Profitability Metrics allow a company to maximise efficiency thereby minimising costs (for a given level of sales) and improve overall profitability.
Inventory Metrics
Generally in traditional manufacturing or retail businesses, the largest percentage of costs relative to sales is taken up by costs of the goods being sold. Before selling, the goods will be sitting on the company’s Balance Sheet as Inventory (which will usually be valued at the cost paid to make or buy that product) and likewise the physical product itself will be sitting around either on a shelf in a shop, in a factory or held in a warehouse or distribution centre. Worse, it could be tied up in a delayed production process in a factory or manufacturing plant somewhere, or caught up on a lorry in some strike-induced border crossing lorry jam.
Inventory idly sitting around not getting sold has incurred the business cash to make or buy it, but isn’t being converted back to cash by being sold to a customer, and this is a clear inefficiency. The key metric to measure here is Inventory Days, which measures the average number of days a company holds its inventory before selling it, showing how many days funds are tied up in inventory.
A high value for inventory days (arising from a slow turnaround of stock) will mean a correspondingly large negative float. That is, the amount of time between paying cash out to suppliers for buying in or making product/stock and selling it on to customers and recovering the sales receipts and generating a surplus of cash. To fund the negative float, the company will require some spare/surplus cash, or working capital. Tying up more of those surplus funds or working capital in inventory will result in either an interest cost (if the funds have had to be borrowed) or an opportunity cost (the cost of not being able to use those surplus funds directly in immediately revenue- and profit-generating activities).
The inventory days corresponds to the Inventory Turnover metric (also known as Stockturn), which measures the number of times the current value of inventory can be sold/used in a given period, usually one year, at the current level of sales (calculated as net sales divided by the cost of goods sold). The lower the stockturn number, the slower the stock is moving.
There will also be a cost of storing the slow-moving stock, such as warehousing costs, and further administrative costs of managing, recording, tracking and reconciling the stock and its value to the business. These are all Fixed Costs of Inventory Management – unavoidable and definite candidates for minimising.
Warehousing and other fixed stock management costs can be allocated against the stock sold (number of units of inventory sold in the year divided by the annual fixed costs of inventory management) to give an Average Stock Holding Cost Per Unit Sold.
Another inventory measure is Wastage, caused either by production faults causing stock to have to be scrapped, or when inventory sitting around in factories, warehouses or on retail shelves not being sold results in deterioration or wastage of the stock (where the stock type is a Wasting Asset). The wasted stock will need to be written off, meaning a direct cost and a loss to the business. The level of wastage can vary by type of inventory (e.g. perishable goods such as food, unrented hotel rooms, airline seats not sold before flight).
Closely allied to wastage is Obsolescence where items in stock are superseded by more advanced models (e.g. technical gadgets, software versions, fashion clothing) or where manufacture and supply significantly outstripped global lifetime demand for that product meaning the item can never be fully sold out. In both cases, the inventory will need to be written off, resulting in a cost and a loss to the business.
The Average Number of Days Inventory is Held (or Inventory Days) metric can be calculated using (£ value of inventory at year-end divided by £ cost of goods sold in the year) multiplied by 365 days. The metric gives a good feel for how well or how badly overall the company is selling its inventory, with the lower the number the better the company is converting its stock through sales. Generally speaking a number lower than 50 days is very good while greater than 365 is not, although this will of course vary from industry to industry.
The problem with the above metrics is that, as aggregates and averages, they won’t highlight performance of specific categories or individual line items (SKU’s). Not will they account for seasonality in sales of some stock items. This can be overcome by tracking key inventory metrics for each individual SKU (i.e. at individual product level). This will give management a much clearer picture about how individual products are performing, allowing deeper analysis and insight into why some are performing well while others are not, which will aid more effective and efficient stock management overall.
Best practice in inventory management will be to run both the Inventory Turnaround and Inventory Days metrics for each individual SKU (i.e. at individual product level), with this detailed product-level analysis also sub-divided by retail store (or marketing campaign) level, by geographical region, and so on.
Each individual SKU should ideally have a planned or expected Days Inventory target metric – taking into account geographical and seasonal sales fluctuations – so as to maximise stock-holding and shelf-space allocation in order to maximise sales while minimising stock holding costs. Actual Days Inventory should then be monitored against the planned target.
Out-of-stocks may be tracked either by clickstream data (how many times did customers view/try to buy an item which was out of stock/unavailable) resulting in a lost sale. Another way of getting a sense of the lost sales due to stock-pouts is to track number of SKU’s Reaching Zero Stock, or the number of Customer Complaints about unavailable stock can be tracked.