Inventory velocity is the time period beginning with the receipt of raw materials and ending with the sale of the resulting finished goods. Thus, it is the period over which a business has ownership of inventory. It is very much in the interest of a company to keep inventory velocity as high as possible, for several reasons:
- Cost of money. When a business owns inventory, this represents a significant investment of cash. If interest rates are high, this means the company is foregoing the investment of that cash in an investment that would have generated a significant return. Thus, reducing the cash investment in inventory increases the returns to a business.
- Holding costs. It is expensive to hold inventory. It requires a warehouse, warehouse staff, shelving, forklifts, insurance, fire suppression systems, security arrangements, tracking systems, and more. A reduced amount of inventory therefore equates to fewer holding costs.
- Obsolescence. In industries where products age quickly, inventory must be sold off rapidly in order to reduce the risk of a sudden decline in the value of that inventory. This issue may be less of a concern for the parts used to create finished goods, since the parts may be repurposed into the construction of a more modern product.
To measure inventory velocity, divide the cost of goods sold by the average inventory for the measurement period. However, this metric only applies to the inventory in general, and not to more specific inventory items. To gain more insight into the measurement, track inventory velocity for specific items, especially those most subject to obsolescence.
It is possible to focus too much on a high inventory velocity level. If a company keeps little stock on hand, it may find that it cannot fill unexpected customer demand, and so must forego these sales. Thus, it may be necessary to maintain a certain minimum investment in inventory that places an upper cap on inventory velocity.
Inventory velocity is also known as inventory turnover.