Inventory-turnover Analysis Its Importance for On-site

Food Service

by Dennis Reynolds

inventory-turnover analysis can tell you whether food is being used at

an appropriate rate and, just as important, whether some of it may be

“walking” out the door.

E ven before the now-popular inventory-management practices such as “zero inventory” and “just in time” became the standard in most manufacturing settings, some food- service managers were relying on inventory-turnover analysis as a valuable asset-management tool. The cyclical menus and the large number of food offerings of on-site food-service operations (e.g., busi- ness and industry, health care, and education settings) make inventory- turnover analysis particularly valu

Dennis Reynolds is a Ph.D. candidate at Cornell University? School of Hotel Administration c{derl7@cornell.edu~~.

0 1999, Cornell University

54 ~OR~E~~ HOTELAND RESTAURANTADMlNlSTfiATlONQUARTERLY

able to on-site managers.’ This is especially true now, given many on- site operations’ relatively complex menu cycles as compared to those used not too many years ago.

In simple terms, inventory turn- over is the cycle of using and replac- ing goods. Quantitatively, inventory turnover can be measured by divid- ing the dollar cost of food used dur- ing a period by the dollar value of the average inventory on hand dur- ing the same period. Inventory turn- over provides a measure of how long food remains in inventory. Inventory-turnover analysis is a measure of kitchen efficiency and, perhaps of greatest importance, is a tool that can help an operation to optimize its product-handling ef- forts. This is not to say that there is an ideal minimum or maximum ratio. Rather, proper analysis and the resulting operational changes should allow managers to maintain an opti- mum cycle of inventory turnover for their specific operations.

Inventory-turnover analysis is important because the manner in which inventory is managed trans- lates directly into an operation’s profitability. Inventory is a current asset that provides no return on investment until it is prepared and sold. Excess inventory, then, is a non-performing asset. To underscore this, one estimate suggested that every dollar of inventory represents at least 25 cents per year in terms of expenses related to financing, han- dling, storage, and insurance.*

Excess inventory can negatively affect profits in other ways. As every food-service manager knows, one of the difficulties in dealing with food

’ For a detailed discussion of the different segments of on-site food service, see: Dennis

Reynolds,“Managed-Services Companm,” Cornell Hotel and Restaurant Administration Qunrterfy, Vol. 37, No. 3 (June 1997),pp. 88-95.

‘William Wiersema,“Inventory: Horn Much Is Too Much?,” Electrical Appararus, Vol. 51, No. 7 (July 1998), pp. 40-42.

is its highly portable feature. In other words, too much inventory provides opportunities for theft. Furthermore, unnecessarily large inventories result in inordinate waste and increased labor costs ow- ing to the need to rotate and handle the food. Inflated soft costs such as utility expenses associated with re- frigerators and freezers can also result from overstocked inventories.

Too little inventory, on the other hand, results in menu items that can not be offered-what those in the manufacturing sector call “stock- outs.” In turn, customer expecta- tions are not met and the entire service experience is diminished. Or worse, inappropriate recipe substitu- tions are made that can result in low-quality products, thereby di- minishing customers’ confidence in product consistency.

Inventory analysis, therefore, is simply good management practice. Specifically, inventory-turnover analysis can serve as a valuable gauge of an operation’s efficiency and profitability. Owing to the adage of “slow and old or fast and fresh,” inventory-turnover analysis can aid operators in identifying problems related to inventory management and can help reduce associated costs.

Calculating Inventoty Turnover Inventory turnover can be calcu- lated as follows:

Food cost for the period Inventory

= turnover for Average inventory

value for the the period

period

For example, assume that Central Medical Center (CMC), a 250-bed, acute-care facility, has weekly food- related sales of $40,000 with an associated food cost of $15,000. CMC’s food-service department takes a physical inventory every week. For the targeted week, the average inventory value was $15,850

(i.e,, the inventory’s beginning and ending valuations divided by two). The inventory-turnover statistic for CMC, then, is:

$15,000 _ = 0.95 turns per week $15,850

Of course, a single week’s turn- over statistic is not a valid bench- mark for assessing overall inventory- management success. A more useful measure would be to calculate the inventory-turnover statistic over a multi-week period. It is important to note that this calculation can be applied to categories of food and even to individual food items in cases where problems with the inventory-management process are severe. Such analyses are especially helpful in identifying unexplained spikes in specific-item use, particu- larly for high-price items such as meat.

Some operators use variations of the inventory-turnover formula. For example, an eastern-U.S. regional managed-services company uses the period’s “budgeted food cost” as the numerator (rather than actual food cost), and “ending inventory value” as the denominator (as opposed to the inventory’s average value for the period in question). While provid- ing a standard benchmark, this par- ticular variation is less useful than other measures. Using a budgeted value for food cost (versus actual cost) implies that the budget is both accurate and representative of those changes that affect sales (e.g., sea- sonality). In practice, however, some budgets are prepared on an annual basis (for corporate purposes) and are simply divided by 12 to get a per-month figure (without regard for the needs of on-site operators who are trying to manage their business on a daily basis). Moreover, using a point-in-time value for the inventory fails to account for fluc- tuations over time of the inventory’s actual value.

Number, please? What is a satisfactory inventory-to-food-cost ratio? Some cost-control experts suggest that an appropriate ratio for food-service operations in general

Tlw periodic analg(sis is a shrruld be anywhere between one and f&e turns per month.3 In prac- tice, the best measure for an indi-

&~ll~~~h~~ tfiat EM lnd~te ?a& q-ion depend on its industry segment, menu design,

l&M s&or ~~~~~~ $!wltS salw ID&, and marketing strategies, among o*er factors,

i~~~~l~~~~ u&w ~ur~~~ In the on-site arena, the leading

managed-services companies have

~~l~~.~u i~$~~~ md e&&shed benchmarks for inven- tory turnover by segment. For ex-

recur '3 ~r~l~~. ample, an executive at AFUMARK told me that his operators in the business and industry (B&I) seg- ment strive for approximately two turns per month.4 He explained that that is a reasonable goal, given that many operations carry more than 1,500 &fferent inventory items to accommodate their diverse menu offerings.

interestingly, &MARK uses “total sales net of taxes” divided by “aver- age inventory on hand” to calculate its inventory turnover. ARAMARK'S alteration of the formula I presented earlier offers the advantage of using actual sales as opposed to food cost. (There’s an advantage because, in many cases, managers inaccurately estimate food cost based on incor- rect purchasing records or inaccu- rate inventory valuations; even worse, some operators may deter- mine food cost simply as a percent- age of sales.) On the other hand, using the ARAMARK formula makes a comparison among its B&I opera- tions meaningless, since sales can

3 Cursory discussions of inventory turnover can be found in many texts on cost controls. For

example, see: James Keiser, Controlling and Ana- lyzing Carts in Food-service Operations (New York: Macmillan, 1989), p. 209; and Paul Dittmer and Gerald Griffin, Principles ofFood, Beverage, and labor Cost Controls/or Hotels and Restaurmtr (New York: Van Nostrand Reinhold, 1984), pp. 137-139.

4 That is, using my equation, the month’s actual food cost + by the month’s average inventory = 2.

include a variety of non-food items. Likewise, contribution margins across menus may not be similar. For example, many outlets include gift shops or convenience stores that sell goods ranging from magazines to home-meal replacements. In addi- tion, some units may be subsidized, thereby altering the cost percentages of goods. Such variation confounds inventory-turnover analysis when comparing one operation with an- other. However, it’s certainly true that ARAMARK'S sales-based turnover statistic is valuable for comparing same-store inventory-management practices.

At Chartwells, Compass Group’s education-food-service division, operators in North America use a benchmark of five turns per month for large accounts (those with an- nual sales of at least $1 ,OOO,OOO). For small units in the education segment, inventory is monitored to ensure that it turns over at least twice per month. Company-wide comparisons are possible when ac- counts are grouped by sales levels. For elementary and high-school food-service accounts, having a district-by-district basis for com- parison is also useful.

Health-care-food-service opera- tors at Sodexho Marriott aim for between two-and-a-half to four turns per month, depending on the facility. Units with a high percent- age of retail activity (e.g., coffee shops and cafeterias) aim for the high end of that range. That range is fairly typical across the different subcategories of health care (e.g., acute care, long-term care). Refer- ring back to our example of CMC, the inventory-turnover calculation produced a ratio of 0.95 turns per week. If that turnover statistic is typical for the health-care operation, we can infer that the inventory is being relatively well managed (i.e., the weekly statistic of .95 compares to a monthly statistic of close to 4).

55 CURNEll HOTELANDRESTAUFiANTADMlNlSTRATlON QUARTERLY

Using the Turnover Statistic The actual usefulness of inventory- turnover analysis is perhaps greatest when monitoring a single opera- tion over time, particularly for self- operated units (i.e., those not run by a managed-services company, sometimes called “self 0~s”). Even if an operator regularly achieves similar levels of turnover, anomalies may indicate cause for concern. In Exhibit 1, for example, we see that the average monthly statistic for CMC is within the target range of from 2.5 to 4 for health-care op- erations. However, closer inspection reveals cause for concern.

CMC. For the first six months of the period under scrutiny, the operator maintained good inven- tory turnover, ranging from 3.6 to 3.9 turns per month. However, for the next several months, a disturb- ing pattern emerged. The inven- tory turnover for months 7 and 8 was only 3.5 turns per month, and declined further during the next four months.

Such a pattern indicates poten- tial problems. First, the inconsis- tency signifies erratic inventory management, which is undesirable under any circumstances. Second, the decline beginning at month 7 may indicate a change in sales or reflect other operational problems and warrants immediate investiga- tion. Third, the decline in turnover may be the result of employee theft or collusion in the inventory- valuation process. No matter what the cause of the decline, the peri- odic analysis is a bellwether that indicates when senior managers should investigate other operating statistics to identify and remedy the problem. (Of course, the cause may be innocuous, such as a change in vendor accompanied by a new delivery pattern. The point is to know when something different is happening, and to be prepared to do something about it.)

Stop! Thief! As suggested above, a key attribute of single-unit inventory-turnover analysis is that it provides a method for identifying problems associated with food theft, particularly if the theft is perpe- trated by an individual who has a role in the inventory-management process. Imagine an operation where the chef is supplementing his personal catering business by steal- ing food from his employer. Obvi- ously, such food losses will result in reduced profits, and that trend will be discovered eventually. Theoreti- cally, however, the chef could cover his actions in the short term by artificially inflating the inventory’s value whenever he is responsible for taking the physical inventory. In essence, he could simply report that the items he stole were still in in- ventory. Unless efficient requisition and invoice-monitoring procedures are in place, such behavior could go unnoticed for some time.’ Inventory-turnover analysis would indicate an erratic turnover trend, however, and quickly reveal his manipulation.

Exhibit 1

Month Turns par month

1 3.6 2 3.9 3 3.7 4 3.9 5 3.6 6 3.6 7 3.5 6 3.5 9 3.3

10 3.4 11 3.5 12 3.1

Hypothetical inventory-turnover information for Central Medical Center (as described in the text).

Returning to the CMC example (Exhibit l), a sign that theft may be the problem is the cyclical nature of the inventory-turnover declines. That is, every three months the inventory-turnover statistic makes a notable downturn. This can be explained if the same employee (or group of employees) had a hand in the inventory process during those periods and is attempting to hide fraudulent activity.

Operators who think that such theft is unlikely to occur, or who believe that all unit managers are wise enough to uncover such

5 On the other hand, effective internal-control measures would render such fraud extremely diffkult. See: A. Neal Geller, “Rule Out Fraud and Theft: Controlling Your Food-Service Operation,” Cornell Hotel and Restaurant Adminir- tration Quarterly, Vol. 32,No. 4 (December 1991), pp. 55-65.

April 1999 l 57

crimes on their own, are likely to be unpleasantly surprised. I suggest that, owing largely to the size and complexity of many of today’s on- site food-service units, managers need as many tools as possible to monitor their operations. Inventory- turnover analysis is one of those tools.6

Optimizing Inventory Management

In addition to traditional inventory control (e.g., consistent use of requi- sitioning procedures, weighing items on delivery), a number of less-well- known practices can help to im- prove inventory management. When in place, these steps will help main- tain a consistent inventory-turnover statistic (in the absence of opera- tional anomalies such as declining sales or theft) and can enhance the quality of daily operations.

Limit the number of vendors. Today’s ordering and delivery systems allow managers to plan deliveries to the day and sometimes to the day part. Furthermore, most major food dis- tributors now notify operators of stockouts when the order is placed, not when it was supposed to be delivered. Hence, there is no longer the need for excessive lead times or for maintaining large inventories of food products.

The breadth of products offered by most food distributors also means that there is no longer the need to use more than a handful of suppli- ers. With fewer suppliers, there can be greater oversight of quality, price, and inventory control. While using a large number of suppliers allows an operator to “shop” for the best possible price, in reality the reliabil- ity and consistency provided by a few key vendors are more important than the potential savings from mi- nor price differences among many

“Productivity analysis is another useful tool. See: Dennis KLynolds,“Productivity Analysis in the On-site Food-service Segment,” Corrrel/ Hotel md Rertnurant .4dminisrration Quart+, Vol. 39. No. 3 CJune 1998), pp. 22-31.

vendors. Favored suppliers-those with whom an operator conducts the majority of business-also may offer smaller quantities with more frequent deliveries, thereby increas- ing convenience and minimizing the need to carry excess inventory. Finally, a favored supplier is likely to go the extra mile to provide quality service for a preferred customer when unusual circumstances present themselves.

Standardize and rotate stock. Reci- pes sometimes specify distinct brands or cuts. When it does not lessen the quality of the end prod- uct, it is advisable to pare down the number of items in stock by select- ing common types and styles of food. Another good practice is to rotate stock continuously, regardless of the product (including nonper- ishables such as canned goods and paper items). It is not good practice to hold on to stock that has outlived its usefulness. Sometimes it is better simply to take the loss than to con- tinue to incur the costs of handling the same items over and over again.7 If other items are accumulating on the shelves, that may be a sign that forecasts and ordering schedules need to be adjusted.*

Focus on the inventory-valuation process. Actually conducting an in- ventory valuation (i.e., counting items) is key to the inventory- management process. The critical assumption underlying any inven- tory valuation is that it is accurate.

’ in some cases excess inventory can be do- nated through a clearinghouse to charity in exchange for a federal income-tax deduction. For more information, contact: NAEIR (Na- tional Assocntion for the Exchange of Industrial Resources), 560 McClure Street, Galesburg, IL 61401; 800-289-4551 or 800-562-0955, ext. 205; fax: 309-343-7316; e-mail:Jackz.naei~mlsshnk.net *http://www.misslink.net/tiaeir.htm)).

d One exception to accumulatmn being a problem is in the health-care segment, where operations m some states by law must mamtain a three-day (or longer) supply of food and water for patients, commonly called “safety stock.” Those items should be rotated routinely and included as part ofthe regular inventory during the valuatmn process using current prices.

It is assumed that the individuals who perform the actual counting and recording do so honestly and take reasonable care not to make errors. As discussed earlier, it is pos- sible that varying levels of error, dishonesty, and, in extreme cases, collusion, may confound the turn- over statistic (and wreak havoc on profits).

To increase accuracy as well as morale, and to reduce temptation, it is advisable to rotate the responsibil- ity of conducting the physical in- ventory among appropriate staff members. Doing so can minimize the likelihood that a single em- ployee will effectively use the inventory-taking process to hide pilferage. It also reduces the likeli- hood of workers’ collusion. Finally, rotating the responsibility minimizes the fatigue and careless errors that frequently result when the same two people take the physical inventory every week.

Update those prices. Prices must be updated regularly. If even a handful of items are incorrectly valued as the result of inaccurate prices, the entire inventory valuation becomes inaccurate. Goods must be valued based on their replacement cost. Hence, if the cost of an item in- creases, the value of the product on the shelf must reflect the current cost of replacement, not the price that was originally paid for the item.

Conclusion

An effective inventory system should be accurate; it should be dynamic in that it should conform to factors affecting sales (e.g., sea- sonality, marketing campaigns); and it should reflect the specific needs of the industry segment. Periodic inventory-turnover analysis is a use- ful tool to measure the progress toward achieving those important objectives. Moreover, it provides managers with a tool to gauge the effectiveness of the operation’s inventory-management system. CQ

58 ClJRNEll HOTELANDRESTAURANTADMINISTRATIONQUARTERLY