Your inventory is one of your small business's most important assets - if it's managed properly. A well-run inventory system helps with planning, cash flow and sticking with your budget. The management process itself is an enormously powerful tool to measure the overall success of the business.
Inventory management doesn't just benefit your business and your customers, however. It is also critical for ensuring that your manufacturers and their raw materials inventories are well managed. When one of your manufacturers runs out of raw materials, it's costly to them and adversely affects their ability to supply you the products your customers demand.
Getting the number of inventory "turns " (times you sell through your inventory) optimized ensures you will earn the best possible return. Too few turns means products age in inventory, so they're less likely to be sold at retail price. Plus, they take up space. Don't think of it as product on your shelves. Think of it as money laying there dormant, that could be in your pocket.
Calculating Inventory Turns
It is important to Calculate yearly inventory turns. First, determining the Cost of Goods Sold (COGS) over the past year. Divide your COGS by your current inventory on hand. That's the number of inventory turns you had over the past year. Here's a simple example: say your COGS over the past year is $300,000. Your current inventory is valued at $60,000. Calculate inventory turns as:
$300,000 ÷ $60,000 = 5 inventory turns over the past year.
If you want to calculate the average number of days required for inventory to turn, divide 365 by your 5 inventory turns to get 73 days. This is the average time it takes to turn your inventory.
How Many Inventory Turns Should You Have?
Though it varies by industry, generally acceptable turn rate is between five and 10 inventory turns per year. A figure in this range indicates you're keeping your inventory at a reasonable level. It typically means that you are buying the right amount of inventory at the right time to cover your normal demand. Using our example, although at any given time your inventory may be higher of lower, you will always have, in stock or in the pipeline, a supply adequate to cover the next 73 days.
High and Low Inventory Levels Are Bad
When your inventory turns are low you have to begin to think about what you are going to have to do to liquidate slow-moving items. We all know that liquidating means turning something material into cash. Actually, liquidation is the primary object of having inventory - turning it back into cash. Profit happens when you generate more cash than you spent to acquire your inventory. It's unfortunate that we typically use the term "liquidate" only when a business is trying to sell overstock or going out of business.
An excessively high number of inventory turns indicates that your business is likely running out of products too quickly and unable to supply demand. This can happen as a result of limited production capacity at your business or at a supplier's. It could mean that something in the market has created unusually high demand - a situation that is out of your control. Like a media mention of your key product a holiday time. Or, it could mean that you are not purchasing in adequate quantities, often a sign of a business being cash-poor.
How to Maintain the Right Level of Inventory
The "correct" amount of time it should take you to turn over your inventory depends on what industry you're in. Groceries (low cost and often perishable), for example, need a higher turnover rate than luxury automobiles (high cost and expected to last a long time).
Inventory turns aren't glamorous, but they are metrics that provide vital clues about the health of your business. It is unfortunate that too many small businesses tend to not to monitor inventory turns. It's unfortunate because inventory turns in something that is totally under your control. And that's also the GOOD NEWS!
Think of it this way: You have cash in the bank and you have cash on your shelves in the form of product. If you are short on cash in the bank, but have lots of it tied up in product on your shelves, you need to convert what is on the shelves into cash. Why? Because the bank won't let you deposit your inventory into your bank account.
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