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What should a CFO know about inventory and inventory turns?

An effort to reduce inventory without seeing the amount in context is a recipe for disaster. Here's information that can help the finance team avoid such costly mistakes.

Inventory, as a large item on the balance sheet, is always an important concern for a manufacturing company and its finance team. Most financial managers would like to see inventory reduced to free up cash for other purposes. Since inventory is necessary to support sales with product availability, it makes sense to measure inventory relative to sales volume using inventory turns, a measure of the ratio of cost of goods sold to inventory.

The CFO should realize two important points about inventory. One, inventory does serve a purpose -- it is the finished product available for sale and the parts available for production -- and two, there is a "right" amount of inventory needed to meet expected demands. A certain amount of inventory is usually kept to accommodate variability and uncertainties, like forecast error, production disruptions, quality problems and the like. Usually called safety stock, this additional inventory reduces expediting and helps ensure availability and the desired customer service level.

Operations managers are just as interested in reducing inventory as the finance team is, but they immediately and more directly feel the effects of too little inventory, usually at significant cost. Undue pressure from finance to raise inventory turns or reduce inventory to a level below what's required to avoid shortages can lead to undesirable -- that is, expensive -- consequences, including disrupted production schedules, expedited orders, premium freight costs, backordering and lost orders from customers who cannot wait for their products.

Operations hopes that finance will view the inventory balance and inventory turns in the context of why you have inventory and what the right amount of inventory is. For its part, operations can and should work toward lowering inventory, or more correctly, increasing inventory turns, by addressing the factors that threaten availability, thereby requiring safety stock.

Companies should be able to easily justify investments and performance improvement projects to increase forecast accuracy, improve inventory control, record accuracy, increase visibility and drive supplier and production reliability (reduce the risk of late deliveries). As these improvements take hold, safety stock can be reduced without reducing availability.

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This was last published in August 2016

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What inventory turnover ratio do you believe is optimal, and on what reasoning do you base that opinion?
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Hi

It depends upon nature of Business. There is no any standard optimal value. In case of FMCG , Inventory turn is very high.
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Exactly right. A turns ration of 4 might be really good in one industry but a disaster in another.That's why inventory turns (or any other measure, for that matter) must be viewed and used in context. Compare your turns to your primary competitors or industry averages. Compare it to what it was last year or the year before. Is it moving in the right direction? (usually that means higher) and most importantly has an improved turns ratio (lower relative inventory) had a damaging effect on customer service (increased shortages)?
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