention used by financial institutions calculating daily rates and when accuracy to several decimal places is unnecessary. Here, where a hundredth of a cent per day per item can mean thousands of dollars of costs over a year's period, greater accuracy is called for.
Figure 1How to Calculate Average Age of Inventory (AAI) The amount of time that your cash is in someone else's hands is directly affected by the amount of time that your product sits in the warehouse. The Inventory Holding Period starts with the receipt of goods and materials from suppliers, extends through the time it takes to convert raw materials into finished goods, and includes the time that inventory is unsold on the shelf. It ends when the customer rakes delivery. Following is an explanation of how to calculate the Average Age of the company's Inventory (AAI). Step 1: Determine Your Average Inventory Value
Add up the month-end inventory figures on each of last year's months'-end Balance Sheers and divide by 12. Use a monthly average to avoid seasonal variations that would distort the numbers. Example: | January | $950,000 | | February | 975,000 | | March | 1,110,000 | | April | 1,050,000 | | May | 1,100,000 | | June | 1,300,000 | | July | 1,325,000 | | August | 1,400,000 | | September | 1,375,000 | | October | 975,000 | | November | 800,000 | | December | 850,000 | | Total | 13,210,000/12 = $1,100,833 |
Step II: Determine last year's total Cost of Goods Sold (COGS)
Take this figure from the year-end operating statement for the previous year. Be sure that the period matches that from which the monthly inventory average was calculated, and be sure that your definition of Cost of Goods Sold includes all raw materials and direct labor to produce your product, but does not include overhead, managerial labor, or advertising and marketing expenses. COGS as a proportion of sales price may vary for different products or categories of products, but you want the total cost of all goods produced or purchased by your company. Example: Operating Statement | Sales | $11,000,000 | | Cost of Goods | 5,575,000 | | Gross Profits | $5,425,000 |
Cost of Goods Sold is $5,575,000. Step III: Find the Inventory Turnover Rate
Divide the year's Cost of Goods Sold (COGS) by the Average Inventory from #1 above to yield the Inventory Turnover Rate. This number represents the number of times that you sold the complete value of your inventory during the year. Example: If your average inventory is $1,100,833 and total COGS is $5,575,000, then Inventory Turnover = 5,575,000/1,100,833 = 5.06. Step IV: Calculate the Average Age of your Inventory (AAI)
Divide the Inventory Tumover Rate from #3 into the number of days in the year (360). Example: If the inventory turnover rate is 5.06, then the average age of the inventory (the average number of days that an item is held in inventory) is 360/5.06 = 71. Continue to Part 3, Payables Management click here for next > See also: Capital, Credit & Dept Management |
