Inventory turnover definition
/What is Inventory Turnover?
Inventory turnover is the average number of times in a year that a business sells and replaces its inventory. Low turnover equates to a large investment in inventory, while high turnover equates to a low investment in inventory. Continual monitoring of inventory turnover is good management practice, in order to maintain a relatively low investment in this area.
How to Calculate Inventory Turnover
Inventory turnover is calculated by dividing the cost of goods sold for the year by ending inventory. The cost of goods sold figure is used instead of sales, because the sales figure includes a markup that is irrelevant to the calculation, and artificially inflates the turnover figure. The formula is as follows:
Annual cost of goods sold ÷ Ending inventory = Inventory turnover
In the calculation, the cost of goods sold refers to the cost of the finished goods or services delivered to customers. This cost includes all direct materials, direct labor, and factory overhead associated with the construction of the finished goods or services that were sold.
If the ending inventory figure is not representative of the typical inventory balance during the measurement period, then an average inventory figure can be used instead. Average inventory may be derived by adding together the beginning and ending inventory values and dividing by two. Alternatively, if the company has a perpetual inventory system, it may be possible to compile a daily inventory value, from which an average inventory figure can be derived. The averaging calculation can cover a relatively lengthy period of time, to reduce the impact of seasonality on the outcome.
Example of Inventory Turnover
As an example of inventory turnover, if ABC International had $10,000,000 in cost of goods sold in its most recent fiscal year, and the ending inventory was $2,000,000, then its inventory turnover was 5:1, or 5x.
The common management perception is that inventory turnover should be extremely high, since this means that you are operating a business with a smaller cash investment in inventory. To continue the example, ABC International is investing an average of $2,000,000 in inventory (based on the ending inventory number). If ABC could somehow double its inventory turnover while maintaining sales at the same level, then its inventory investment would drop to $1,000,000, thereby saving it $1,000,000 of cash that it can use elsewhere.
Related AccountingTools Courses
Understanding Inventory Turnover
When the inventory turnover ratio is high, it indicates that a business is selling off its inventory at a rapid rate. This can indicate that its products are popular with customers, are being sold at a competitive price, or are being bolstered by a strong marketing campaign. However, rapid turnover can also indicate that the business does not have sufficient working capital to support a larger inventory. In the latter case, customers may be experiencing long wait times before their orders are shipped to them, because the company must wait for new deliveries from suppliers. It is also possible that the company has installed excellent inventory management systems; it may be using a just-in-time production system that requires minimal inventory levels, and it may be exercising tight control over its obsolete inventory.
When the inventory turnover ratio is low, it indicates that a business has too much inventory on hand. This can indicate that much of the inventory is obsolete or that the firm has acquired more inventory than it can sell within a reasonable period of time. It is a strong indicator of poor inventory control practices, such as purchasing in excessive volumes and not selling off obsolete inventory before it loses all of its value. However, low turnover can also indicate that management has committed to the practice of fulfilling all customer orders immediately, which calls for a larger investment in inventory.
Generally, low inventory turnover is to be avoided, because it imposes inventory holding costs on the seller. These costs include the cost of storage space, depreciation on storage racks and forklifts, insurance, utilities, and compensation for the materials management staff. It is also likely that there will be inventory obsolescence costs associated with goods that can no longer be sold, as well as damage to inventory items while they are held in storage. A further concern with low inventory turnover is that goods not being sold are taking up valuable shelf space that could be more profitably taken up by other products with better sales potential.
The inventory turnover ratio cannot be used to predict the profitability of a business. Some businesses, such as manufacturers of luxury goods, typically experience slow inventory turnover, and yet can produce spectacular profits. Conversely, a business that sells commodity products may turn over its inventory at a prodigious rate, and yet cannot generate much of a profit, because competition forces it to maintain low price points.
Inventory Turnover vs. Days Sales of Inventory
Another common inventory measurement is days sales of inventory. The inventory turnover measurement that we have been describing indicates the speed with which a business can sell or otherwise dispose of its inventory. The days sales metric takes a somewhat different approach, measuring the number of days that it would take for the business to convert its inventory into sales. For example, an inventory turnover rate of four times per year approximately corresponds to 90 days that will be required for inventory to be sold off.
Why is Inventory Turnover Significant?
The inventory turnover measure should be incorporated into an organization’s budgeting and management systems, so that management can take the actions noted below. The intent of the following items is to increase inventory turnover, so that the working capital investment of the business can be reduced.
Cash flow projections. One of the best uses of the inventory turnover measurement is to predict the amount of cash flow in future periods. The turnover rate can be paired with projected sales levels to determine the amount of inventory that will likely be on hand at any given time, which tells management how much cash will be needed to support the projected inventory level. This approach works well when the turnover rate is relatively consistent from period to period.
Pricing changes. When the inventory turnover rate is quite low, this can trigger a management action to lower selected product prices, thereby increasing sales and flushing out excess inventory. The lower prices will reduce the profit percentage, but also reduces the risk of incurring expenses for obsolete inventory.
Purchasing management. If a business finds that its inventory turnover is slowing down, this is a strong indicator that it should alter its purchasing practices to acquire a reduced amount of goods. This is an especially important issue for seasonal businesses, which do not want to be caught with too much inventory on hand once the main sales season is over. Alternatively, a high rate of inventory turnover will mandate more frequent and/or larger purchases. A flaw in this approach is that purchasing practices are usually more refined, involving the usage tracking of individual products.
Sales forecasting. By using the days sales of inventory calculation, you can estimate the number of days that will be required before a business can sell the entire amount of inventory currently on hand. The calculation is to divide the average inventory value by the cost of goods sold and then multiply the result by 365. A flaw in this type of forecast is that some of the inventory is slow-moving or obsolete, and so will not sell at all unless prices are dropped substantially.
How to Improve Inventory Turnover
There are many ways to improve inventory turnover. As we note below, these actions can include the alteration of price points, elimination of poorly-selling products, and installation of a just-in-time production system.
Alter price points. The amount of inventory sold depends on the price being charged for it. If sales appear to be slowing down, it can make sense to reduce the price being charged for a period of time, until the excess inventory has been sold off. When prices must be dropped, this could be a more general sign that customer demand for the goods in question is weakening, which calls for a more permanent price drop.
Dispose of obsolete inventory. Inventory turnover can be improved simply by rooting through the warehouse and disposing of any inventory items that have not been selling. It is especially important to eliminate obsolete inventory from stock as early as possible, when these goods still have some market value, and so can be sold off at a reduced loss. By waiting too long to dispose of obsolete inventory, a business is reducing the amount of cash that it can collect from its disposition. While this can be a reasonable short-term solution, it does not address the underlying issue of why inventory items are becoming obsolete. Unless this issue is addressed, a business will find that it must periodically eliminate obsolete inventory from stock.
Eliminate poorly-selling products. Periodically review sales levels and see if any products should be dropped from the company’s line-up. Doing so not only keeps these items from clogging up the warehouse, but also presents customers with a fresher product line-up as replacement goods are routinely brought in to replace stale ones.
Enhance marketing activities. The volume of inventory sold can be enhanced by increasing the volume of marketing activities. For example, running a special deal for certain poorly-selling items may increase their sales, flushing them out of inventory. As the example indicates, marketing is an especially useful tool for eliminating slow-moving inventory. This is a good way to avoid having to take obsolete inventory write-offs later on. The trick to effective marketing is to identify situations in which sales are tailing off and inventory levels are too high to be completely eliminated by the projected reduced sales level. Conversely, marketing activities are not needed when inventory levels are relatively low and when sales have not yet begun to decline. In short, marketing activities should be planned based on the inventory turnover trend for specific inventory items.
Install a just-in-time system. Inventory turnover can be improved through the use of just-in-time manufacturing systems, where inventory is only produced when there is a customer order in hand, and little inventory is maintained anywhere in the system. Additional raw materials are only acquired when production has been authorized based on an actual customer order. It can be difficult to transition to a just-in-time system, since the process differs markedly from the production of goods to a sales forecast - which is the more common approach.
Purchase raw materials more frequently. Another option for improving inventory turnover is to purchase raw materials more frequently, but in smaller quantities per order. Doing so keeps the raw materials and merchandise investment lower, on average. This increases the cost per order, so there is a limit to how far this approach can be taken. A good way to efficiently employ more frequent purchases is to set up a master purchase order for a large quantity of purchases, and then issue a release against this purchase order at frequent intervals.
Schedule shorter production runs. Yet another turnover improvement approach is to have shorter production runs, which reduces the amount of finished goods inventory. It is especially useful when sales are both seasonal and unpredictable, so that the business is caught with less inventory on hand when the season is over. It works best when setup costs are relatively low. If setup costs are high, it makes more sense to have longer production runs, to keep the average cost per unit down.
Use engineering change orders. A business needs to time the introduction of product design changes, so that all components associated with the old product design have been used up before the new design is introduced. Otherwise, a business will find itself with a large number of unused components that it may trouble getting rid of. This change-over is conducted with an engineering change order, which specifies the date on which the new version will be introduced, as well as which components will be altered.
Impact of Seasonality on Inventory Turnover
Inventory turnover can also vary during the year if a business is locked into a seasonal sales cycle. For example, a snow shovel manufacturer will likely produce shovels all year, with inventory levels gradually rising until the Fall sales season, when sales occur and inventory plummets. This is simply the manner in which a company must build its products in order to meet demand, and it results (in the example) in declining inventory turnover as inventory levels rise, with a sudden acceleration in the turnover rate when the sales season arrives and the company sells off all of its inventory.
Factors Impacting Inventory Turnover
The rate of inventory turnover is driven by a number of factors, including the following items:
Length of distribution channel. If suppliers are located far away, companies tend to keep more safety stock on hand. Doing so ensures that a reserve of inventory will still be on hand, even if there are problems with the timely delivery of goods from these more distant suppliers.
Fulfillment policy. If management wants to fulfill most customer orders at once, this requires the maintenance of a larger amount of stock on hand. This is a strategy issue; management should be aware of the inventory investment required if it insists on implementing a fast fulfillment policy.
Materials management system. A push system, such as material requirements planning, tends to require more inventory than a pull system, such as a just-in-time system. This is because a push system is based on estimates of what will be sold, while a pull system is based on actual customer orders. Consequently, the presence of estimates in a push system results in excess finished goods inventory.
Inventory on consignment. Some companies retain ownership of their goods at consignee locations, which increases the amount invested in inventory. Otherwise, distributors and retailers would have bought the goods at once, resulting in a small inventory investment by the manufacturer.
Purchasing policy. A company may buy raw materials in large quantities in order to obtain lower bulk rates, though this increases its inventory investment. In many cases, a better approach is to pay somewhat more per unit for smaller purchase quantities, resulting in a significantly smaller inventory investment. Buying in smaller quantities may not actually be more expensive, since it reduces inventory carrying costs, as well as inventory obsolescence costs.
Product versions. If there are many product versions, each one is typically kept in stock, which increases inventory levels. An alternative is to eliminate those product versions with low sales levels, thereby also eliminating the associated inventory investment. It is possible that some of the sales lost from doing so will be recovered when customers instead purchase from the remaining product selection.
Drop shipping. A seller can arrange with its supplier to ship goods directly to a customer. By using such a drop shipping arrangement, the seller maintains no inventory levels at all. However, this can reduce the speed of delivery to customers, since the seller has no control over the speed with which the supplier ships goods.
When Not to Increase Inventory Turnover
While a high level of inventory turnover is an enticing goal, it is quite possible to take the concept too far. For example, if you are a high-end Internet retailer with a reputation for fulfilling all customer orders within 24 hours of receipt, this can be pretty difficult if you have shrunk the inventory to such an extent that most orders are backlogged until you can get them from a supplier (which is precisely how many Internet retailers with minimal cash on hand operate). Thus, there is a natural limit to the amount of inventory turnover that your customers will tolerate, just based on the duration of order backlogs.