Inventory Turnover

The speed at which a business sells it's inventory.

What is Inventory Turnover?

Inventory turnover, also called stock turns, is the amount of times a business sells and replaces its stock of goods during a given period. It considers the cost of goods sold, relative to its average inventory for a year or in any a set period of time. A high inventory turnover generally means that goods are sold faster and a low turnover indicates weak sales and excess inventories which may be challenging for a business. Periodic stock turns are then compared to  previous ratios, planned ratios, and industry averages to assess competitiveness, planned profits, and intra-industry performance.  Inventory turns can vary significantly by industry.

How to Calculate Inventory Turnover Ratio?

Inventory Turnover Ratio =   (Cost of Goods Sold)/(Average Inventory)      

For example:
Republican Manufacturing Co. has a cost of goods sold worth $5M for the current year. The company’s cost of beginning inventory was $600,000 and cost of ending inventory was $400,000. Given the inventory balances, the average cost of inventory during the year is calculated at $500,000. As a result, inventory turnover is rated at 10 times a year.

What is Cost of Goods Sold?

Cost of goods sold is an expense incurred from directly creating a product, including, the raw materials and labor costs applied to it. However, in a merchandising business, cost incurred is usually the actual amount of the finished product (plus shipping cost if any if applicable) purchased paid for by a merchandiser from a manufacturer or supplier. In both types of businesses, the cost of a sales is properly determined through using an inventory account or list of raw materials or goods purchased, maintained by the owner orthe company.

What is Average Inventory?

Average inventory is the average cost of a set of goods during two or more specified time periods. It takes into account the beginning inventory balance at the start of the fiscal year plus the ending inventory balance of the same year. These two account balances are then divided in half to obtain the average cost of goods resulting in  sales. It is not necessarily computed on a yearly basis; it may be on a monthly or quarterly, depending on the amount of analysis required to assess the inventory account.

Why is it Important to Determine Inventory Turnover for a Business?

One way to ascertain sound business performance is to know how fast inventory sells and, how it meets the market demand , and how its sales stack up to other products in its class category. Businesses rely on inventory turnover to evaluate product effectiveness, as this is the business’s primary source of revenue to survive the operations. Higher stock turns are favorable, because they imply product marketability and reduce holding costs, such as: rent, utilities, insurance, theft, and other costs of maintaining goods.

A Decreasing in holding costs means an increase in profits and in turn, positive revenue performance remains unchanged. Another purpose of inventory turnover is in to compare a business with other businesses in the same industry. comparing businesses within the same industry. Companies gauge their operational efficiency based upon whether their inventory turnover is at par with or surpasses the average benchmark set, as per industry standards.