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Inventory turnover formula is a ratio that measures the number of times inventory is sold or consumed in a given time period. Also known as inventory turns, stock turn, and stock turnover, the formula is calculated by dividing the cost of goods sold (COGS) by average inventory.
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This ratio is critically important because total turnover depends on two fundamental components of performance.
The first is stock purchasing. If large amounts of inventory are purchased during the year, your company will have to sell greater amounts of inventory to improve its turnover. If you can’t, it will incur storage costs and other holding costs.
The second component is sales. Sales have to match inventory purchases otherwise the inventory will not turn effectively. That is why the purchasing and sales departments must be in tune with each other.
How do you calculate your company-wide inventory turnover ratio?
Note, average inventory is used instead of ending inventory because merchandise fluctuates greatly throughout the year.
Now, let’s take the turnover ratio a step further.
Once you have the turn rate, calculating the number of days it takes to clear your inventory only takes a few seconds. Since there are 365 days in a year, simply divide 365 by your turnover ratio.
The result is the average number of days it takes to sell through inventory.
[Inventory turnover period = 365 / Inventory turnover ratio]
As a test case, let’s say you spent $137,457 (COGS) on 15,273 units of inventory (average inventory) in the last 12 months.
[Inventory turnover rate = $137,457 / 15,273 = 9]
[Inventory turnover period = 365 / 9 = 40.5]
Thus, a turnover rate of 9 becomes 40.5 days — your company sells through its stock roughly every one and a half months.
So, what does this tell you?
A company’s inventory turnover varies greatly by industry. Fashion retailers average between 4 and 6. Automotive components can be as high as 40. Grocery stores are around 14. And car dealerships are often as low as 2 to 3.
In short, low-margin industries tend to have higher inventory turnover ratios than high-margin industries because low-margin industries must offset lower per-unit profits with higher unit-sales volume.
Moreover, it is important to understand that the timing of inventory purchases — particularly those made in preparation for special promotions or new product introductions — can suddenly and somewhat artificially change the ratio.
These factors mean two things when benchmarking your inventory turnover:
Inventory turnover can be used to measure the overall efficiency of a business. In general, higher inventory turnover indicates better performance and lower turnover, inefficiency.
This is because a high turn shows that your not overspending by buying too much and wasting resources on storage costs. It also shows that you’re effectively selling the inventory you buy and replenishing cash quickly.
Alternatively, a low inventory turnover rate may be caused by overstocking or inefficiencies in the product line or sales and marketing effort. It is usually a bad sign because products tend to deteriorate as they sit in a warehouse while incurring holding costs. Furthermore, excess inventory ties up a company’s cash and makes you vulnerable to drops in market prices.
But there’s nuance and exceptions to those general principles. An exceptionally high turnover rate may point to strong sales or ineffective buying, ultimately leading to a loss in business as the inventory is too low. This can result in stock shortages and, eventually, lower sales.
A good rule of thumb is that if your inventory turnover ratio multiplied by gross profit margin (in percentage) is 100% or higher, then the average inventory is not too high.
Naturally, an item whose inventory is sold once a year has a higher holding cost than one that turns over more often.
Increasing inventory turnover drives profitability for three reasons:
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