This is sometimes a difficult concept to understand. I’ve found that many people can’t wrap their head around the ground level, or the “what does it mean to me”, connection between low inventory turnover and cash flow. Hopefully, a short explanation will help shed some light on why poor control can cost so much.
What is inventory turnover? Simply stated, inventory turnover is the number of times you buy and sell a product in a year. If you buy one 40 lb bag of that very special diet food, artichoke and woodchuck, and sell that one bag within a year, your turnover ratio = 1 for that item.
A caveat: Some consultants state that a practice should have “$ x.xx of inventory on hand for each veterinarian fte”. Frankly, I think that’s balderdash and it encourages poor management. Your practice should have on hand the exact amount of inventory that you will sell and/or consume in about 6 weeks of typical activity, whatever that amount may be. Obviously, the amount of each individual item will depend on several variables such as: availability of the product, the delivery time of the item when re-ordered, the urgency of the need of the product, and deferred payment options, among other considerations.
Consider this example:
On January 1st you buy $10,000 worth of widgets that you mark up 100%. You sell this inventory over the course of one year for $20,000. That results in a $10,000 gross profit, a 100% return and the turnover ratio = 1 because you placed only one order during the year for a $10,000 investment.
But what if you had purchased $5,000 worth of widgets on January 1st and $5,000 more on July 1st? You have the same sales volume during the year, $20,000, the same gross profit of $10,000 but now you experience a 200% return! And your turnover ratio = 2 because you placed two orders during the year for a $5,000 investment. You used the same $5,000 to purchase the widgets in July that you used in January (remember you sold the January products by July at a 100% markup?)
And if you purchased $2,500 worth of widgets every 3 months? Your return would be 400%, gross profit of $10,000, inventory turnover ratio = 4, total investment of $2,500.
Your cash flow gets incrementally better the more times you order, and sell, during the year. In the example above, with a turnover ratio of 1, you took $10,000 out of your cash reserves in January and tied it up all year. However, by simply purchasing less of the item more often (turnover ratio of 4) you were able to accomplish the exact same thing but tied up only $2,500 of your cash during the same period.
The bottom line is to think of inventory as if it were cash. Because, well, it is.
