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All companies keep track of the value of inventory that they have in stock because it is an important part of the company’s financial status -- usually one of the larger assets on the balance sheet. Total inventory value is not a useful measurement for operations, however. It needs context, and that’s what is provided by inventory turns.
Inventory turns is the value of inventory in relation to the sales or usage volume of the company. For finished goods, divide the annual cost of goods sold (COGS) by the amount of inventory. If, for example, annual sales are $12 million and COGS is $10 million, and the finished goods inventory is valued at $5 million, inventory turns is 2. The company can be said to "turn over" the inventory twice per year. A similar measure, integrally related to inventory turns, is days of supply. A company with 2 inventory turns can be said to have a 6-month supply on hand.
Generally, higher inventory turns are better, meaning that less inventory (and therefore a lower investment) is needed to support a given level of sales. The nice thing about turns is that it puts inventory level in context. Let's say our example company increased sales by 50% from $12 million to $18 million (and COGS from $10 million to $15 million), and inventory increased from $5 million to $8 million, inventory turns would be reduced from 2 to 1.875. So although sales are up significantly, company performance costs and margin are likely not keeping up because the company is holding proportionally more inventory. For the same amount of sales, if inventory is reduced to, say, $4 million, inventory turns increase from 2 to 2.5 (and supply decreases from 6 months to 4.8). This indicates lower costs and an overall improvement in performance and margin.
It makes sense to measure inventory turns for finished goods separate from raw materials and components because these inventories support different objectives. One supports sales and one supports production, and each is managed by different business functions using different tools and philosophies. In contrast to sales, raw material turns is calculated from annual usage divided by inventory level. Again, higher turns are generally better, as long as the reduction in inventory does not cause an increase in shortages, expediting or lost business.
There is no universal target for inventory turns. Each industry and market may have specific requirements that determine the best level of inventory to support customer service objectives. Most companies watch industry averages or competitor performance measurements and strive to do better than their peers to gain a competitive edge.
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