“Inventory velocity is one of a handful of key performance measures we watch very closely. It focuses us on working with our suppliers to keep reducing inventory and increasing speed.” Michael Dell
To understand the importance of inventory management with clarity, we have to understand a key metric, inventory velocity. Simply stated, inventory velocity is the speed at which a business can move it’s stock. The speed at which a business moves it’s inventory will impact substantially on its profitability and ROI. Whenever the subject of inventory velocity is brought up, the example of Dell is almost certain to arise. Dell revolutionized the personal computer industry with it’s direct sales model. Michael Dell understood that in an industry where margins are low, and inventory depreciates rapidly, the only way to be highly profitable is the ability to improve inventory cycles faster. His business model hence eradicated the need for holding inventory to the absolute minimum, resulting in Dell becoming an industry leader.
Inventory velocity can be calculated by simply dividing the cost of goods sold by the average inventory for the period. This is a benchmark all businesses should watch very closely. When your inventory velocity is low as compared to your peers, this is definitely a red flag which management should take very seriously. Having excess inventory left over, poses a major risk to any business. The inventory experiences depreciation, holding cost and reduction in the price of the product. In my experience getting rid of old inventory in the market place is a very challenging task. Therefore I recommend most businesses to have internal policies to deal with inventory which has not been moved a particular period of time say 12 months. These should either be disposed of or sold at whatever price the market will offer.
The concept of inventory velocity can also be applied in some cases to the services sector. For example, if you are running a consulting practice and bill your clients by the number of hours. The number of hours that are left outstanding at the end of a certain period of time, is your inventory. Inability to turn around your inventory quickly will result in massive cashflow gluts which can severly harm business operations. Lets say that one calculates on average the business settles outstanding balances in 90 days. What do you have to do to reduce the average to say 60 days? How will be the impact of the available cash flow? We have to think of ways to optimize our business operations continuously. As a younger company, this is always a challenge as larger companies take advantage of their clout. However keep track vigilantly of this key metric, and work on increasing it.