I literally grew up in an environment of business. My uncle (Batukbhai) was a great guy and a fantastic salesman (in the best sense of the word). He was always in motion and wasn’t happy unless everyone else was as well. There was constant noise and activity in our office and warehouse. We lived by the motto, “when in doubt, run in circles, scream and shout”.
Unfortunately, Batukbhai was too busy to sit down and look at financial reports to see if we were actually making any money. He thought that as long as everyone was busy (or looked busy) all was well. Batukbhai confused activity with productivity. As long he was dead tired at the end of the day, he thought he achieved success. He was in business for the glory and not the money.
It took me a while to understand that this was misguided thinking and that the goal of a manufacturer should be to meet or exceed their customers’ expectations of product availability while maximizing net profits.
When we work with a new client we always begin by “dissecting” their inventory. One of the basic measurements we look at is the Turn-Earn Index which multiplies annual inventory turnover by the gross margin you earn. The Turn/Earn Index (T/E/Index) will help you balance turnover and profits. It highlights situations where high margins will compensate for low inventory turns. It will also bring to your attention situations where low margins are not compensated for by a high turnover of inventory.
Say, for example, you turnover inventory of an item four times a year and earn an average 30% gross margin on each sale of the product. That’s a T/E Index of 120 (four turns * 30% gross margin = 120). We get the same return on investment value if we turn the inventory of an item only twice, but make an average gross margin of 60% on every sale (two turns * 60% gross margin = 120). On the other hand, the stock of a product with an average margin of 20% has to turnover six times in order to achieve the same 120 T/E Index (6 turns * 20% gross margin = 120.)
The acceptable minimum turn/earn index is 80 (e.g. four turns at a 20% margin). But most manufacturers / distributors don’t want to operate at a minimum acceptable level.
Here are some statistics from our client base:
- To be in the upper 50% of manufacturers / distributors (based on profitability) you need a T/E Index of 120
- To be in the upper 25% of manufacturers / distributors you need a T/E Index of 150
- To be in the upper 10% of manufacturers / distributors you need a T/E Index of 180
- The higher the T/E Index, the better!
A similar measurement to the T/E Index is Gross Margin Return on Investment (GMROI). It also measures the profitability of your investment in inventory. GMROI is calculated by dividing gross profit dollars from sales in the past 12 months by the average inventory investment over the same time period:
Gross Profit Dollars from Past 12 Months ÷ Average Inventory Value
For example, if you earned $20,000 in gross profits from an average inventory investment of $10,000, your GMROI would be 200 ($20,000 ÷ $10,000 = 2.00). By convention, we eliminate the decimal point. In this example, you are earning $2.00 for every dollar invested in inventory.
Please note that while the Turn/Earn Index and GMROI both measure profitability, they do so based on two different scales (sort of like Fahrenheit and Centigrade temperatures). The acceptable minimum GMROI is 100. Compare the calculated T/E Index and GMROI using the following data:
- 12 Mo Sales Dollars $8,000
- 12 Mo COGS Dollars $6,000
- 12 Mo Gross Profit Dollars $2,000
- Gross Marg ($2,000 ÷ $8,000) 25%
- Average Inventory Value $1,000
- Turnover = ($6,000 ÷ $1,000)
- 6.0 Turns per Year
- T/E Index = 6.0 * 25% = 150
- GMROI = 2,000 ÷ $1,000 = 200
Because they utilize different scales, the GMROI will always be greater than the corresponding T/E Index. It doesn’t matter whether you calculate a T/E Index or GMROI. Either is a wonderful gauge of the profitability performance of your investment in stock inventory.
To know more about how The Idea Smith lean principles and PDCA methodology can help your company improve profitability by reducing lead times, costs and wastes while increasing throughput and customer satisfaction , get in touch