Inventory Analysis-1: Accuracy, Turnover, Availability, Storage Cost Per Item

Inventory MeasurementThis post will focus on “how to measure inventory performance with analysis, why the analysis are important, How to calculate, what the formula is and what things you should note when you analyze on each“. There are actually 32 common analysis/measuerements for inventory control purpose, but I will post four of them at first, they are: Inventory Accuracy, Inventory Turnover, Inventory Availability and Storage Cost per Item.

Let’s start with inventory Accuracy…………

 

[1]. INVENTORY ACCURACY

 

Why Inventory Accuracy is an Important Analysis

If a company’s inventory records are inaccurate, timely production of its products becomes a near impossibility. For example, if a key part is not located at the spot in the warehouse where its record indicates it should be, or its indicated quantity is incorrect, then the materials handling staff must frantically search for it and probably issue a rush order to a supplier for more of it, while the production line remains idle, waiting for the key raw materials.

To avoid this problem: a company must ensure that not only the quantity and location of a raw material is correct, but also that its units of measure and part number are accurate. If any of these four items are wrong, there is a strong chance that the production process will be negatively impacted. Thus, inventory accuracy is one of the most important materials handling measurements.

 

How To Calculate Inventory Accuracy

Divide the number of accurate test items sampled by the total number of items sampled. The definition of an accurate test item is one whose actual quantity, unit Inventory of measure, description, and location match those indicated in the warehouse records. If any one of these items is incorrect, then the test item should be considered inaccurate.

 

Inventory Accuracy Formula:

Number of accurate test items
————————————––
Total number of items sampled

 

Notes:

It is extremely important to conduct this measurement using all four of the criteria noted in the formula derivation. The quantity, unit of measure, description, and location must match the inventory record. If this is not the case, then the reason for using it—ensuring that the correct amount of inventory is on hand for production needs—will be invalidated. For example, even if the inventory is available in the correct quantity, if its location code is wrong, then no one can find it in order to use it in the production process. Similarly, the quantity recorded may exactly match the amount located in the warehouse, but this will still lead to an incorrect quantity if the unit of measure in the inventory record is something different, such as dozens instead of each.

 

[2]. INVENTORY TURNOVER

 

Why Inventory Turnover is an Important Analysis

Inventory is often the largest component of a company’s working capital; in such situations, if inventory is not being used by operations at a reasonable pace, then a company has invested a large part of its cash in an asset that may be difficult to liquidate in short order. Accordingly, keeping close track of the rate of inventory turnover is a significant function of management. Turnover should be tracked on a trend line in order to see if there are gradual reductions in the rate of turnover, which can indicate that corrective action is required to eliminate excess inventory stocks.

 

How To Calculate Inventory Turnover

The most simple turnover calculation is to divide the period-end inventory into the annualized cost of sales. One can also use an average inventory figure in the denominator, which avoids sudden changes in the inventory level that are likely to occur on any specific period-end date.

 

Inventory Turnover Formula:

Cost of goods sold
————————
Inventory

 

More understandable Inventory Turnover Formulas

A variation on the preceding formula is to divide it into 365 days, which yields the number of days of inventory on hand. This may be more understandable to the layperson; for example, 43 days of inventory is more clear than 8.5 inventory turns, even though they represent the same situation.

So the Inventory Turnover formula became as follows:

                    Cost of goods sold
365 [divide] ————————–
                    Inventory

 

Raw Material (specifically) Turnover Formula

The preceding two formulas use the entire cost of goods sold in the numerator, which includes direct labor, direct materials, and overhead. However, only direct materials costs directly relate to the level of raw materials inventory. Consequently, a clearer relationship is to compare the value of direct materials expense to raw materials inventory, yielding a raw materials turnover figure. This measurement can also be divided into 365 days in order to yield the number of days of raw materials on hand. The formula is as follows:

 

Direct materials expense
——————————–
Raw materials inventory

Or:

                    Direct materials expense
365 [divide] ——————————–
                    Raw materials inventory

 

Notes:

The preceding formula does not yield as clean a relationship between direct materials expense and work-in-process or finished goods, because these two categories of inventory also include cost allocations for direct labor and overhead.

However, if these added costs can be stripped out of the work-in-process and finished goods valuations, then there are reasonable grounds for comparing them to the direct materials expense as a valid ratio.

The turnover ratio can be skewed by changes in the underlying costing methods used to allocate direct labor and especially overhead cost pools to the inventory. For example, if additional categories of costs are added to the overhead cost pool, then the allocation to inventory will increase, which will reduce the reported level of inventory turnover—even though the turnover level under the original calculation method has not changed at all. The problem can also arise if the method of allocating costs is changed; for example, it may be shifted from an allocation based on labor hours worked to one based on machine hours worked, which can alter the total amount of overhead costs assigned to inventory. The problem can also arise if the inventory valuation is based on standard costs and the underlying standards are altered. In all three cases, the amount of inventory on hand has not changed, but the costing systems used have altered the reported level of inventory costs, which impacts the reported level of turnover.

A separate issue is that the basic inventory turnover figure may not be sufficient evidence of exactly where an inventory overage problem may lie. Accordingly, one can subdivide the measurement, so that there are separate calculations for raw materials, work-in-process, and finished goods (and perhaps be subdivided further by location). This approach allows for more precise management of inventory related problems.

 

[3]. INVENTORY AVILABILITY

 

Why Inventory Availability is an Important Analysis

One of the primary reasons for having inventory is to satisfy customer demand in a timely manner. Maintaining a high level of inventory availability is usually cited as the primary reason why companies keep such high levels of finished goods and service parts on hand. Given this logic, one should measure a company’s success in filling orders to see if high inventory retention is working as a policy.

 

How To Calculate Inventory Availability

To measure inventory availability, divide the total number of completed orders received by customers no later than their required date during the measurement period by the total number of completed orders that customers should have received during the measurement period.

 

Inventory Availability Formula:

Total number of completed orders received by customer by required date
——————————————————————————————
Total number of orders that should have been completed

 

Notes:

The measurement emphasizes a successful order fulfillment as one received by the customer on time, because the customer is not being served properly if the order was merely shipped as of the required due date. Most company systems have no provision for tracking customer receipt dates. To avoid this problem, a company can train the order entry staff to subtract shipping time from a customer’s required date on receipt of the order, and enter the shortened date in the order entry system.

A company can falsely assume that it has a high availability rate if it counts any sort of partial shipment as a completed order in the numerator, possibly on the grounds that it has successfully shipped nearly all of an order. This measurement approach certainly is not the view of the customer, who may well stop using the company on the basis of a “completed” order, which it sees as a failure.

 

[4]. STORAGE COST PER ITEM

Why Storage Cost Per Item is an Important Measurement

Inventory items can languish in the warehouse for years. During that time, one can forget their presence on the assumption that they are accumulating no costs and so can be safely ignored. Unfortunately, inventory accumulates more costs every day in the form of rack space taken, insurance coverage expenses, the opportunity cost of invested funds, and so on. One must be aware of these costs or be ignorant of a major portion of a company’s cost structure.

 

How To calculate Storage Cost per Item

There are several ways to measure the storage cost of an inventory item. At a summary level, one can simply divide the total number of SKUs actually on hand into all warehouse costs, which comprise the fully burdened wages of all warehouse staff, depreciation on all fixed assets, inventory insurance coverage, utilities, obsolescence, scrap costs resulting from damaged goods, and the corporate cost of capital on funds invested in inventory. At this simplified level, the calculation is as follows:

 

Storage Per Item Formula:

Total warehouse expenses
————————————–—–
Total stock keeping units on hand

 

Notes:

The problem with this calculation is that not all SKUs incur the same costs. For example, a high-value item should be charged a higher proportion of insurance costs, whereas perishable goods must be charged with a higher proportion of obsolescence costs. Thus, a better approach is to adopt an activity-based costing (ABC) approach to measuring the storage cost per item. Under ABC, costs are accumulated by activity (such as by put away or picking transaction), and then costs are charged out to individual SKUs based on their use of these transactions. Although the ABC calculation can be lengthy, a typical finding is that a large proportion of all SKUs on hand are costing a company far more than they earn on the gross margin from their eventual sale.

Author: Lie Dharma Putra

Putra is a CPA. His last position, in the corporate world, was a controller for a corporation in Costa Mesa, CA. After spending 15 years as a nine-to-five employee, he decided to serve more companies, families and even individuals, as a trusted business advisor. He blogs about accounting, finance and tax, during his spare time, and helps accounting students (around the globe) to understand the subject matter easier , faster. Follow him on twitter @LieDharmaPutra or add him to your circle at Google Plus Lie+

11 thoughts on “Inventory Analysis-1: Accuracy, Turnover, Availability, Storage Cost Per Item”

  1. Hi,

    I am working in a warehouse inventory department.

    I am trying to find the formula or criteria to calculate the warehousing cost for each stored product (SKU), during a period (month).

    Objective:
    To determine slow moving items warehousing cost.

    Question:
    What is required to know?and what is the formula?

    – Total Square Footage of Warehouse = 72000m2
    – Total warehouse cost for June = 6,353,217 USD
    – Warehouse total locations number = 32,000 locations
    – Warehouse utilization during that period= 73% (Occupied)
    – Total products (SKUs): = 5100
    – Total Shipped Cases during June = 1,316,403
    – Total Received Cases during June = 1,948,398

    Regards,

    Alan

  2. Alan,

    As it is discussed in this post, to calculate storage cost per item [SKU], you can simply divide the total warehouse expenses by total stock keeping unit on hand for the period. So before attempting to calculate the storage cost per item, you would need to determine the total warehouse cost and expenses first.

    The most challenging task here is to determine the total warehouse cost. It is a long..long calculation:

    1. Determine the corporate cost of capital [fund invested in the inventory].
    2. Determine the Scrap and obsolescence inventory costs.
    3. determine utility cost related to the warehouse
    4. Annual Insurance premium for inventory divided by 12 [months]
    5. Depreciation cost of all fixed assets [building, equipments, tools] related to the warehouse for the period. If you lease any of them, then you would need to include the lease expenses for the period [or its amortization]
    6. Wages of all warehouse staffs

    If you’re unable to calculate any of those costs, you can always ask your cost accountant for the number you need. They are your best resource for the cost. They are the expert.

    The next step is to determine number of items [SKU] you keep for the period. It is much easier to calculate. You should be able to calculate yourself:

    Total number of items remaining from the previous period [inventory opening balance in unit or SKU] [plus] total items you received for the period.

    Once these two steps completed, then you can calculate storage cost per item by the formula provided in this post.

    Good luck!

  3. Thank you Putra.

    That was valuable and appreciated.

    But isn’t item throughput also related or should be related to the calculation.

    I’ve read couple of books mentioning that but it wasn’t clear for me, how its related.
    There is something also about taking item throughput for a month and dividing it by 2 = Item turn.

    Example:

    If WH received 100 Cases from one item and WH shipped 80 cases from it in June.
    So, we still have 10% that will be shipped in August.

    The warehousing/storage cost for shipped 80% is different than 10%.

    It’ll be more difficult if you considered storing more than one item.
    And even if we have the daily quantity on hand & daily total warehouse expenses … how should we calculate or get slow moving items cost?

    What do you think ?

    Regards,

    Alan

  4. Hi, Putra,

    When you said:

    “Total number of items remaining from the previous period [inventory opening balance in unit or SKU] [plus] total items you received for the period.”

    – Did you mean by “Total number of items remaining from the previous period”:
    The units that still available in the warehouse from previous period (quantity on hand)?

    – Did you mean by “plus, total items you received for the period”:
    received units or received items?

    1,000,000 (Remaining Units or On Hand Qty) + 2,000,000 (Received units in June)

    OR

    4,732 items (Remaining items) + 2121 items (Received items in June)

    Regards,

    Alan

  5. Alan,

    If you’re attempting to calculate storage cost per items, then it is item. If storage cost per unit. Then it is unit. But, if I am not wrong; storage cots per item is your goal, if so then it is item.

    Trying to determine storage cost specifically for the “slow moving” items only, is somewhat hard to accomplish.
    – Firstly, you need to set “inventory turnover standard”.
    – Second, calculate inventory turnover [use formulas provided on this post].
    – Compare the actual turnover to the standard. Any items movement slower than the standard than you can classify them as the slow moving category. You got the number.

    The next task, is to allocate all the warehose expense to the items which you have classified as the slow moving items.

    Last step is to devide the expenses by number of items/quantity [whatever you are trying to calculate] of the slow moving items you keep for the period.

    Please also pay attention to the note at the bottom of this post:

    “The problem with this calculation is that not all SKUs incur the same costs. For example, a high-value item should be charged a higher proportion of insurance costs, whereas perishable goods must be charged with a higher proportion of obsolescence costs. Thus, a better approach is to adopt an activity-based costing (ABC) approach to measuring the storage cost per item. Under ABC, costs are accumulated by activity (such as by put away or picking transaction), and then costs are charged out to individual SKUs based on their use of these transactions”

  6. Hi Putra,

    This is Alan again….

    In a warehouse:

    How can you calculate item movement per case according to the following example?
    (If there is a formula to calculate the cost too, that will be appreciated.)

    Receiving:

    – On January 1st, 2009, we received 1 pallet from item A where each pallet holds 60 cases.
    – One location for one pallet.

    Picking/shipping:

    – Pallet A0001 in location A1 (60 Cases)

    – On January 7th, we picked 10 cases from Pallet A0001.
    – On January 10th, we picked 10 cases from Pallet A0001.
    – On January 13th, we picked 10 cases from Pallet A0001.
    – On January 15th, we picked 10 cases from Pallet A0001.

    – On January 16th, we picked 19 cases from Pallet A0001.
    – On January 28th, we picked 1 case from Pallet A0001. ((Important: 1 case remained for 12 days occupying pallet location))

    Thank you …

    Regards,

    Alan

  7. Hi,
    I am a part of logistics department, I am looking for a formula/calculation to estimate the pallet space in a warehouse, below is the step that I have done, appreciate can have your advice on the following step.
    For Example,
    I have group all the shipment data (SKU’s) from cases convert into pallet from Jan – Jul
    Item A = 100 pallet per month ( target inventory day = 10 )
    Item B = 200 pallet per month ( target inventory day = 20 )
    Item C = 300 pallet per month ( target inventory day = 30 )
    Item D = 200 pallet per month ( target inventory day = 20 )
    Item E = 100 pallet per month ( target inventory day = 10 )

    Thank you

    Rdgs,
    Nick

  8. Hi

    We manage an aftermarket business based on a 90% availability and $66M inventory.

    The challenge is to estimate inventory valuation if we increase availability in 1% intervals.

    Thanks

  9. Hi
    my self ravinder resendly my transfer fild to warehouse and prmot me but i haven’t knowledge of new department i am read some book related warehouse anlysis for update us. But if you could tell me some reporting formula in use in regaularly / month end. it important for me
    i hope u do this ASAP

    THANKS
    RAVINDER

  10. Hi
    I am Karishma Sahoch . I am pursuing MBA and I am very much enthusiastic with the projects that we take up in our curriculum.
    Currently I am an intern at a small scale manufacturing unit and facing problems to work out the inventory carrying and ordering cost of the company.
    I shall be glad to use your advice for the same.
    Thank you

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