Calculation Level
A simple inventory turnover ratio can be used to see how many times an inventory has been sold and replaced during the course of a year. This ratio is typically calculated at the financial statement level by dividing the total cost of goods sold by the average inventory balance. The benefit to this calculation is that the value is easy to interpret and the calculation can be done quickly with information readily found on a company’s financial statements.
While the ratio discussed above is certainly helpful, the analysis is benefited with additional detail. A sales report at the product family level indicating quantity and revenue, coupled with an inventory report, can be used with a slightly different calculation to determine the amount of inventory on hand relative to historical sales. This analysis expresses the supply and demand relationship at the product family level and better summarizes the calculation in terms of the amount of inventory on hand, as opposed to simply how fast it turns.
The most detailed level of the analysis is at the individual stock keeping unit (SKU) level. The analysis requires SKU level sales and inventory reports and can be calculated using the same methodology as the product family analysis. Sales activity, measured in such a fashion, is often utilized as an indicator of an individual item’s attractiveness. The benefit to this analysis is the detailed nature of the results.
The decision as to whether the calculation should be performed using summary, product, or SKU level detail ultimately depends on the data and time available as well as the intended use of the results. For example, competitive analysis and quick high-level tests would be well suited using the financial level calculation, whereas detailed analyses, such as those found in appraisals for secured lending purposes, would be more accurate and reliable using the detailed product or SKU level calculations. The product family level calculation is particularly useful for comparing types of products and is also a good solution when a detailed analysis is desired but SKU level information is not available or practical.
Duration of Sales File
The duration of the sales information used in the analysis can drastically impact the analysis results. For example, the typical analysis utilizes sales information from one full year. However, the results can be different depending on whether that year was the previous calendar (or fiscal) year versus the previous rolling 12-months. Similarly, the analysis results can be different if using abbreviated or extended sales information such as for year-to-date periods, a trailing fraction of a year, or a combined fiscal year and year-to-date timeframe.
Presentation
As is the case in most analyses, the presentation is equally important. Analysis results can be presented in a variety of ways, although the basic premise typically relates to two different types. One presentation expresses supply and demand as a single value whereas the other expresses the supply and demand in the form of a sell-through summary.
Usage
While the discussion above has focused on historical sales levels, the same calculation can be done using usage information rather than sales. While not an indicator of external demand, usage information when used in a supply and demand analysis can be a great way to assess internal inventory usage. The calculation can be particularly useful for raw materials and parts inventories where an understanding of historical usage and the balance of the inventory is particularly helpful.
Other Considerations
Other considerations that can impact the months-on-hand analysis that should be accounted for include new product introductions, make-to-order inventory, slow-moving or obsolete inventory, and open orders. These additional considerations (along with others) should be considered and possibly adjusted for in order to accurately analyze supply and demand as well as provide meaningful data for interpretation. While the supply and demand analysis is a mathematical equation, the point is that it should not be rigid and should flex with changing inventory and market conditions.
Conclusion
Clearly, a supply and demand analysis can be a valuable tool when evaluating an inventory. However, it is important to understand that there are numerous considerations that impact the analysis, the results presented, and therefore how the information should be interpreted. When performing a supply and demand analysis, it is important to understand the inventory, business, industry, and source data, in order to understand how the analysis should be constructed and what variables should be taken into consideration. Users of these analyses should understand how the analysis was conducted in order to fully understand the results.