Inventory turnover formula
/What is the Inventory Turnover Formula?
The inventory turnover formula measures the rate at which inventory is used over a measurement period. It can be used to see if a business has an excessive inventory investment in comparison to its sales, which can indicate either unexpectedly low sales or poor inventory planning. It is routinely used to benchmark the inventory holdings of a business against the holdings of competing businesses.
What Issues Can Change Inventory Turnover?
The following issues can impact the amount of inventory turnover experienced by a business:
Seasonal build. Inventory may be built up in advance of a seasonal selling season.
Obsolescence. Some portion of the inventory may be out-of-date and so cannot be sold.
Cost accounting. The inventory accounting method used, combined with changes in prices paid for inventory, can result in significant swings in the reported amount of inventory.
Flow method used. A pull system that only manufactures on demand requires much less inventory than a "push" system that manufactures based on estimated demand.
Purchasing practices. The purchasing manager may advocate purchasing in bulk to obtain volume purchase discounts. Doing so can substantially increase the investment in inventory.
When there is a low rate of inventory turnover, this implies that a business may have a flawed purchasing system that bought too many goods, or that stocks were increased in anticipation of sales that did not occur. In both cases, there is a high risk of inventory aging, in which case it becomes obsolete and has little residual value.
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When there is a high rate of inventory turnover, this implies that the purchasing function is tightly managed. However, it may also mean that a business does not have the cash reserves to maintain normal inventory levels, and so is turning away prospective sales. The latter scenario is most likely when the amount of debt is unusually high and there are few cash reserves.
Inventory Turnover Formula
To calculate inventory turnover, divide the ending inventory figure into the annualized cost of sales. If the ending inventory figure is not a representative number, then use an average figure instead, such as the average of the beginning and ending inventory balances. The formula is:
Annual cost of goods sold ÷ Inventory = Inventory turnover
A more refined measurement is to exclude direct labor and overhead from the annual cost of goods sold in the numerator of the formula, thereby concentrating attention on just the cost of materials.
Inventory Turnover Period
You can also divide the result of the inventory turnover calculation into 365 days to arrive at days of inventory on hand, which may be a more understandable figure. Thus, a turnover rate of 4.0 becomes 91 days of inventory. This is known as the inventory turnover period.
Problems with the Inventory Turnover Formula
The inventory turnover formula is a useful metric for measuring how efficiently a company manages its inventory. However, it has several limitations and potential problems, including the following:
Seasonal fluctuations can skew results. Businesses with seasonal sales (e.g., retail, agriculture) may show misleading turnover rates depending on when inventory levels are measured. A high turnover during peak seasons may give a false sense of efficiency, while a low turnover in the off-season may suggest poor management even if it’s normal for the business cycle.
Different accounting methods affect results. Inventory valuation methods (FIFO, LIFO, or weighted average) can impact the cost of goods sold (COGS) and inventory balance, leading to variations in turnover ratios. A company using LIFO in times of rising costs may show a lower turnover compared to FIFO users, even if actual sales activity remains unchanged.
Does not consider profitability or sales performance. A high inventory turnover ratio might indicate strong sales, but it could also mean the company is selling at very low margins or struggling with stock shortages. On the other hand, a low turnover ratio isn’t always bad if the company deals with high-margin, slow-moving goods (e.g., luxury items).
Bulk purchases or stockpiling can distort the ratio. If a company makes a large inventory purchase before the period ends, the average inventory value will rise, making turnover appear lower than it should be. Conversely, if inventory levels are unusually low due to supply chain issues, turnover may appear inflated.
Does not differentiate between types of inventory. The formula treats all inventory as a single unit, which can be misleading if a business has different product categories with vastly different turnover rates. For example, fast-moving consumer goods and specialized machinery will have very different inventory cycles, but the formula averages them out.
No insight into stockouts or overstocking issues. A high turnover ratio might indicate efficient inventory management, but it could also suggest frequent stockouts, leading to lost sales and unhappy customers. Conversely, a low turnover ratio might suggest overstocking, tying up capital and increasing storage costs, but the formula itself does not provide details on these risks.
Industry comparisons can be misleading. Comparing turnover ratios across industries is not always meaningful since different sectors have vastly different inventory management practices. For example, a grocery store will naturally have a much higher turnover than an automotive dealership, making direct comparisons unreliable.
While the inventory turnover formula is a useful metric for assessing inventory efficiency, it should not be used in isolation. Businesses should consider additional factors such as profit margins, demand forecasting, stock management policies, and financial health for a complete picture.
Example of Inventory Turnover
The Hegemony Toy Company is reviewing its inventory levels. The related information is $8,150,000 of cost of goods sold in the past year, and ending inventory of $1,630,000. Total inventory turnover is calculated as:
$8,150,000 Cost of Goods Sold / $1,630,000 Inventory = 5 Turns Per Year
The 5 turns figure is then divided into 365 days to arrive at 73 days of inventory on hand.
Terms Similar to Inventory Turnover
The inventory turnover formula is also known as the inventory turnover ratio and the stock turnover ratio.