When it comes to inventory accounting, the process of measuring the impact of inventory on a company’s balance sheet, there are a wealth of metrics to follow. Inventory Aging, Inventory Turn, Gross Margin by Item, Inventory Carrying Cost and others can all provide powerful insights into managing inventory, accounting for it and optimizing your supply chain and sales plans.
However, all those metrics can leave executives and warehouse managers drowning in data. Determining which metrics are the most important and have the biggest impact on the bottom line is critical to a successful operation. While different businesses can weigh different metrics for a wide range of reasons, what follows are three critical inventory accounting metrics:
Inventory Turn or Turnover. Inventory turnover is a measure of how often goods are sold and replaced over a specific time period, usually measured by the year. High turnover means goods are moving off the shelves quickly and sales are up. Low inventory turnover can suggest that the business has too much inventory and should consider reducing orders to save on carrying cost or evaluating different products. A common metric used to measure inventory turnover is the average days to sell, which presents the business with the length of time it takes to sell a specific product on average and how many day’s worth of sales are in inventory. A low average day to sell is often a positive but can present the problem of stock outs, impacting the customer experience. Alternatively, higher average days to sell suggest overstock and wasted warehouse or shelf space.
Inventory Carrying Cost. Carrying cost refers to all the costs associated with holding inventory and is also referred to as cost of holding inventory or holding cost. This includes a wide range of costs including rent, maintenance and utilities at the warehouse, costs associated with perishable items that can include shrinkage, leakage or items exceeding their “best if used by” date and obsolescence. There are also financial implications, including opportunity cost, the cost of insuring inventory and costs associated with software to track the inventory. The carrying cost metric is typically calculated using the total costs for the year and expressed as a percentage of the cost of the inventory item itself. For example, if a company’s inventory is worth $100,000 and the cost of holding that inventory is $20,000, its inventory carrying cost is 20%. Target inventory carrying costs can vary greatly based on the business, the type of inventory and customer demand.
Some organizations measure carrying costs as a percentage of revenue. In a 2010 study, The Supply Chain Consortium benchmarked the inventory carrying costs as a percentage of revenue for manufacturers as 2.25%. For retailers, the average was around 1.8% and the top quartile of companies in the study carried an average of .5%.
Inventory Aging. Also termed Average Age of Inventory, this metric is basic but important. It represents the number of days it takes to sell a product and is generally calculated as the cost of inventory divided by the cost of the goods sold and multiplied by 365 to represent the year. The older your inventory is, the more it’s costing you and the more it can say about whether your products are properly priced. Again, the Average Age of Inventory can vary widely by business or product. For example, Halloween decorations can still be sold the next year, but it’s still costing the business to warehouse it. Consumer electronics, where new versions come out regularly, aging inventory can become a big cost. In retail, a general benchmark is if the age of inventory exceeds 120 days, it’s time to consider reducing the price (markdown), bundling it with other products or selling it off to low cost distributors.
Identifying the right inventory accounting metrics is critically important to optimizing inventory management, but it requires more than just the metrics. Clean, accurate data is a vital component of any inventory management strategy. Businesses that keep their inventory data spread across disparate software systems and spreadsheets find it increasingly difficult to provide metrics with real-time accuracy and when they do, it requires extensive manual data entry and data consolidation to feed the systems that can provide the reports and dashboards personnel need to take action.
A centralized ERP system that accounts not only for inventory, but financial data, order data, customer data and the extended supply chain can make the difference in a successful inventory accounting program and one that fails.