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IJPDLM 30,1

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Received April 1999 Revised September 1999

Evaluating inventory management performance using a turnover curve

Weatherhead School of Management, Case Western Reserve University, Cleveland, Ohio, USA
Keywords Logistics, Supply chain, Inventory, Warehousing Abstract Managing inventory levels in the aggregate is a common concern of senior management. A generalized formula (turnover curve) developed in previous research that mimics practical inventory control is used to audit inventory control performance of inventories in the aggregate and at multiple stocking points. The same turnover curve is used to estimate the impact of changing the inventory control procedures or to set new targets for inventory levels. It is a simple yet powerful tool for evaluating inventory managerial performance that can be developed from readily available company data. This research provides additional examples to further validate the practical usefulness of the turnover curve.

Ronald H. Ballou

International Journal of Physical Distribution & Logistics Management, Vol. 30 No. 1, 2000, pp. 72-85. # MCB University Press, 0960-0035

Introduction Are our inventory policies producing the desired inventory turnover? How much inventory will there be if we add another warehouse? Or consolidate inventories into fewer warehouses? What is the inventory investment impact if we increase our inventory turns? How good is our inventory management performance? Senior management asks these questions about its inventories. Since inventories represent a significant investment by many firms, and with annual carrying costs typically ranging from 20 to 40 percent of inventory value, managing them well is a top-management priority. In practice, it is common to apply replenishment rules to manage each item in inventory at each stocking point. Familiar procedures are economic order quantity (EOQ) based methods, just-in-time methods such as materials requirements planning (MRP), or variants of push and pull procedures. (For a review, see Ballou, 1999, chapter 10.) The application of these methods produces an overall level of inventory that senior management typically judges in terms of an inventory turnover ratio (annual sales/average inventory) or a total asset level. Auditing the overall performance of these policies, or projecting the effect of a change in the policies, is difficult if there are thousands of items in inventory at multiple locations and item-level methods are used. In this article, it is shown that inventory management performance auditing can be accomplished at the aggregate level by using a formula described as the turnover curve. The relationship between average inventory and facility throughput was first reported by this author in 1981 and will be referred to subsequently as previous research (Ballou, 1981). At that time, a limited number of independent

examples were available to determine the accuracy in applying the relationship to actual data. Data were obtained from warehouse location studies, where estimating inventory level changes with the various numbers of locations was important to such analyses. Since then, additional examples have been collected for a variety of firms from this author's own consulting work and from a case study reported by the Harvard Business School. These data are used to further confirm the accuracy of the turnover curve and to illustrate its usefulness beyond location studies, where it seems to have found its greatest application. The turnover curve It has been shown in the previous research that a formula of the general form IT
N X i1

Evaluating inventory management 73

w mDi aDib

where IT = total network inventory, units or $; Di = annual stocking point throughput at location i, units or $; N = number of stocking points at which the products are held; and w; m; a; b = constants to be determined from the particular inventory being modeled can be used to estimate the total amount of inventory in a multiple stocking point network. This formula replicates the inventory-level results of various inventory policies used in practice. The terms in the equation have the following general meaning: w = the average amount of promotional, speculative, obsolete, or production overrun stock at a stocking point. mDib = the amount of safety stock at stocking point i. aDi = the amount of regular stock at stocking point i, but may also represent some safety stock. Since the coefficients within the model are determined by fitting the formula to the inventory turnover ratios at the stocking points in the logistics network, the formula is referred to as a turnover curve. Note: The theoretical development of this formula is explained in the previous research (Ballou, 1981) and is not repeated here. Equation (1) represents a variety of inventory policies. These policies typically range from EOQ-based ones (inventory levels increase at a decreasing rate with D) to stock-to-demand types (inventory levels increase at a linear rate with D and there is no significant amount of startup stock, i.e., w (% 0). The practical range of the formula is for b = 0.5 with w = 0 and m = 0 to b = 1 with w = 0 and m = 0. N P b The levels of well-managed inventories could be expressed as IT aD1 i1 with b % 0.7, as noted in the previous study.

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Although the turnover curve can represent a variety of applied inventory policies simply by manipulating the terms in the formula, the forms of the N P equation most useful in practice are the linear form, IT w mDi , where N P i1 aDib . Where w > 0, the w sometimes may be zero, and the power form, IT linear and power forms may similarly represent the relationship of inventory levels to the demand placed on them. Including additional terms of equation (1), while sometimes offering a better statistical fit, frequently results in difficult problems of interpretation. They may be used, but are not recommended unless the meaning can be explained. The exponent b to which Di is raised in the power form of the turnover curve gives insight as to the replenishment rules being used and as to their performance. When the exponent on Di is 0.5, i.e. Di0:5 , inventories are likely to be managed based on EOQ principles. This extreme value occurs when no safety stock is maintained in the system, i.e. cycle stock is dominant, and, hence, represents the lowest value of b that can be expected. Recall that in the p economic order quantity formula (Q 2DS=H ) the order quantity Q is the square root of the demand D. Since the average inventory level is Q/2, the average inventory level is related to D0:5 . (This policy also may be approximated in equation (1) where w > 0, m > 0, and a = 0.) Consider a practical example:
A specialty chemical company acquired a computer software package to forecast item sales and an inventory control package to manage its finished goods inventories in 22 warehouses. Inventory control was a trigger-point method with item replenishment quantities being determined by EOQ principles. All warehouses carried the same mix of products, although slow moving products were held only at plants. The power function of the turnover curve showed a b = 0.58, which is consistent with the firm's inventory policy.
i1

On the other hand, when the exponent b is 1 in the power form of equation (1), the stock replenishment rules produce inventory levels in direct proportion to the stocking point throughput (stock-to-demand policy), such as with a stocking rule that maintains inventory levels at a given number of days of demand. Consider the following example:
A cement producer stocks bagged concrete at 18 distribution points (Bodegas) to serve the demand of construction sites throughout Mexico. The inventory policy is to maintain inventory at a two-day supply level. From the inventory turnover ratios for these Bodegas, a linear turnover curve is the best fit with a small intercept value representing a slight deviation from the general nature of the inventory policy. Actually, 3.6 days of supply was being maintained.

The directly proportional inventory policy frequently occurs in practice, probably because it is simple to understand and execute. It may also be represented in equation (1) where P= 0 and aP0 leaving the mD term. That is, w = equations expressed in the forms mDi and aD1 are the same. It makes little long-run sense when using the power form of the turnover curve for b to be greater than 1, since stocking points with high throughputs

will hold disproportionately more inventory than low throughput points. This situation sometimes occurs in the short run where goods are stocked in anticipation of demand. For example:
The military will order goods from manufacturers used to meet demand that occurs over a future short time span, such as in a military conflict. The supply of these goods moving into stocking points may span several years. Although stocking levels eventually will be depleted by demand or product obsolescence, observing inventory levels over the time period of a year will show that they are increasing relative to demand.

Evaluating inventory management 75

However, a b of 1 is the highest practical value to be seen in most commercial operations since increasing inventory levels relative to demand (b > 1) cannot be supported indefinitely. Previous research (Ballou, 1981) has shown the typical value of b in the power form to be 0.7 for inventory levels that grow at a decreasing rate with the amount of demand placed on them. This was determined by averaging the b values for all the data samples where the inventory-throughput relationship was best described by a power function. Seven new company examples of the current study show b to average 0.73. Since the standard deviation is approximately 0.1, the differences in b values between the two studies is statistically insignificant. This confirms the earlier result. Thus, a b value of 0.7 is a good average value for what many firms are able to achieve when their inventory policy is to have stocking levels that increase disproportionately with demand. It serves as a reference value for what is likely to be achieved with the execution of EOQ-based inventory policies. Constructing a turnover curve Data used in developing a company's turnover curve are generally available. Stock status reports that show inventory levels and shipping volumes are a common source. Different curves should be prepared for significantly different items, but similar items may be classified together and plotted as a group. Items that are similar would be determined according to the stocking rules applied to them. For example, only A items of an ABC classification should be plotted in one graph. There should be at least three stocking points for each item class, but more is preferred for statistical significance. If data are collected for time increments of less than a year, say monthly, then inventory levels should be averaged and throughput should be summed to represent a year. This averages out seasonal variations and unrepresentative data shifts that can occur between short time periods. Variability may be reduced by plotting annual data, but plotting monthly data may, at times, provide better insight as to the nature of the turnover curve. Care should be taken to separate inventory according to its function. If a warehouse (or plant) inventory serves local customers, as well as supplying other warehouses in the network, only that portion of the stock maintained to serve customers should be included in the plotted data, assuming that the turnover curve is being constructed for finished-goods inventories. The types of inventory may be separated by proportioning the inventory according to the shipments for each.

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To illustrate, consider the inventory of a specialty chemical company that produced metal coating chemicals for corrosion prevention. The company sold to industrial customers in bulk quantities, and in lesser quantities through a telemarketing program. The smaller-quantity orders were filled through nine warehouses, whereas the larger orders were supplied from a single plant. The inventories in the nine locations were managed by an EOQ-based reorder point system. Warehouse stock replenishment orders were filled from the plant. Plotting the turnover ratios for each warehouse produces Figure 1. Fitting regression lines of the linear and power forms shows the power form to have the highest adjusted correlation coefficient. The turnover curve has the equation of IT 4:72Di0:611 . The line fit is only moderately good with an adjusted correlation coefficient of 0.77, meaning that the execution of the company's stocking rules is only moderately consistent throughout the warehousing network. The exponent b = 0.611 in the turnover curve indicates a strong consolidating effect in the inventories. That is, if the number of stocking points was reduced, there would be less total inventory than in the original nine stocking points. Auditing and inferring with the turnover curve A primary use of the turnover curve is to audit inventory management performance. A company may employ well-defined inventory management rules that are imbedded in computerized inventory control systems, use rules based on judgment, or apply rules that are a combination of these. Inventory levels may deviate from those expected based on the rules being applied. The extent of the deviation will not be known unless an item-by-item analysis is conducted for each item stocked at each warehouse to establish a benchmark

Figure 1. Inventory turnover for a specialty chemical company's nine warehouses

against which current stocking levels may be compared. This analysis can be time consuming and is usually not carried out. The turnover curve is a good alternative to this evaluation process. Several examples are used to illustrate the audit process, with data taken from actual company files and reports. Each represents an independent and significantly different situation. The auditing process involves answering several key questions: . What is the nature of the best curve to fit the turnover data? Linear or nonlinear? . What is the value of the exponent b, if the turnover curve is a power function? How significant is w, if the turnover curve is a linear function? . How well is the current inventory management policy being executed? Example 1 Consider the inventories maintained by the California Fruit Growers, a disguised name. Products of the company, e.g. dried fruits, were maintained in 24 locations around the country to supply retail outlets. Collecting data on the annual shipments from these warehouses and the average inventory levels held in them and then plotting the results gives Figure 2. The line of best fit is linear with a very low intercept value. Such a turnover curve indicates that the manner in which inventory levels are controlled is to set them in direct proportion to the demand on each warehouse. The inventory stocking policy might well be one where a forecast of the expected demand in a warehouse territory is made and replenishment quantities are determined by subtracting the quantity on hand from the forecast quantity. This stock-to-

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Figure 2. Inventories for the California fruit growers

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demand type of policy produces a constant turnover ratio for all warehouses. The policy is simple and easy to execute, which probably is the reason for its use. The high correlation coefficient of 0.96 indicates that the inventory policy is being well executed. Except for perhaps one data point, the turnover ratio for each warehouse is near the turnover curve. A question to be raised is whether the stock-to-demand policy is the correct one to be using. This will be answered subsequently. Example 2 The Polaroid Corporation maintained inventories of instant photographic products in a central warehouse and ten subsidiary warehouses throughout Europe to supply consumers and commercial customers. The central warehouse replenished the subsidiaries, which in turn supplied retail, wholesale, and industrial locations. Each warehouse served a national market within the European Economic Community (EEC). From data on sales and inventory investment levels, turnover ratios were determined for each warehouse. Data for this example are from a case study on Polaroid (Harvard Business School, 1995). The results are graphed in Figure 3. The linear and power curves fit the data equally well with an adjusted correlation coefficient of about 0.80. Overall, the b value in the power curve is about average at 0.69, indicating typical inventory management performance for finished goods. There is moderate variation of the individual inventory turnover ratios, probably due to differences in the service levels and

Figure 3. Inventory turnover ratios for ten European warehouses of the Polaroid Corporation

replenishment rules used within each country of the EEC. The inventory control rules are fundamentally sound with b % 0.7, but the company would likely benefit from more consistency in their application. Example 3 Pharmaceuticals is a high-valued product line of a major drug-store chain. It is one of four product categories into which all line items are classified. Supplies are maintained at five warehouses to serve individual retail outlets. Figure 4 shows a plot of warehouse inventory turnover ratios, in this case as monthly ending inventory and monthly throughput that has been annualized. The inventory control rules are being consistently executed, as indicated by a correlation coefficient of 0.97. However, the b value of 0.86 in the power curve suggests that inventory levels are nearly proportional to the warehouse throughput. Since the product line is of high value, there is a concern that the inventory policy being used is not producing the desired economies that one would expect. That is, there should be a greater taper in the power curve with a b value between 0.5 and 0.7. There should be disproportionately less inventory as throughput increases. Other observations Occasionally, b values in the power form of the turnover curve that are outside of expected values will be seen. A b value of less than 0.5 in a well-defined data set is not theoretically possible using current inventory control procedures. A 0.5 value occurs when EOQ-based pull procedures are used, there is no uncertainty in replenishment lead times or in demand, and the inventory

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Figure 4. Inventory for pharmaceuticals in the warehouses

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control rules are not violated. On the other hand, a b value greater than 1 occasionally occurs. This means that larger warehouses are taking disproportionately more stock than the smaller ones. When developing the turnover curve, the classification of the items may be too broad or the function of the stocking point may be misrepresented. For example, if the inventory-throughput data represent all inventory items within the ABC classification, then the assumption is that all items are stocked at all warehouses. In practice, each item class is more likely to be managed differently and is not likely to be placed in the same warehouses as other item classes. The larger warehouses may contain all item classes, whereas the smaller warehouses may contain only A items. Also, some warehouses may have a dual role, first as a field warehouse whose purpose is to supply customers, and second as a regional or plant warehouse to restock field warehouses. More inventory is likely to be held in the dual-function stocking points than in the single-function ones. In both of these cases, distortion in the turnover curve will result. It is possible that the turnover ratio is so low in the larger warehouses relative to the smaller ones that inventory levels appear to increase with higher throughputs rather than decline. The remedy is to carefully prepare the data to represent a consistent product class and inventory function in warehouses. Estimating with the turnover curve Another use of the turnover curve, in addition to auditing, is to estimate the effect of bringing errant stocking points in line with existing inventory policy and to project the benefit of changing inventory policy. Errant points Figure 5 illustrates the inventory turnover ratios for specialty chemicals. Seven warehouses stock the company's product to serve customer demand, but three additional inventories are maintained at plant locations. The plant locations hold dual-purpose inventories that serve local customers, but they also are used to replenish the inventories of the seven field warehouses. The plants are Atlanta, Detroit, and Los Angeles, with the inventory for the plants in Figure 5 representing only that which filled the field warehouse function. The turnover ratios were substantially different for the plant warehouses as compared to the field warehouses. According to company personnel, there were EOQ-based stocking rules in place at the warehouses, but the plant managers controlled inventories using their own rules. As can be seen in Figure 5, the Atlanta and Los Angeles plants have low turnovers, probably reflecting a riskaverse strategy in inventory management. The turnover ratios are 1 and 2, respectively. The Detroit plant manager minimizes inventories, perhaps at the expense of higher than normal customer service failures, but the inventory has

Evaluating inventory management 81

Figure 5. Inventory turnover for a specialty chemicals company

a high turnover ratio of 18. What would the net result be if these disparities were eliminated, i.e. the plant warehouse inventories were brought in line with the turnover curve shown in Figure 5? Moving the plant inventory levels to those estimated by the turnover curve gives the results shown in Table I. Encouraging the plant managers to follow the inventory policy established for the field warehouses can reduce the company's average inventory by 255,000lb of chemicals. Changing the inventory policy A food processor manufactures and distributes numerous food products to retail outlets. Dry grocery inventory is located in ten stocking points as shown in Figure 6. A linear turnover curve has a very high adjusted correlation coefficient of 0.98, indicating a consistent execution of the company's inventory control rules. The low intercept and the linear curve signals that the inventory policy was a stock-to-demand type, which was verified by the company. In fact,
Current average inventory, 000s lb 395 380 30 805

Plant Atlanta Los Angeles Detroit Notes:

a

Annual throughput, 000s lb 395 750 540

Estimated inventory, 000s lb 145 225 180 550

a

Change in inventory, 000s lb 250 155 150 225

145 = 2.5094D0.679 = 2.5094(395)0.679

Table I. Average inventory change for a specialty chemical company when plant inventory policy replicates that of its field warehouses

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Figure 6. Inventory turnover curve for a foods processor

inventory control was described as ``a ROP/ROQ with ROP equal to safety stock plus forecast over lead time, and ROQ equal to one week forecast for A items''. Although inventory control rules were well executed, they do not produce the expected reduction in inventory levels as the warehouse throughput increases. This example clearly shows that the two large warehouses are realizing about the same turnover as the smaller ones. Would EOQ-based inventory replenishment rules produce the expected economies of scale? Using a medium-size warehouse from the data set having a turnover of ten and a throughput of 3,500,000 cases as a reasonable midpoint, a power curve can be fit to this point. A power curve with a b exponent of 0.7 is used, since b = 0.7 represents a normative value for an EOQ-based inventory P control policy. Fitting the curve IT a i Di0:7 to the data gives the a P coefficient of 1.158 and a power curve formulation of IT 1:158 i Di0:7 . This curve is plotted in Figure 6, which, when used to project the inventory level for each warehouse at its current throughput level, shows revised turnover ratios. In this case, the larger warehouses show the greatest change. Whereas the overall turnover ratio was 10.9, it is now projected to be 11.7 with the change in the inventory replenishment rules. The turnover differences are shown in Table II with an overall increase in the turnover ratio in favor of the EOQ-based policy. Target turns It is common for management to target the number of turns that a system of warehouse inventories is to achieve. However, the turnover ratio for each warehouse should not be identical, unless a stock-to-demand inventory policy

is in effect. As was previously mentioned, the turnover ratios for larger throughput warehouses should be higher than for smaller ones, if all warehouses hold the same product mix and provide comparable levels of product availability. What should the target turnover ratios be for each stocking point? A major furniture company purchases furniture items from numerous vendors for sale through its retail stores. Inventory is maintained in eight warehouses. The turnover curve for the warehouse inventories is shown in Figure 7. The adjusted correlation coefficient is high at 0.93, indicating that the inventory policy, on the average, is being consistently applied across the eight

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Warehouse 1 2 3 4 5 6 7 8 9 10 Turnover

Throughput, cases (000s) 4,192 10,230 3,961 3,522 2,102 13,597 2,883 2,714 4,481 3,957

Existing turnover 10.35 13.03 13.34 10.00 11.87 10.32 9.42 10.73 10.75 9.29 10.91

Turnover ratio Existing fitted curve TO = Di/(12.8 + 0.089Di) 10.86 11.08 10.84 10.80 10.52 11.12 10.70 10.67 10.89 10.84 10.94

Revised policy, TO=Di/1.158D0.7 i 10.54 13.78 10.37 10.00 8.57 15.01 9.42 9.25 10.76 10.36 11.68

Table II. A turnover ratio comparison of the existing inventory policy and a revised EOQ-based policy for the example shown in Figure 6

Figure 7. Inventory turnover for a furniture retailer with a target turnover ratio and associated turnover curve

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warehouses. The b value, approaching 1, suggests that stock-to-demand replenishment policy might be in effect. The distribution manager described the method of restocking inventories as looking over the usage rates for the last eight months and projecting the sales rate for the next six weeks. The reorder size is based on the difference between the forecast and the quantity on hand. Order sizes are adjusted for those items that are to be placed on sale. The quantities for promotional items exceed the quantities typically ordered for these items. The current system-wide turnover ratio is 8.8. This is a stock-to-demand type of inventory control policy suggested by the nature of the turnover curve as fitted to the company's inventory data. Suppose that management wants to achieve ten turns per year system wide. There are two actions that can help to achieve the desired result. First, employ an EOQ-based inventory method of control that will reduce the b exponent in the power curve to at least a reasonable 0.7 value. Second, increase the turnover ratio in the warehouses until the target system ratio is achieved. Estimating the target turnover ratios for each warehouse requires constructing a new turnover curve. A reasonable target point is established for a mid-point or representative throughput level, and the throughput is divided by the target turnover ratio to give the target inventory level. The point is shown as in Figure 7. With the resulting estimated inventory for this point, solve the power curve for a using b = 0.7. Plot the revised turnover curve and compute the inventory levels for the throughput for each warehouse. The turnover ratios can also be found for each warehouse by solving the revised turnover curve for each warehouse throughput level, as shown in Table III. If the turnover for the system is not close enough to the desired ratio, revise the target point and re-compute until the target system-wide inventory turnover ratio is achieved.
Warehouse annual throughput, $000s $45,613 75,517 83,734 102,248 111,506 114,890 127,304 132,402 $793,214
a

Warehouse no. 1 2 3 4 5 6 7 8 Notes:

Current inventory level, $000s $5,079 10,472 10,860 12,144 11,887 11,772 13,159 14,856 $90,229

Current turnover ratio 9.0 7.2 7.7 8.4 9.4 7.8 9.7 8.9 8.8

Revised inventory level, $000s $5,670a 8,069 8,674 9,976 10,600 10,824 11,630 11,954 $77,397

Revised turnover ratio 8.0 9.4 9.7 10.2 10.5 10.6 10.9 11.1 10.2

Table III. Estimating inventory levels based on a target turnover ratio of ten

5,670 = 3.106(45,613)0.7

Conclusions It has been the intent of this article to provide additional data and examples to confirm and extend the previous research on the turnover curve. Several previous conclusions are given further credibility, specifically: . that the turnover curve is a reasonable representation of common inventory control policies; . that the normative exponent in the power form of the turnover curve is 0.7; and . that the turnover curve is a reasonable predictor of the type of inventory policy that a firm is actually using for individual item control. It is further observed that the linear and power forms of the turnover curve are the most valuable in expressing the types of inventory policies observed in practice. The turnover curve is a good representation of how inventories are being managed in the aggregate. Because of this, the curve provides good insight as to nature of the rules being used to manage inventory levels at multiple stocking points within a supply chain network. From the turnover curve, appraisals can be made as to how well a company's current inventory control rules are being executed. Good and questionable inventory control performance are easily seen in a plot of inventory turnover ratios. Projections can be made as to the possible benefit of bringing inventory management performance, as represented by inventory turnover ratios, in line with a company's stated inventory control procedures. In addition, these projections can be extended to show the effect of changing the manner in which inventories are managed. The turnover curve is useful in estimating the impact on system-wide inventory levels when a new target is set for the system turnover ratio. The turnover curve is easily developed from readily available data that a firm routinely collects. It is also a simple yet powerful tool for auditing inventory management performance and estimating the effect of inventory management change.
References Ballou, R.H. (1981), ``Estimating and auditing aggregate inventory levels at multiple stocking points'', Journal of Operations Management, Vol. 1 No. 3, pp. 143-53. Ballou, R.H. (1999), Business Logistics Management, 4th edition, Prentice-Hall, Upper Saddle River, NJ. Harvard Business School (1995), Polaroid Corporation: European Distribution System (Teaching note 5-696-044), Harvard Business School Press, Boston, MA.

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