Guide to Management Accounting Inventory turnover for managers: Theory & Practice: How to utilize management indicators to assist decision-making

Introduction

ROE (Return on Equity) has been gradually improving in Japan and is drawing attention now.

According to the Ito report announced by the Ministry of Economy, Trade and Industry in August 2014, it was pointed out that the issues of Japanese companies are not in asset turnover rates and financial leverage, but in terms of their ability to make earnings, compared to western companies. However, I believe that both accounts receivable turnover and inventory turnover are generally lower than those in Europe and the United States, among asset turnover rates, which is an issue for CCC (Cash Conversion Cycle) management.

As for inventory, we position inventory turnover days as company-wide common control index for decision-making, not traditional inventory turnover rate and inventory turnover period, and we propose integrated activities of management team and operation site to improve ROE and ROIC (Return on Invested Capital).

Inventory is an important management resource

Inventory is said to be a source of profit for business, at the same time, to cause loss. Especially in manufacturing, retail and wholesale business, management indicators are used to measure whether product inventory is being converted into sales efficiently.

In general, the following two indicators are used.

1.Inventory turnover rate

Inventory turnover = sales · cost of sales (annual) ÷ inventory amount

The inventory turnover rate is mainly used by executives for presentations for investors or shareholders.

2.Inventory turnover period

The inventory turnover period is an indicator that shows how long it takes to have inventory for days or months, or to consume (sell) all inventory.

Inventory turnover period = inventory amount ÷ sales or cost of sales (monthly or daily)

In fast-rotating industries such as foods, the daily sales are used for denominator and days of inventory is indicated.

The inventory turnover period is practically used well.

Whereas annual average or month end inventory amount is used, the actual data of sales or cost of sales for the relevant period is used. And inventory figures are sometimes indicated in terms of quantity or weight, but in this book we will focus on the amount of inventory rather than quantity or weight from the viewpoint of balance sheet management.

Both are said to be indicators to see if inventory is appropriate. It is enough to tell about past and current situation of inventory, but I think that it is inappropriate as an indicator for future decision making. In other words, it is an index for financial accounting, not inventory turnover as management accounting.

With regard to inventory turnover period, in the case of products with low seasonal fluctuation, it may be good in the past sales results, but it can not be a reference for judgment criteria for procurement, judgment criteria for production.

Because inventory exists for future salle, so the calculation formula will be as below.

Inventory turnover days = inventory amount ÷ cost of sales (estimate, actual) of following months or weeks

As an Inventory-centric management consultant, I am convinced that inventory turnover days are an indicator that can assist decision-making to be shared by management, operations staffs such as sales, manufacturing, procurement and logistics.

The background of ROE, ROIC and CCC is being introduced to Japan is as follows.

(Nikkei newspaper December 5, 2012)

ROE: introduced in the mid-1990s when the number of foreign shareholders increased and the Japanese companies have been pointed as not satisfactory in terms of capital efficiency, and the Pension Fund Association introduced the ROE as one of the criteria for exercising voting rights.

ROIC: introduced at the beginning of 2000s when ROIC became increasingly focused on the capital efficiency of the business, and the movement to use the operating margin against invested capital as a management index expanded.

CCC: Since first half of 2010, CCC reaffirmed the importance of cash flow due to the financial crisis.

This book explains to executives, managers, practitioners and students in an easy-to-understand manner as a guide (theory and practice) of management accounting Inventory turnover.

Rather than handling inventory turnover as a mere indicator used at the operation site, in order to create corporate value, in relation to other management indicators as management accounting, and also in order to effectively encourage the improvement activities, what kind of practical knowledge, the systems which supports and finally practical solutions and concrete examples for inventory management through my vast experience accumulated are explained.

Freshness is indispensable for Product and Information.

One of my mottos is Freshness is indispensable for Product and Information. Will this be applicable regardless of industry or business? In this book, I have explained CCC using the latest quarterly settlement of accounts figures (as of the end of January 2019) that can be grasped at the time of publication which also different from conventional books.

As this is related to Management Accounting CCC, I have emphasized on the freshness of information and explain it based on the past 11 years (43 quarters).

In addition, I would be grateful if you could kindly take a look of my books for better understanding.

Guide to Japan-born Inventory Freshness Control for managers (Gentosha) written in English and Japanese, and its e-book titled Guide to Japan-born Inventory and Accounts Receivable Freshness Control for managers (IFC Consulting Ltd.) written in English, Japanese, Chinese, Vietnamese and Thai, and e-book titled Guide to Management Accounting CCC for managers (IFC Consulting Ltd.) written in English and Japanese.

March 2019

Inventory-centric management consultant

Shigeaki Takai

Chapter 1

Now, why inventory turnover is paying attention?

In this chapter, I will talk about why inventory turnover is regarded as management accounting, and the background of attaching the subtitle - theory and practice: How to utilize management indicators to assist decision-making.

In general, Japanese corporate executives have the recognition that inventory is important, but practically leaving inventory control to operational staffs such as procurement, production, sales and basically receiving financial results only.

If it is a listed company, there may be cases in which investors express concern, but in unlisted companies it is not. Also, does a company that places inventory as its management index lead to improvement activities? Through this book, I would like to introduce it to readers in detail.

(1) Inventory is a scorecard of the corporation

This is the word of former Sony Vice Chairman and Sony Electronics CEO, Mr. Ryoji Chubachi, President, National Institute of Advanced Industrial Science and Technology (AIST). Inventory is the result of operations and is also valuable evidence of process improvement activities. He used to analyze the reasons for inventory thoroughly and discussed the importance of using it for improvement activities and emphasized the relationship between inventory and cash flow.

He often asked two questions whenever there is problem at inventory while he was Sony Electronics CEO.

1.Is the balance of PSI (production, sales, inventory) okay?

2.Is there any stagnant inventory?

In the retail industry, when procuring goods, in the manufacturing industry, when procuring and producing materials, we will determine the quantity in consideration of supply and demand. And it will be sold to business partners. When the sale is completed, the inventory of the company will be reduced, but you need to check whether those are sleeping in the distributor's warehouse or sleeping at the shop.

The table below shows the inventory and lead time by process. In the case of the manufacturing industry, inventories are material parts, work-in-process, finished goods, dealer inventory, logistics warehouse inventory, and channel inventory.

(Source: author)

For a company, inventory refers to the inventory that is displayed as the inventory in the balance sheet (B/S).

Although it is described as consolidated inventory in the above, it is greatly affected by distribution stock. In supply chains, in general, actual demand means actual sales, meaning that products are sold to end consumers after transferring assets.

Therefore, when talking about the appropriateness of your inventory, you need to grasp the proper value of the inventory situation of the business partner.

In Sony, consolidated inventory (sales company’s inventory and manufacturing plants inventory) and channel inventory are called as super consolidated inventory. Sales companies will grasp the channel inventory of the market as much as possible and confirm it together with their own inventory and place or revise the order to manufacturing plants.

After the Lehman shock in 2008 which was an unprecedented financial crisis in particular, the way of sales activities was also greatly revised.

As for Sony, the above-mentioned in the article, the super consolidated inventory* management has started around this time to focus on the management soundness and inventory reduction while monitoring worldwide sell-through at retail shops.

-To visualize Weekly Consolidated Inventory worldwide.

-To visualize on the weekly basis channel inventory and fix standard inventory level based on inventory turns and to increase Inventory turns by replenishment operation based on sell out.

-To increase portion of less added value inventory and adapt to the change.

-Production system that can respond quickly and flexibly to changes in demand

* Super consolidated Inventory is Sony’s SCM terminology of Inventory (Consolidated Inventory and Channel Inventory)

The increase of inventory listed below can generally occur. What do you think about the responsibility?

1.Production increase was decided by management judgement, which resulted in increase of inventory.

2.Increased the purchase quantity for the final production of repair parts of the product.

3.In order to avoid the price increase due to changes in foreign currency exchange rates, we have decided to purchase extra quantity at the current price.

4.To increase production efficiency, we have increased production more than the demanded quantity.

5.Assuming extra sales, we have decided to increase production, but sales were not realized as expected. So inventory went up.

6.It was subject to the influence of price reduction of a competitor, shipment with the present price becomes impossible, and it was in stock.

7.Due to quality problem, the shipment was suspended and remained as inventory.

8.In sourcing parts, since purchase more than requirements was performed for price-reduction negotiation, stock increased in number.

9.Since problem on credit control found, we have decided not to ship this month, which caused inventory up.

10.Due to a sudden strike by a carrier, it could not be shipped and remained as inventory.

11.There was a request from major business partner to postpone the delivery schedule due to inventory adjustment at the time of financial closing, and it became inventory.

The increase of inventory is usually due to the management, production, sales, procurement, logistics, business partner and so on.

Since these inventory increases are directly linked to cash flow deterioration, it is necessary to analyze the cause and measures for the department concerned. Inventory is a scorecard of the corporation means proper inventory management to advance measures and improvement activities by grasping these factors

(2) Management efficiency

The indicators that show the efficiency of management are described in detail in Chapter 2, but here we explain the indices related to inventory. In general, the following two are used.

1.Inventory turnover rate

Inventory turnover = sales · cost of sales (annual) ÷ ​​inventory amount

The inventory turnover rate is mainly used by executives for presentations for investors or shareholders.

2.Inventory turnover period

Inventory turnover period = inventory amount ÷ sales or cost of sales (monthly or daily)

In fast-rotating industries such as foods, the daily sales are used for denominator and days of inventory is indicated.

The inventory turnover period is practically used well.

Whereas annual average or month end inventory amount is used, the actual data of sales or cost of sales for the relevant period is used.

It is enough to explain the past and current situation of inventory, but I think that it is inappropriate as an indicator for future decision-making internally. In other words, it is not inventory turnover as management accounting.

With regard to inventory turnover period, in the case of products with low seasonal fluctuation, it may be good in the past sales results, but it can not be a reference for judgment criteria for procurement, judgment criteria for production.

Because inventory exists for future sales, so the calculation formula will be as below.

Inventory turnover days = inventory amount ÷ cost of sales (estimate, actual) of following months or weeks

In order to assist decision-making at the operation site, it is possible to show how much sales prospects are available for existing stocks, and how much procurement and production are necessary for that, all by inventory turnover days.

I would like to express indices when valuing inventory at a company, and it may be required to develop it all across the company. As an inventory-centric management consultant, I am frequently asked questions about proper inventory level and I encourage them to do the inventory turnover days weekly and monthly.

In weekly cases, if you use the cost of sales for the preceding 4 weeks (28 days), it becomes as follows.

Inventory turnover days = Inventory ÷ cost of sales (estimate, actual) x 28 days (Week)

Inventory turnover days = Inventory ÷ cost of sales (estimate, actual) x 30 days (Month)

Depending on the company, there seems to be a case where the cost of sales is not the next month but past month because of convenience.

To the extent that a single item is measured, shortfall or excess is clear.

However, when applied to all stocks handled by companies (products / goods, work in process, raw materials, etc.), as a disadvantage, since shortfall and excess stocks are offset, which will lead to erroneously evaluate that the stock is healthy as a whole.

Originally, inventory turnover days measured by quantity / weight should be the same value even if they are calculated by the amount.

The inventory as an asset is based on the amount stated in B / S. On the other hand, inventory used in operations are based on quantities or weight. Both figures are different. Even if you can grasp past trends, it will not be used as an indicator to decide future procurement / production.

Inventory turnover days information is based on criteria for determining future purchase / production

For example, when you start a new business or establishing a sales company and you start trading products, you will take the next step.

1.Establish sales prospects

2.Build Purchase / Production Plan

3.Plan inventory

4.Plan inventory turnover days

The table below summarizes the achievement of Product A.

In the plan, the level below 30 days of inventory turnover days is considered appropriate.

Purchase / production can be changed 4 weeks ahead.

Sales: Initially exceeded plan but went downwards from 6th to 9th week.

Purchase / Production: Increased for 4th to 5th week, but after that, adjusted due to slowdown of sales.

Inventory turnover days: calculated by (weekend stock) ÷ (preceding 4 weeks sales) × 28 days

It will be a trigger to make purchase / production adjustments to fall below 30 days.

Inventory turnover days is important as an indicator for assisting decision-making as management accounting. Although the above was only Product A,