Dollars or Units?
The most fundamental measure of inventory is Units of Measure
(U/M). This may be pieces, gallons, pounds, lineal feet or other
unit and varies from SKU to SKU. U/M is most useful for the
operational perspective or when examining a particular SKU.
In general, SKUs cannot be aggregated using units of measure
unless they are all very similar. For the most part, SKUs are
not interchangeable as production components or as items sold to
a customer. When analyzing stockouts or history, the individual
SKU is important and we often use U/M.
From a financial perspective, the funds invested in inventory
are the primary interest. Item-by-item information is less
important and there is a need to aggregate all items or various
classes of items such as Finished Goods (FG), Work-In-Process
(WIP) and Purchased Parts or Raw Materials (PP/RM). To do so,
the value of each item is multiplied by the number of items. The
sum of various items measures the total inventory in a
particular class. Table 2 illustrates.
Turnover
The
total dollar amount for an item or class of items can be
deceptive. Fast moving items may require a larger number on-hand
to satisfy customer demand than slow-moving items. Turnover
incorporates sales or demand to adjust for this fact.
This is the most common form of the equation. There are many
variations. For our purposes, the variations make little
difference as long as there is consistency.
One modification is to use average rather than year-end
inventory. This is appropriate where seasonality exists and
year-end inventory does not give a true picture. However,
year-end inventory is easy to obtain from the balance sheets and
average inventory may not be available. Another modification is
to use different time periods, say, monthly or weekly. This is
useful to identify short-term cycles or medium-term trends.
For distribution and warehouse operations, sales is usually
expressed as Cost-of-Goods-sold (COGS) and inventory value as
Cost-of-Goods (COG). This is the preferred method. However,
there are different inventory valuation methods and the
available data may dictate some other valuation.
For manufacturing, the calculation of COG varies between
companies. Moreover, the presence of significant Work-In-Process
further complicates the situation. For manufacturing, we often
substitute sales income as the sales figure rather than COG.
This introduces another variable (Gross Margin) but assures
consistency. The sales data is usually more available than COG.
Level of Accuracy
Overall inventory measurements and analyses discussed here
rarely require high accuracy for operational purposes. The
problems that inventory points to tend to be major (although
hidden) problems and small differences in valuation, turnover,
TEI or inventory value do not affect major conclusions.
This is not the same as Inventory Record Accuracy, the
measure of how many individual records match the physical
inventory in count and location. Inventory Record Accuracy (IRA)
is very important to operations and does require high accuracy.
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Figure 2 Turn-Earn Index Example
Turn-Earn Index (TEI)
When all SKUs have the same gross margin, turnover is the
only measure of inventory efficiency necessary. However, margins
may differ between items. When this is the case, the Turn-Earn
Index (TEI) helps account for this added variable.
TEI = Turnover X Gross margin (%)
Equation 2 Turn-Earn Index
Slow-moving items have a bad reputation.
In reality, they can be a profitable and an important part of
the product mix under the following conditions:
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Slow movers are necessary to fill out a product
line.
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They do not crowd out fast
movers.
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Margins are high enough to
justify their storage costs.
The TEI helps to identify those slow-movers that do not meet
these conditions. Items with low turns and low margins show a
low TEI. Items with slow movement but high margins show a
respectable TEI. Items with high turnover and low margins also
show a respectable TEI. Generally, the TEI should be above 120.
Figure 2 shows both turnover and TEI for the inventory
example of Table 2. Examining turnover for the second SKU
(A-67324), a turnover of 9.2 would generally be considered as
adequate although it does not compare favorably with SKU #5 with
a turnover of 25.7. However, SKU #2 has a high margin that gives
it a TEI of 460 that is extremely good.
In contrast, SKU #5 (X-45556) shows a very good turnover of
25. However, the margin is low on this SKU and the TEI is about
half of SKU #2’s TEI. Still, a TEI of 260 is quite good. The
remaining three SKUs have both a low TEI and low turnover. Here,
both the margins and the stock level should get scrutiny.
Questions to ask are:
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Can stock levels be lowered?
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Is the margin adequate to cover the cost of storage?
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Other good reasons (e.g. filling out product line) to
maintain these items?
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