Page 189 - DMGT206_PRODUCTION_AND_OPERATIONS_MANAGEMENT

Production and Operations Management

Notes Inventory Turnover Ratio

In order to overcome this problem, inventory turnover ratio is used. This measure allows for
better comparison among companies. This is calculated as a ratio of the company’s sales to its
average inventory investment:
Inventory turnover = annual cost of goods sold/average inventory investment
This is a measure of how many times during a year the inventory turns over. Because it is a
relative measure, companies of different sizes can be more easily compared. A higher turnover
ratio reflects there are less idle resources in the company, and therefore the company is using its
inventory efficiently. This ratio can only be used in this manner to compare companies that are
similar.

Example: Even in the same industry depending on the distribution channels, a retailer
would have a much lower inventory turnover ratio than the wholesaler or distributor.

Notes Days of Inventory
A measure that tries to overcome the disadvantage, to a limited degree, and is closely
related to inventory turnover is ‘days of inventory’. This measure is an indication of
approximately how many days of sales can be supplied solely from inventory. The lower
this value, the more efficiently inventory is being used if customer demands are being
met in full. There are two ways of calculating ‘days of inventory’. It can be directly calculated,
or inventory turnover can be converted to days of inventory. Both procedures are shown
below:
Days of inventory = avg. inventory investment/(annual cost of goods sold/days per year)
Days of inventory = days per year/inventory turnover rate

Detailed measures of inventory accuracy and availability are very important in order to
maximize manufacturing and non-manufacturing efficiency and financial results. In
companies where consignment inventory programs have an important role, it is important
to measure the performance of these programs.
Inventory obsolescence measures can be very important for items with short shelf lives,
due to aging or technological changes.
Finally, collecting accurate data on which to construct inventory measures can be
challenging. Processes have to be in place to ensure that inventory is counted accurately
and on a timely basis.

9.4.2 Economic Order Quantity (EOQ)/Optimal Order Quantity

The optimum quantity (lot size) using a tabular approach is called the Economic Order Quantity
(EOQ). The order quantity at which the total cost is minimum (Q*) can mathematically be
expressed as:
As TVC(Q) = DS/Q + HQ/2 ...(1)

Differentiating the Equation
dTVC(Q)/dQ = - C R/Q + H/2 = 0
2

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