Behind the Metrics: Inventory

This set of blogs will take you behind some of the metrics you should be measuring in your business. We’ll talk about what they are, what they really mean and more.

We know what you’re thinking … of course it’s important to track inventory. And you’re right, it absolutely is. But it’s more than just the physical finished product in your warehouse you need to track. Inventory has several layers and they’re all important to your business.inventory

Let’s start at the beginning.

Inventory, at its most basic, is your goods on hand. We don’t just mean finished goods either.

Typically there are three components under your inventory account:

  • Raw materials (read, the things you’re using to create your product)
  • Work in progress (the product that’s almost there, but not quite)
  • Finished goods (we’re not going to explain this one)

These are all consider part of your business’ assets.

Seems pretty straight forward.

Well, not quite. Inventory might be a pretty straightforward concept, but tracking it isn’t. In fact, it can get pretty complex. Let’s take a look at the basics…

Raw materials are the basic components that go into producing your product. When raw materials are purchased you debit Raw Materials Inventory and credit Accounts Payable (or another payment type).

Once your product goes to production, you need to start adding in costs such as labor, supplies, occupancy and equipment. These costs can be broken into two (2) categories: direct and indirect.

Direct costs are costs that are easily identifiable to one (1) unit. For example, let’s say it takes a line worker two hours to assemble a unit [and line workers track their time to a specific unit]. The line worker makes $30 per hour. Therefore, you would add $60 to the cost of the unit.

Indirect costs are costs related to the production process however are not easily identifiable to one (1) unit. For example, as a part of the assembly process, the line worker must glue a component to the unit. You wouldn’t necessarily want to measure the glue each time; so you allocate a cost for the glue. You know that one (1) gallon of glue costs $20 and you expect to be able to complete 10 units for every gallon; so you allocate $2 to each unit for the cost of glue.

The direct and indirect costs are added to the raw materials throughout the production process. Here’s what the accounting could look like (actual accounting may differ based on specific circumstances … but this should give you the idea).

 

Account Debit Credit
Work in Progress $XXX
Raw Materials $XXX
Labor Allocation* $XXX
Supplies Allocation* $XXX

*Assuming when you pay the line worker and purchased the supplies, you recorded it to a wages and supplies expense, respectively under costs of goods sold.

Once the production of the unit is complete, you would debit Finished Goods Inventory and credit Work in Progress.

So what can your inventory tell you?

Other than the value of the asset you are holding, inventory can have a direct correlation to how they’re doing (we are talking profitability and cash flow).

What do we mean? Well if you’re holding on to too much inventory and not selling it, you’re basically a costly storage facility. Plus, if you use anything that could spoil, you’ve lost money. Not to mention, your inventory costs money to produce which is recouped when you sell the units; that can lead a cash shortfall if not managed properly. If you have too little inventory, on the other hand, you run the risk of not being able to complete sales in a timely fashion. Which might led to your customers going elsewhere to get the product.

So what do you do? Use an inventory management system. Oh, and a little thing like benchmarking against your peers will also help.

What else do I need to know?

Here are a few common metrics to be looking at within inventory.

Inventory Turnover

In simplest form, this is how often your inventory is sold and then replaced over a period of time. For instance, you can use this metric to see how many times you sell through your inventory in one year. One of the best things to do is then compare this to industry averages to gauge where you stand.

Here’s how you calculate it:

Cost of Sales

Average Inventory

Low turnover could indicate an excessive amount of inventory, as well as low sales. A high ratio, on the other hand, could indicate strong sales. Or it could indicate a large discount.

In essence, inventory turnover is about speed. But inventory turnover is also tied directly to profit. Why? Well, it doesn’t matter how fast you sell inventory if you’re not making a profit each time.

Days Sales of Inventory

Taking your inventory turnover one more step, this is a measurement of how many days it takes you turn your inventory into sales.

Here’s how you calculate it:

365

Inventory Turnover

The inventory to sales ratio is also the first part in a larger ratio, known as the cash conversion cycle. This cycle tracks how long it takes you as a business to convert your resources into cash flow.

Inventory Days of Supply

Days of supply takes your current sales levels and then tracks how many days your current inventory will last. As you can guess, this is an important metric because if you’re low, you’ll risk running out of inventory and not being able to fulfill sales.

The moral of the story …

Inventory management is important and has a direct effect on your business. So ensure you’re not only tracking your inventory, but also looking at it in relation to the sales cycle.

 

 

 

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