Employees often complain about their company’s tight inventory. Managers complain about tight inventory budgets. Buyers complain about not getting approval to buy sufficient quantity of a given item to get a 10% discount.
So what’s the benefit of a tight inventory? Sure, there are some obvious things like where to put excess inventory. Also, excess inventory carries increased risk of breakage and obsolescence. But if you have enough space to put the stuff, will sell it before it becomes obsolete and will be careful not to damage any of it, what’s the problem?
Turnover is profit.
Two businesses, Biz A and Biz B, both make $12,000 in sales for the year. Biz A had an inventory cost (cost of goods sold in accounting terms) of $5,000. Biz B had a cost of goods sold of $6,000. Which business is more profitable?
So, surely Biz A is more profitable. Biz A made $7,000 and Biz B made $6,000. It’s a clear case, right? Not so clear.
Let’s say that Biz A spent $5,000 to buy a year’s inventory at a savings of $1,000.
Biz B spent $500 for single month’s inventory. ($500 X 12 = $6,000 for the year)
At the end of the first month, both Biz A and Biz B have $1,000 in sales.
Biz A invested $500 and had sales of $1,000 with a gross profit of $500.
Biz B invested $5,000, made sales of $1,000 and has a gross profit of? Well, Biz B doesn’t have a gross profit yet. Biz B is still $4,000 in the hole.
In month 2, Biz A buys another $500 of inventory, makes $1,000 of sales and shows another $500 of gross profit.
Biz B makes sales of $1,000 and is now only $3,000 in the hole.
At the end of the year, Biz A has made $6,000 in gross profit. But Biz A only invested $500! Biz A, because of tight inventory control made $6,000 on an investment of $500—the same $500 is used each month to buy inventory. The real return for Biz A is 1200%!
Biz B spent $5,000 to make $7,000 or a gross return of 140%.
Can you see the benefit of making the same or even less markup on an inventory that turns more often?
Look at it this way, which would you prefer? Invest $500 and get back $6,000? Or, invest $5,000 to get back $7,000?
The more turns, the better the return.
To calculate your inventory turn rate, divide your month’s sales by your inventory at the end of the month. (Sales $10,000/$15,000 inventory = .66)
(Sales $10,000/$90,000 inventory = .11) The HIGHER the number, the better. The number represents the number of times you turn your total inventory per month.
Inventory turnover is the most important, least understood concept in business. This is the reason for “just in time” inventory. Just in time means more turnover. But it’s not about cutting the time of delivery as closely as possible—this is where the MBAs go wrong. It’s about turns. Timing does not matter if you achieve the turnover!
Cut things too close, as is common practice these days, and you fling open the door to trouble. Murphy’s Law kicks in and things go wrong. Don’t think time, think turns.
Even the smallest business needs to understand this.
Need a new laptop? Can it produce for you immediately? How fast is the pay-back? Can the pay-back be accelerated? If not, can you forgo the purchase until you absolutely need the laptop? Can you wait until you’ve got a project that will pay for the new laptop? Then wait.