Inventory Analysis

A business should keep enough inventory on hand to meet the needs of its customers and its operations. At the same time, however, an excessive amount of inventory reduces liquidity by tying up funds. Excess inventories also increase insurance expense, property taxes, storage costs, and other related expenses. These expenses further reduce funds that could be used elsewhere to improve operations. Finally, excess inventory also increases the risk of losses because of price declines or obsolescence of the inventory. Two measures that are useful for evaluating inventory efficiency are the inventory turnover and the number of days’ sales in inventory. Inventory Turnover. The relationship between the volume of goods (merchandise) sold and inventory may be stated as the inventory turnover. It is computed by dividing the cost of goods sold by the average inventory. If monthly data are not available, the average of the inventory at the beginning and the end of the year may be used.

The inventory is often a significant asset category for many companies. Thus, inventory efficiency will be an important component of total asset efficiency. Pixar’s inventory turnover is approximately one full turn slower than DreamWorks. That is, Pixar is less efficient in moving inventory than is DreamWorks. Differences across inventories, companies, and industries are too great to allow a general statement on what is a good inventory turnover. For example, a firm selling food should have a higher turnover than a firm selling furniture or jewelry. Likewise, the perishable foods department of a supermarket should have a higher turnover than the soaps and cleansers department. For Pixar and DreamWorks, the inventory is the cost of films. Films have a much longer life cycle than, say, on-the-shelf consumer products. Thus, the inventory turnover is much slower than would be the case for a consumer products company, such as Procter & Gamble, which has an inventory turnover of 11.68. Each business or each department within a business has a reasonable turnover rate. A turnover lower than this rate could mean that inventory is not being managed properly.

Number of Days’ Sales in Inventory. Another measure of the relationship between the cost of goods sold and inventory is the number of days’ sales in inventory. This measure is computed by dividing the average inventory by the average daily cost of goods sold (cost of goods sold divided by 365)