Calculating the KPI
If you are focused on optimizing inventory, another useful measure of inventory or working capital is the ratio of inventory to sales or inventory as a percentage of sales. It is a simple and easy process to calculate KPI. It is also intuitive.
Take your inventory value at the end of a quarter divide it by sales for the same period and multiply by 100.
Inventory as a percentage of Sales= ((Quarter ending Inventory Value)/(Sales for the Quarter))×100
Benefits of KPI
This measure is very useful when comparing businesses or business units within the same company with different levels of sales. Consider the example in the table below for three divisions, A, B, and C, of a company.
We see that sales vary. Business unit B is 67% of total sales and clearly the largest unit of our company. The other two business units combined are only 33% of sales. It is not fair or reasonable to compare the inventory value of the three different business units.
|Business Unit||Inventory in Millions||Sales in Millions||Inv % Sales||% of Total Sales|
Business unit B, while being the largest, actually has the smallest inventory percentage of sales at 7.8%. Business unit A having only 20% of the sales of business unit B operates with its inventory percentage of sales at 15.38%. This begs the question why? Are there supply chain practices in business unit B that can be implemented in the other two business units? Assuming that the product offerings in the business units are the same, we might want to look at COGS to see if business units B and C are getting more favorable purchasing prices.
Inventory as a Percentage of Sales vs. Turns
Having brought up COGS you might wonder, “why not just use inventory turns?”. Inventory turns or the inverse, days coverage, also allow us to compare business units with varying levels of sales. This is a valid point especially considering the popularity of turns and coverage as inventory KPIs. The main reason companies use inventory as a percentage of sales KPI instead of or in addition to turns is for one of two reasons.
- It is a legacy KPI that finance and general management are used to seeing. We cannot ever discount the importance of this. As supply chain professionals we have to make sure that our metric set ties in with finance and includes the KPIs that management wants to see.
- Many other costs and expenditures are looked at as a percentage of sales. This includes labor cost, overhead, non-variable overhead, and others. If we are used to looking at and comparing the various percentage of sales ratios, we might want to look at inventory the same way.
Plex DemandCaster advocates that companies look at inventory turns. We do however like to have inventory as a percentage of sales available to look at as well.
In a study of 37 companies, we found the following relationship between inventory as a percentage of sales and inventory turns.
There is a relationship between the two metrics. It is better defined for the tails: companies with turns > 40 and companies whose inventories are > 10% of sales.
Let us further consider business unit B in our example. In the table below, we see show both turns and inventory as a percentage of sales. How much inventory must we reduce?
|Current||Increase Turns by 1||Decrease Inv % of Sales by 1 pt|
|Inv % Sales||7.8%||6.6%||6.8%|
For turns, the inventory is the denominator where Turns=COGS/Inventory. If we assume a fixed level of COGS, the inventory turns denominator is essentially a hyperbola and not linear in terms of inventory. For inventory as a percentage of sales, inventory is a numerator: Inv % Sales=(Inventory/Sales) x100. In this case, assuming that sales is fixed, this KPI is linear in terms of Inventory.
Another very good reason to look at inventory as a percentage of sales as a KPI is because it is linear in terms of inventory. Assuming sales stays fixed, a point reduction will always be the same amount of savings or cash generation. With inventory turns, each increase in turns delivers a smaller and smaller amount of savings or cash generation.
Ultimately, it is up to you and your management team to determine the key or lead KPI in terms of measure and which measures you want to track on a secondary basis.