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Managing Inventory Turnover Ratio to Improve Manufacturing Efficiency

Posted by Jason Cope, CPA on Jan 11, 2021 8:45:00 AM

Even in “normal” times, achieving and maintaining a good inventory turnover ratio (ITR) is a balancing act. Manufacturers don’t want to have to restock too often, but they also don’t want inventory piling up, or worse yet, becoming obsolete. The COVID-19 pandemic has raised many concerns about the supply chain and the need to adjust inventory levels. Depending on their business, some manufacturers have increased their safety stock to guard against further supply chain disruptions, moving toward a just in case (JIC) inventory system—at least for the time being. However, just in time (JIT) inventory systems will continue to be the management strategy of choice for most manufacturers, especially by the second half of 2021. Every manufacturer wants to become more effective in managing inventory to maintain a healthy cash flow and meet customer demand, especially during challenging economic times.

Overview

Simply put, ITR is the number of times you sell your products over a period of time, such as a quarter or the entire year. Understanding ITR provides a good indication of the ratio between the sales you make and the inventory on hand. Specifically, ITR is an essential metric for:

  • Understanding how your company compares to industry averages to gain a clearer perspective of how your company is performing
  • Gaining perspective on how well coordinated your sales and purchases are
  • Revealing the liquidity of your company’s inventory

Calculating Inventory Turnover Ratio

If your cost of goods sold (COGS) in 2020 is $500,000 and your inventory is worth $50,000, your ITR is 10.  Or, if your company has a monthly average inventory of $5,000 and a COGS of $7,000, you will end up with an inventory turnover ratio of 1.4. In other words, you will have turned over your inventory just under one and a half times in that time. So what is the right ITR for you? Like many things, it depends. An inventory ratio between 2 and 4 might work well for retail, but for other manufacturers, a higher inventory ratio can range from 5 to 10. Generally, inventory turnover for most manufacturers will be four times a year.

There is no one right answer to what your ITR should be; what’s more important is that you are doing a good job of balancing sales, inventory, and costs. A higher ratio generally indicates more efficient inventory management because it requires you to keep less inventory in stock. Less inventory means paying lower storage fees, which could free up cash or potentially reduce your borrowing needs. Let’s say you manufacture products used for technology. A higher inventory ratio decreases your risk of obsolescence. By better understanding your inventory turnover, you will be able to maintain tighter control on your supply chain and determine the best ITR for your particular business.

ITR Benchmarking

An excellent way to achieve greater manufacturing efficiency is to tap into industry data to benchmark your ITR—by doing so, you will understand what is typical for your business. You can begin to reevaluate your ITR by calculating your inventory turnover ratio each month to identify a trend analysis. Once you have the analysis in hand, you can use it for budgeting and forecasting needs. As a result, you may decide to take one or more of the following steps:

  • Order smaller quantities from suppliers more frequently
  • Order what you only expect to sell
  • Reduce lead time from vendors and suppliers
  • Look for more affordable distributors
  • Eliminate some inventory and prioritize top-selling products

Automate Your Way to Manufacturing Efficiency

As you likely know, managing inventory through manual processes and endless paperwork is tedious. This approach doesn’t easily scale across multiple warehouses with lots of stock. One way of gaining greater manufacturing efficiencies is to use automated systems to track inventory and sales demands. You can use inventory management software to automate reorders based on preset stock levels and current availability. By using software to track inventory against profits, you will be able to calculate the best ITR for your business. For more information, read our related blog: 7 Ways to Optimize Your Inventory Management.

A good manufacturing accountant can work with you to examine your data and income statements to determine what is best for your profitability.

Do you have questions about manufacturing inventory turnover ratios or other manufacturing and distribution topics? Our manufacturing accountants can help. Please contact Jason Cope at 214-635-2508.

Note: This content is accurate as of the date published above and is subject to change. Please seek professional advice before acting on any matter contained in this article.

Topics: Manufacturing, inventory, ITR