Most retailers likely have many KPI’s like conversion, average value per transaction, traffic, GMROI, and units per transaction, to name a few, but all retailers answer to the big four financial metrics: Sales, Gross Margin, Gross Margin Percent, and Inventory Turnover, or T/O. In this post, I’ll explore the inventory turnover metric, a terrific indicator of how efficiently working capital is being utilized.
Inventory turnover has many dimensions depending on the audience but the basic calculation is fairly straight-forward:
It’s hard to believe there are so many worthy topics on such a simple equation but I will delve into all of them here.
- The proper way to calculate average inventory
- Gaming the time dimension
- Different valuations and what they mean
- How to double your turnover (or more)
The correct way to calculate average inventory is to take the beginning onhand plus all the subsequent ending onhands and divide by the number of time periods plus 1. Alternatively, you could take the BOP values and the last EOP value. Unfortunately I see far too often the calculation for average inventory missing the plus 1, even in textbooks.
BOP = Beginning of Period Onhand
EOP = Ending of Period Onhand
The time period can be expressed in years, seasons, quarters, months, weeks, even days. Best practices for retail is to use months or weeks, but honestly, weeks are better to prevent the gaming. Plus months can be 4 or 5 weeks long so it’s not really a fair comparison.
Merchants love companies that compute financial turnover monthly because it gives them the entire month to sell product without penalty. All a merchant has to do is bring their receipts for the month on day 2, since day 1 is when the BOP is calculated. Apparel companies are even more susceptible if they measure their selling periods in seasons which are typically even longer than one month: Spring, Summer, Fall, Holiday, etc..
Most Open-To-Buy calculations are monthly which makes it easy and convenient to discuss turnover in monthly terms as well. The problem is that, from a financial perspective, measuring turnover this way is not telling the proper story about how efficiently the company’s working capital is being used.
Say a merchant has 10,000 USD of commodity/basic product she wants to bring in the month of March, a 5 week month. Her beginning inventory on day 1 is 10,000 USD. She will sell 2,000 USD each week.
Let’s take a look at what happens when she brings the entire 10,000 USD on the 2nd day of the month. We’ll calculate a monthly turnover and a weekly turnover.
This is a fairly simple example but you can clearly see the advantage merchants obtain when turnover is calculated monthly. In fact, a weekly turnover will disincentivize merchants to needlessly bring in their inventory early.
Turnover can be calculated on different inventory valuations and each has a different meaning. From a financial standpoint, cost is probably the most important since it measures the uses of working capital.
- Units. Unit turnover is effective at measuring bulk and selling space effectiveness, particularly if gross margin gets tossed into the mix. Gross margin per average unit sold, or number of average units sold per square meter/foot.
- Cost. Most popular use of turnover calculations as it measures the working capital employed. It’s important though that Cost of goods sold, or COGS, is used with average inventory at cost. Using retail sales is certainly a valid KPI expressing how many dollars you sold per average cost but that’s not really a turnover calculation.
- Wholesale. For those that need to see how their wholesale accounts are faring, this valuation can be used. For those retailers fortunate enough to get their respective sales from their accounts, they can use the sales at wholesale. Otherwise, they’ll have to rely on the shipments into the account’s network.
- Retail. There are still a few retail holdouts using retail inventory method, or RIM. For those retailers measuring turnover at retail can produce some interesting effects because markdowns and discounts become a variable merchants can leverage to improve their turnover.
- Original Price. Original price, sometimes referred to as manufacturer’s suggested retail price, or MSRP, can be used but in today’s retail environment where discounts are commonplace, this measurement can be misleading.
In another article, I will show you how you can, rather easily, double your turnover.