This series will take you behind some of the metrics you should be measuring in your business, including: profit, accounts payable and receivable, inventory and payroll. We’ll talk about what they are, what they really mean and more.
When it comes to inventory management, there are several layers, and they’re all important to your business. Inventory, at its most basic, is your goods on hand—and not just your finished goods. Typically, there are three components:
These are all considered part of your business’s assets. As you can see, it’s not just as simple as looking at the physical finished product. 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 categories: direct and indirect.
Learn the basics of inventory in our Behind the Metrics Video
Direct vs. Indirect Costs & How They Apply to Inventory Management
Direct costs are costs that are easily identifiable to one 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 that are not easily identifiable to one 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 gallon of glue costs $20 and you expect to be able to complete 10 units for every gallon, so you allocate $2 to each unit for the cost of glue.
The direct and indirect costs are added to the raw materials throughout the production process. Here’s what the accounting could look like:
|Work in Progress||$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 the Finished Goods and credit Work in Progress.
What Inventory Management Can Tell You
Aside from the value of the asset you are holding, inventory management can have a direct correlation to how your assets are doing as far as profitability and cash flow. If you’re holding on to too much inventory and not selling it, you’re basically a costly storage facility. Plus, if you have anything perishable, you’ve lost money if it spoils. Your inventory costs money to produce. which is recouped when you sell the units, so an overstock can lead to a cash shortfall if not managed properly.
On the other hand, if you have too little, you run the risk of not being able to complete sales in a timely fashion. This could lead to your customers going elsewhere to get the product. An inventory management system can help you prevent these pitfalls, and benchmarking against your peers can help further.
Common Metrics within Inventory Management
Here are a few common metrics to look at:
Inventory turnover is a measure of 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.
Inventory turnover is calculated by taking your cost of sales and dividing it by your average inventory. Low turnover could indicate an excessive amount of inventory, as well as low sales. A high ratio, 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, because it doesn’t matter how fast you sell inventory if you’re not making a profit each time.
Days Sales of Inventory
Day sales of inventory takes things one step further. This is a measurement of how many days it takes you turn your inventory into sales, and it’s calculated by dividing 365 by your 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
The days of supply metric takes your current sales levels and 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.
Why Inventory Management Matters
Inventory management is important and has a direct effect on your business. It’s important to ensure you’re not only tracking your inventory, but you’re also looking at it in relation to the sales cycle. If you need help with benchmarking or inventory analysis, your business advisor should be able to help.