Understanding Metrics: Inventory as a Percentage of Sales

By Dan Zeiger, Institute for Supply Management

Since the start of the coronavirus pandemic in 2020, inventory managers have chosen — or been forced — to become more familiar with certain dynamics regarding their supply stocks, and that includes this month’s metric.

Under normal business conditions, inventory as a percentage of sales is a purview mostly of the accounting department, which is especially attentive to the money tied up in carrying stock, especially when revenue slows. But when COVID-19 caused companies to scramble for supply, with many abandoning a just-in-time (JIT) strategy to carry more safety stock, such measurements became everyone’s business.

“Since it was so hard for companies to get their hands on inventory or raw materials for finish goods, that metric may have been artificially low,” says Tracey Smith, MBA, MAS, CPSM, president of Numerical Insights LLC, a boutique analytics firm in Williamsville, New York. “And when you’re carrying more safety stock, that would swing the metric back up.

“As things get back to a more normal state, that metric will probably be somewhere in between, definitely more realistic than what was thrust on companies (by the pandemic).”

Amid more stable business conditions, Smith says, inventory as a percentage of sales is a good gauge for supply managers to continue tracking, especially for companies expanding and adding more stock-keeping units (SKUs). It helps companies keep their inventory levels in line with sales, better identify demand trends, prevent overstocking — and maximize profits.

Meaning of the Metric

Inventory as a percentage of sales (also known as inventory-to-sales ratio) is a self-defining metric, measuring how much stock a company has in relation to how much is sold. It can be measured for overall inventory and a single product or SKU; the formula is a simple fraction, average inventory (in dollars) divided by net sales.

As this space has explained often, inventory management is a tightrope, no more so than in the COVID-19 era. This metric — especially when used in tandem with inventory turnover ratio, inventory carrying cost, inventory age and safety-stock level — gives supply managers a tool to help keep their balance.

A consensus ideal inventory as a percentage of sales is 20 percent to 40 percent, and that’s the sweet spot for such retail giants as Amazon, Walmart and Procter & Gamble. However, Smith employs no benchmarks for the smaller companies that make up her clientele, she says: “Since our goal is continuous improvement, we focus more on how this metric is trending than its specific value today.”

A lower inventory as a percentage of sales will likely translate into happy numbers for other metrics: More sales per item should lead to higher inventory turnover, a lower percentage of aging inventory, and lower inventory carrying cost.

The latter metric was less of a priority for much of the pandemic but its returning to the front burner as JIT principles resume. Some of those principles my be modified, however, as at many companies, the definition of JIT is different than it was before COVID-19. “In many ways, we’re not doing JIT on the same supply chain as before,” Smith says. “It’s definitely an item-by-item strategy. Companies determine which raw materials can be done JIT, but there are still others where they can’t afford the risk.”

How the Metric Goes ‘Out of Whack’

There are many reasons for a rising inventory as a percentage of sales. An expanding company adding more SKUs, Smith says, “may not have the product rationalization discipline to keep the number of SKUs manageable. That means finished-good SKUs, but that impacts the number of raw material parts that have to be carried as well.”

She continues, “When that happens, the cost to inventory tends to rise. And if there are certain products that aren’t selling as well as they used to, then the inventory as a percentage of sales will get out of whack.”

Some of Smith’s client companies have bundled products, which adds to SKUs. “For some, that increased inventory as a percentage of sales,” she says. “At that point, they had two choices: reduce the number of bundles or drill down into the individual items and see which ones are becoming less popular and/or are reaching the end of life.”

But no matter how well a company manages inventory, business conditions and market forces — particularly sluggish consumer demand — can impact the metric. In recent months, that dynamic has been reflected in the Manufacturing ISM® Report On Business® Customers’ Inventories Index, which measures the amount of product on shelves.

The index has risen 26.4 percentage points from its all-time low of 25 percent in July 2021 to 51.4 percent in May, the highest reading since September 2016, when it registered 52.5 percent. A reading above 50 percent (in “too high” territory) is generally considered a bad sign for future demand.

“It may just be as simple as demand,” Smith says, “especially if you’re used to carrying inventory in a certain level of dollars. If sales drop off, that metric is going to rise.”

Working With Safety-Stock Level

Inventory as a percentage of sales can easily be tracked by an enterprise resource planning (ERP) system and tailored to a dashboard, Smith says. Many companies try to quickly spot trends and mitigate demand volatility and measure it on a weekly or monthly basis.

To work effectively with safety-stock level and reorder point, she adds, the monitoring frequency must be in sync.

“Some companies calculate the safety stock and reorder point once a year or maybe every six months,” she says. “It largely depends on whether the ERP system wants a fixed or dynamic number. A dynamic (safety stock) number would mirror lower sales. But a system with a fixed number will force higher inventory levels. That will keep cost as a percentage of sales higher than you want it to be.”

Inventory management remains one of the most challenging supply chain disciplines. However, by understanding and lowering inventory as a percentage of sales, companies can walk the tightrope and gain valuable insights on how to better manage their stocks.

About the Author

Dan Zeiger is Senior Copy Editor/Writer for Inside Supply Management® magazine, covering topics, trends and issues relating to supply chain management.

Originally posted at the Institute of Supply Management. Click here to view the original posting.