There are a lot of inventory performance measures you could track. These are the 10 most crucial metrics for SMEs – so you can get started on reducing inefficiencies and cutting costs.
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In this article on inventory performance measures
Why use performance measures for inventory management?
If you want to make objective, evidence-based strategic decisions about what to do with your business, you need to be using real inventory KPIs.
These quantifiable metrics take all the guesswork and ‘gut feel’ out of your processes and can show you clearly – in real time if you’ve got the right inventory management software – where your inefficiencies are, and what’s costing you more money than you realise.
Using inventory performance metrics can lead to:
- Happier customers – who get what they want, when they want it, at the price they’re willing to pay.
- Healthier profit margins – because you’re taking pressure off your profits by finding money pits and red flags.
- Running a leaner business – as you’ve got a better grip on your inventory and processes, enabling you to trim the fat.
- Better decision-making – as you can make decisions with data, rather than gut feelings.
The 10 most crucial inventory performance metrics for SMEs
1. Lead time
Lead time is one of the most common performance measures you’ll likely use. It measures the time it takes to complete a process from start to finish. In the manufacturing space, for example, it commonly describes how quickly a business can manufacture its product from receiving a customer order through to shipping.
Lead time can be important to finding inefficiencies. By using it over time, you’ll be able to compare your current lead times to previously established benchmarks – perhaps your average lead time, or an agreed target. If you drop below the benchmark, it’ll show you that something has happened to slow you down.
- Reduce lead time to… streamline operations, cut operating costs, improve customer satisfaction rates (speed of delivery).
- Increase lead time… and order handling costs go up, and customers may be dissatisfied with the slower speed of delivery.
How to calculate lead time
Lead time is calculated by adding up the combined time – in hours, days or weeks, depending on the company – of the combined tasks that make up a process. Lead time can cover the entire end-to-end production process, or segments of it.
Different types of lead time
Customer order lead time covers every single process in manufacturing, including order handling and delivery times. But manufacturing lead time covers the period from when a sales order is received to when a product is ready to ship. Delivery lead time covers the period from when a product is ready to deliver to the moment it has been delivered.
2. Order cycle time
Order cycle time is similar to lead time in that it calculates elapsed time. However, cycle time covers specific tasks, not wider processes. You would use cycle time to determine the time it takes to complete one task for one unit – from beginning production through to having that single unit ready to ship, including wait times that occur during this process. So cycle time is often calculated not as minutes or hours, but minutes or hours per unit.
This performance metric is also useful for determining process efficiencies, as well as overall equipment effectiveness (OEE) and staff productivity. You’ll see how much effort goes into producing each unit, which can help you home in on finding inefficient work steps, staff who need more training or practice, broken equipment, ineffective floor plans – and so on.
- Reduce cycle times to… get more products out the door, faster.
- Increasing cycle times… can show you that something is slowing down production.
How to calculate cycle time
Cycle time is calculated by dividing the total manufacturing time of a product by the number of units:
- Cycle time = (Hours spent on task per day x total days in time period) / number of units
Learn more about the difference between cycle time and lead time.
3. Cost of goods sold (COGS)
COGS calculates the total amount that your business has paid to produce its product or service. That is, COGS covers the direct costs of making a product – so raw materials, labour, packaging, purchase cost from a wholesaler, and so on. It does not include indirect costs, such as marketing or overheads.
This is a great metric to track as it tells you your break-even point. Sell your product for any lower than your COGS and you can start to lose money.
- Higher COGS… can lead to lower profit margins, or a higher price for customers.
- Lower COGS… represents a lower break-even point, offering wiggle room for pricing and discounts.
How to calculate cost of goods sold
To calculate a product’s COGS figure, you will need to know the total value of your inventory at the beginning of a time period, as well as any purchase costs accrued in that period. Then you will need to know the inventory value at the end of the period.
- COGS = (Beginning Inventory Value + Purchases Made) – Final Inventory Value
Learn more: Five Effective Ways to Reduce Cost of Goods Sold
4. Gross profit margin
Gross profit is the amount of capital your business retains after it has sold its goods, but before deducting operating costs.
While this figure may not prove overall business profitability (which would include all costs), it’s a great indicator of the profitability of your revenue-generating activities specifically (e.g. manufacturing).
Meanwhile, your gross profit margin is this figure expressed as a percentage. That percentage is the amount of revenue retained per dollar by your company. This profit can be used for other important activities, such as paying debts and operating costs.
- Higher gross profit margin… leads to more money to spend on other things, like paying people a higher wage.
- Lower profit margin… means the business must run a little more lean to trim the fat. There’s less wiggle room.
How to calculate gross profit margin
Gross profit is calculated by subtracting COGS from revenue (net sales). To get this as a percentage, we then divide that final figure by revenue:
- Gross profit margin = ((Net sales – COGS) / Net sales) x 100
Read more on how to calculate profit margins.
5. Product performance
While we’re on the subject of profitability, let’s talk about product performance. As a part of understanding the success of your business, you must understand the success of each individual product. By using various KPIs to track products, you can identify your top-sellers and – perhaps – products that sell so poorly that you could stop selling them at all.
Understanding product performance is critical to cost efficiency. Your overall gross profit margin might look like it’s in the black, but if you break it down by product, you may find that some products are costing you rather than earning, and they’re just being propped up by your top performers.
- Finding top-performing products… helps you prioritise sales and marketing budgets to focus on guaranteed wins.
- Finding low-performing products… can help you direct budget to better marketing your goods, or you may drop them entirely.
KPIs to help you calculate top- and bottom- performing products
You can’t just look at revenue to understand performance. After all, your business may ship low-price, high-volume goods which will never appear to generate a lot of per-product revenue, but they still account for most of your business.
Consider comparing a variety of KPIs, such as:
- Product sales revenue
- Number of units per order
- Average order value
- Return rates per product
- Inventory shrinkage per product
- Change over time for any of the above
Of course, to track these, you’ll want reliable and up-to-date data – we’ll talk about how to get this below.
6. Days sale of inventory (DSI)
Days sale of inventory is a metric to understand how long it takes (in days) to sell through your inventory. It may also be referred to as average age of inventory.
The longer you carry inventory, the more it costs your business (see ‘carrying costs’ below). Often, by lowering your DSI you may be able to reduce inventory-related costs and in this way, increase your margins. Put another way, DSI can be an indicator of strong sales.
- A low DSI… can mean your carrying costs are also low, and you have strong sales figures.
- A high DSI… can mean that you’re spending more on keeping hold of stock, or that sales have slowed.
But there are exceptions to this. To learn more about when a higher DSI might be a good thing, read our more detailed explanation here.
How to calculate DSI
To figure out your DSI, you will need two figures: your average inventory value and your COGS. Average inventory value is just the value of your inventory at the beginning of a time period plus the value at the end, divided by two. Typically we use a period of a year (365 days) or a quarter (90 days).
- Days sales of inventory = (average inventory ÷ COGS) x 365 (or 90, depending on the period)
7. Inventory carrying costs
Your inventory carrying costs – AKA holding costs – are every cost associated with the holding of stock. That can include the cost of the raw materials as well as warehousing, labour and utilities, but it goes beyond that to service costs such as IT, or costs associated with inventory risk (like shrinkage – see below).
A lot of organisations fail to realise the very serious nature of carrying costs. They can make up as much as 25% of the value of a product, and inform a lot of other metrics: COGS, optimal stock levels, and optimal reorder points are all impacted by carrying costs.
- High carrying costs… can be an invisible money pit draining profit from the business if not managed properly.
- Low carrying costs… leave more revenue wiggle room for other costs and investments, and help a business run lean.
Learn more about reorder points: Economic order quantity explained + formulas & how to use them
How to calculate inventory carrying costs
Carrying cost as a metric is the total of four different components, divided by average inventory value for a set time period:
- Inventory carrying cost = (Capital costs + inventory service costs + inventory risk costs + inventory storage costs) / average inventory value
Breaking this down, the components are:
- Capital costs: The cost of products and/or materials, in addition to other factors such as interest and loan maintenance fees.
- Inventory service costs: Extra costs related to holding products, such as IT hardware or software, tax and insurance premiums.
- Inventory storage costs: Those costs associated with owning and operating a storage facility (including shipping).
- Inventory risk costs: Any cost that might reduce the value of your inventory or its saleability. This includes shrinkage, error, theft and loss of product value (e.g. through obsolescence).
8. Inventory backorder rate
Backorders can be seen in both a positive and negative way. In a positive way, backorders could suggest that your products were more popular than anticipated and so you’re making lots of sales. Conversely, it could show a lack of accurate forecasting or a high degree of production inefficiency, meaning you’re not able to keep up with demand.
An increase in backorders can increase your backorder costs as well as customer dissatisfaction, so it’s important to keep an eye on this. To do that, you can measure your backorder rate, which is the percentage of sales that cannot be delivered immediately, but will be delivered later in a given time period. If this creeps up or remains steadily high, there may be a problem.
- A high backorder rate… may indicate product popularity, or inefficiency and lack of accurate forecasting (or both). Either way, customers are waiting and this can lead to dissatisfaction.
- A low backorder rate… is an indicator of stability. Your company is fulfilling the orders it receives. This would need to be compared to other metrics (e.g. shrinkage and carrying costs) to determine if this stability is good or bad for your bottom line.
How to calculate backorder rate
You’ll need to know how many orders went unfulfilled in a given time period, as well as the total number of orders in that same period. From there, the calculation is quite simple:
- Backorder rate = (Number of unfulfilled orders / total orders) x 100
9. Return rate
Return rate represents the number of goods returned to your business after being sold, expressed as a percentage. While simple to calculate, it can be tricky to get good data from this metric when used on its own.
This metric is useful for gaining a quick understanding of how many of your products are coming back. But return rates can increase or decrease for all sorts of reasons, which may be partially out of your control. Some industries, for instance, just have naturally higher return rates. You must understand not just the frequency of returns, but the root cause of the frequency.
- A higher return rate… could mean that people are dissatisfied with your products: they’re breaking easily, they’re faulty, customers struggle to pick the right product for their needs, or it may be a natural by-product of purchasing habits in your industry.
- A lower return rate… can lead to more stable profits for the business, as there will be fewer complex costs associated with the reverse supply chain.
How to calculate your return rate
Simply take the number of returned goods and divide it by the total units sold in a time period.
However, it’s often best to wait until the end of the returns period before calculating the metric. For example, if your goods have a 30-day window for returns, then you’d wait until this has elapsed before working out your return rate – or else it may need to be revised.
- Return rate = (number of units returned / total unit sold) x 100
Note: One thing you’ll also need to account for is whether or not you consider an exchange a ‘return’. If the customer exchanges one item for a similar one, is it considered ‘returned’ for your return rate? This is up to you and what you want to see on your inventory reports.
How to get useful information from a return rate
As mentioned, not all returns are due to manufacturing problems. It could be a customer’s personal preference. Different types of returns warrant different fixes, so before you can get useful information out of this figure you must understand why returns are happening.
Consider asking for a reason for the return at the point of return. From here, you can start to segment returns into different causes and determine return rates for each cause, which will better help you understand what to do next. A high number of faulty products requires a fix at the manufacturing end, whereas a high degree of products returned due to personal taste may be a marketing problem.
10. Inventory shrinkage
Inventory shrinkage refers to the amount of inventory that’s on your books or in your system, but which doesn’t actually exist in real life – or which does exist, but cannot be sold. This can happen for all manner of reasons, with product spoilage, damage, obsolescence and human error being some of the most common causes.
Instantly you can see why this is a vital metric to understand. Shrinkage is a big red flag KPI, showing you that you’re losing money. The more it creeps up, the more you’re potentially losing.
- High inventory shrinkage… indicates serious problems. This could be storage issues, human error, theft, or perhaps something unseen, like evaporation of liquids.
- Low inventory shrinkage… indicates that your business is moving through its products quickly enough that damage and spoilage does not have time to occur, or you’re particularly good at monitoring and counting inventory.
How to calculate inventory shrinkage
This is going to take a stock count, unless you have inventory management software and technology such as barcode scanners that helps you keep track of inventory in real time. You’ll need to know your real, saleable inventory value, as well as the average inventory value you have on your books.
- Inventory shrinkage rate = ((average inventory value – value of actual saleable goods) / average inventory value) x 100
Learn more: The 5 Ps of Inventory Shrinkage
How inventory management software simplifies KPI tracking
If you’ve read through this article and thought, “How do we even get that data without spending hours in a spreadsheet?” then you probably need software that’s designed for the task.
Modern business needs modern solutions, and inventory management is no different. All of the metrics listed above have a very important place in a business. Even if you don’t track them all, just being able to track even half can seriously improve profitability.
This is where inventory management software comes in.
Inventory management software can give you the real-time data you need on stock levels, materials use, sales orders, lead times, supply chain efficiency, and more. By connecting all of this information into one place, you make it easy to access the data and calculate formulas.
Of course, you can make those formulas easier with software, too. In fact, with the right business intelligence (BI) tool, you’ll barely need to know the formulas at all – just which button to press to calculate key performance metrics in an instant.