If you are a business personnel, then how to calculate inventory turnover should not be taken lightly. It is as important as bookkeeping, yet many ignore it. As you read through, we will be helping you understand why inventory turnover is important and how to calculate it.
What Is Inventory Turnover?
Inventory turnover pertains to the duration between a company’s acquisition of an item and its subsequent sale. A full inventory turnover signifies the sale of purchased stock, excluding any losses due to damage or shrinkage.
Thriving enterprises often achieve numerous inventory turnovers annually, although this frequency varies across industries and product categories.
For instance, consumer packaged goods (CPG) commonly exhibit swift turnover, whereas ultra-high-end luxury products like luxury handbags experience fewer yearly sales due to extended production times.
Several hurdles in inventory management can influence turnover, including shifts in customer demand, inadequate supply chain planning, and excessive stockpiling.
To calculate the Inventory turnover, you must first understand what the Inventory Turnover Ratio (ITR) is.
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Let’s have a look at it.
What Is Inventory Turnover Ratio?
The inventory turnover ratio signifies the frequency with which a company sells and replenishes its inventory within a designated timeframe. This equation can also determine the duration required to sell the existing inventory.
The turnover ratio is deduced through a mathematical formula, dividing the cost of goods sold by the average inventory during the same period.
A preference lies with a higher ratio over a lower one, as an elevated ratio typically signifies robust sales.
The computation and monitoring of inventory turnover aid businesses in making informed decisions across various domains like pricing, production, marketing, procurement, and warehouse control.
Ultimately, the inventory turnover ratio gauges the company’s proficiency in generating sales from its stock.
Numerous key performance indicators (KPIs) can provide insights into methods to boost sales or enhance the marketability of specific stock or the overall inventory assortment.
How Does Inventory Turnover Ratio Work?
Average inventory serves as a means to smooth out fluctuations caused by unusual changes occurring within a specific time segment, like a day or a month. This approach ensures a more consistent and dependable measurement.
For instance, during seasonal sales, certain items such as patio furniture or artificial trees experience a significant surge in inventory just before the season, followed by a substantial depletion at its conclusion.
Nonetheless, the turnover ratio can also be computed using ending inventory figures within the same period as the cost of goods sold (COGS) value.
Lastly, the formula can be employed to calculate the duration required to sell the entirety of the existing inventory. In a daily context, this is expressed through the Days Sales of Inventory (DSI) calculation.
DSI = (Average inventory/cost of goods sold) x 365
How to Calculate Inventory Turnover Ratio (ITR)?
Firms have the ability to compute their inventory turnover. This conventional technique involves utilizing either market sales data or the cost of goods sold (COGS) divided by the inventory.
Begin the process by determining the average inventory during a specific period, achieved by dividing the total of the initial and concluding inventory by two:
Average inventory = (beginning inventory + ending inventory) / 2
If the company doesn’t experience seasonal variations, you have the option to substitute ending stock for average inventory.
However, having a greater amount of data is advantageous, so it’s recommended to divide the monthly inventory by 12 to obtain the annual average inventory.
Subsequently, you can proceed to apply the inventory turnover formula:
Inventory Turnover Ratio = Cost of Goods Sold / Avg. Inventory
How to Calculate Inventory Turnover
Whichever inventory turnover equation is most suitable for your organization, it’s essential to extract data from the balance sheet. Hence, comprehending the meanings and implications of these terms and figures is crucial.
Cost of Goods Sold (COGS)
The direct expenses related to producing goods, including raw materials, which are intended for sale by the company, are referred to as “Cost of Goods Sold,” commonly known as COGS.
Average Inventory (AI)
The concept of average inventory evens out the quantity of inventory present over two or more designated periods of time.
Beginning Inventory + ending inventory/number of months in the accounting period
Here are some examples of how to calculate Inventory Turnover:
1. Glory’s Furniture deals with the supply of high-end, handmade dining sets made from specialty woods.
Over Q3, its busiest period, the retailer posted $47,000 in COGS and $16,000 in average inventory.
To find the inventory turnover ratio, we divide $47,000 by $16,000. The inventory turnover is 3.
2. We’ll maintain the same company and scenario mentioned earlier. However, in this instance, we’ll determine the average inventory period, indicating the duration required to sell the existing inventory.
Given that the inventory turnover ratio is established at 3, we can calculate the time it takes to sell the current inventory at the present pace.
By dividing the total of 365 days in a year by 3, the outcome is 121.67 days.
Why is Inventory Turnover Important?
Inventory turnover holds significance for various reasons.
Let’s take a look at them:
1. Inventory turnover quantifies the frequency with which a company refreshes its inventory in relation to its cost of sales. Generally, a higher ratio is considered favorable.
2. A diminished inventory turnover ratio could indicate weak sales or an excessive inventory situation known as overstocking.
This might highlight issues with a retail chain’s product presentation strategy or insufficient marketing efforts.
3. Conversely, a robust inventory turnover ratio suggests vigorous sales. Alternatively, it might signify a shortage of inventory.
In terms of challenges, it’s more favorable for a company to maintain sufficient inventory to support strong sales rather than needing to reduce inventory due to sluggish business.
4. During periods of inflation or disruptions in the supply chain, a low inventory turnover ratio can be advantageous if it signifies a buildup of inventory before supplier price hikes or heightened demand.
The retail sector experienced significant drops in inventories in the initial year of the COVID-19 pandemic, resulting in the industry struggling to meet demand during the subsequent recovery.
5. The velocity at which a company can cycle through its inventory serves as a critical indicator of business performance.
Retailers that swiftly transform inventory into sales tend to outperform comparable competitors.
The longer an item remains in stock, the greater its holding cost becomes, and the lower the likelihood of customers returning to make purchases.
6. A decline in the inventory turnover ratio could signal a waning demand, leading businesses to curtail their production output.
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The inventory turnover ratio of a company provides insight into how many times its inventory has been replenished in relation to its COGS within a specified timeframe.
This ratio plays a valuable role for businesses when making choices related to pricing, production, marketing, and procurement. Its significance is especially pronounced in the retail sector.