A major factor in determining the success of a manufacturer is how well it manages its inventory. When manufacturers have too little inventory, they can’t fully meet customer demands and lose out on revenue as a result. When manufacturers have too much inventory, they trap cash and decrease their liquidity. But when manufacturers maintain the right levels of inventory, operations run smoothly, customers are satisfied, and organic growth usually follows.
The importance of effective inventory management in manufacturing is difficult to overstate. That’s because inventory is a key driver of several profit & loss (P&L) statement components, from revenue all the way down to net profit. Below, we explore a range of key inventory management measures, areas for evaluation, and best practices for getting it right.
Manufacturers should always have an accurate view and understanding of their inventory’s state, including how quickly their inventory is turning over and how they compare to others in their industry. If that view and understanding aren’t present, it’s time to ask questions. How much inventory is being carried on the balance sheet? How much is being charged to cost of sales? What is the percentage of the cost of sales to revenue? Is there a risk of inventory obsolescence with slow moving items? With that in mind, let’s look at inventory turnover.
Inventory Turnover is an efficiency ratio that indicates how quickly a manufacturer is moving their inventory to generate revenue. As the inventory ratio moves higher, it signifies that inventory is generating revenue faster. Conversely, a declining inventory ratio shows that inventory isn’t generating revenue as quickly.
Inventory Turnover Ratio = Cost of Goods Sold for a period ÷ Average of Inventory for the period
Have an expert and objective finance resource validate how your business calculates this ratio and pull together the ingredients that comprise it. If COGS, inventory value, direct material, and related items are incorrectly calculated, then all of the measures that incorporate them are as well.
To compare the state of one’s inventory to others, valuable information can be gathered via the internet, conversations with peers, and general networking. Large companies will have historical information to look back on. Publicly traded companies will have 10Q and 10K filings from which that information can be extracted. A benchmark exercise can also provide insight here.
When inventory is not valued properly, turnover ratios return false information, affect cash, and cloud understanding of how investment in inventory is affecting the business. If the inventory is undervalued, the ratio will appear higher than it actually is. This wrongly signals good inventory utilization and may lead to unwise purchases of more inventory that strains cash and production and introduces risks associated with storage, insurance, and obsolete materials.
Conversely, overstating inventory valuation will lead an organization to think it has too much inventory on hand. When this happens, lowering buying volumes can adversely affect production via increases in variable costs, decreases in production efficiency, and diminished ability to meet demand. A key measure in this area is the Finished Goods Inventory Cost.
The Finished Goods Inventory Cost is the sum of:
How well vendor relationships are managed has a significant impact across several areas of a manufacturer’s business, including supply costs, product quality, and supply availability just to name a few. It’s also important for manufacturers to never be overdependent on a single vendor. Instead, manufacturers should strive for an appropriate level of vendor diversification that affords them options and mitigates unforeseen disruptions.
Strong vendor relationships promote understanding, support transparent conversation, and instill confidence. Understanding involves ensuring clarity surrounding items like invoicing, discount practices, logistics, and more. Transparent conversations provide an avenue for issue resolution, continuous improvement, and dialogue around ways the vendor can support upcoming plans and initiatives. Confidence comes with repeated receipt of needed components at the right time, cost, and quality.
Another vital element of vendor management is a savvy purchasing manager who can negotiate deals and terms, understand all logistical aspects, and liaise effectively with other departments. This is especially important when complexities like maritime logistics and large-volume deals come into play. Effective purchasing managers also help communicate expectations to vendors to support capacity planning. This translates to purchasing power as many vendors are willing to make concessions to keep customers who know how to forecast their needs.
Sales is also a pivotal part of the inventory turnover equation. Reliable sales forecasts help to ensure that everyone involved in inventory management is working with the right set of numbers. For example, a reliable and accurate sales forecast gives operations and production teams information on what to make and when to make it. Not having the right sales numbers and volume expectations at hand makes it very difficult to satisfy customers, control costs, plan for production, manage cash flow, and maintain the strong vendor relationships detailed above.
Manufacturers that have big seasonal swings in their business should also incorporate that seasonality into their forecasts and inventory calculations. To illustrate this, I’m working with a client now who does most of their business across six months of the year. With that being the case, it’s important to examine their average inventory numbers for that particular period. While a 12-month projection is needed to support broader budgeting and forecasting, sharpening their view of those peak periods is a must.
Getting inventory management right calls for careful and continual attention to a wide array of variables and a thorough validation of the many measures that are used by manufacturers to run their businesses. Gaining an accurate view of inventory turnover, properly valuing inventory, developing and maintaining strong vendor relationships, and having reliable views of sales and seasonality across the business go a very long way to helping manufacturers achieve that aim.
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