INVENTORY TURNOVER: POLICY, CALCULATION AND EXAMPLES - DUDAS - 2024

The inventory turnover is an indicator showing the number of times a company has sold and replaced its inventory of products for a certain period. Provides information on how the company manages costs and the effectiveness of its sales efforts.

Managing inventory levels is important for businesses as it can show whether sales efforts are effective or costs are being controlled. The inventory turnover indicator is an important measure of how well a business generates sales from its inventory.

Source: pixabay.com

Inventory is the account of all the goods that a company has in its stock, including raw materials, work-in-progress, and finished goods that will eventually be sold.

It can be very costly for companies to keep inventory that is not selling. This is why inventory turnover can be an important indicator of sales effectiveness, but also for managing operating costs.

Make better decisions

Calculating inventory turnover can help companies make better decisions about pricing, production schedules, how to take advantage of promotions to move excess inventory, and how and when to buy new inventory.

It is used to measure the efficiency of a company's inventory management. In general, a higher value for inventory turnover indicates better performance and a lower value means inefficiency in controlling inventory levels.

What does it consist of?

Inventory turnover measures how quickly a business sells inventory and how it compares to industry averages. The larger it is, the better, as high inventory turnover generally means that a business is selling products very quickly and that there is demand for the product.

Inventory turnover provides an idea if a company is managing its inventory properly. The company may have overestimated demand for its products and bought too many products, as shown by low turnover.

On the other hand, if inventory turns are very high, it is possible that not enough inventory is being purchased and sales opportunities are being lost.

The longer an item is held, the higher its maintenance cost and the lower the reason consumers will have to return to purchase new items.

There is also the opportunity cost of low inventory turnover. An item that takes a long time to sell avoids placing newer items that can be sold more easily.

Inventory turnover and profitability

Sales volume is one component of the calculation of return on assets, while the other component is profitability. Using a technique like discounting can eliminate inventory, but it has the effect of reducing profitability.

Since the return a business makes on its assets is a function of how quickly inventory is sold at a profit, high turnover means nothing unless the business makes a profit on every sale.

Rotation policy

The need to improve this indicator arises when the inventory turnover rate is below industry standards.

A low indicator indicates that the company has more inventory than is required. Generally, if the product is sold faster, the inventory operation will be more efficient.

Therefore, it is best to have a proper plan to improve inventory turnover, either by focusing on better sales or by reducing money stuck in inventory.

A good rule of thumb is that if inventory turnover times gross profit margin is 100% or more, then average inventory is not too high.

Reduce inventory

The purpose of increasing inventory turns is to reduce inventory, for the following reasons:

- Maintenance cost is reduced. The organization spends less money on rent, services, insurance, theft, and other costs of maintaining an inventory of products.

- Lowering the maintenance cost increases profitability, as long as income from the sale of items remains constant.

- Items that rotate faster increase the ability to respond to changes in customer requirements. Additionally, this allows for the replacement of obsolete items.

General considerations

- With inventory rotation, similar products and businesses should be compared. For example, the turnover of automobiles in a dealership can be much slower than that of consumer products sold in a supermarket.

- For most retailers, an excellent turnover rate is three to four rotations per year. Ideally, the inventory turnover rate should match the replenishment rate for a given item.

- Attempting to manipulate discounted inventory turns can significantly reduce profitability.

How it is calculated

To calculate the inventory turnover indicator, the following formulas are found:

Inventory turnover = Cost of merchandise sold / Average inventory, or

Inventory Turnover = Sales / Average Inventory.

It is preferable to divide the cost of merchandise sold, rather than sales, by the average inventory, for greater precision when calculating inventory turns. This is because sales, having an additional margin over cost, inflates inventory turnover.

Average inventory is calculated as: (beginning inventory + ending inventory) / 2. Beginning and ending inventory values ​​can be obtained from balance sheets at the beginning and end of the period.

Average inventory is used in the formula instead of ending inventory, because companies may have higher or lower inventory levels at certain times of the year.

The cost of merchandise sold measures the costs of production of goods and services for a company. It includes the cost of materials, the cost of labor directly related to production, and general manufacturing costs used directly to produce the goods.

Inventory sale days

Inventory sale days measures how many days it takes for inventory to convert to sales. Also known as inventory days. The formula is as follows:

Inventory Days = (Average Inventory / Cost of Merchandise Sold) x 365.

Ideally, this indicator should be low. This would translate into fewer days required to convert inventory to cash.

However, inventory sale days values ​​can vary between industries. As a result, it is important to compare the days of sale of a company's inventory with its peers.

Importance

The inventory turnover indicator is an effective measure of how well a company is converting its inventory into sales. The ratio also shows how well management is managing costs associated with inventory and whether too much or too little inventory is being purchased.

It is always important to compare the inventory turnover indicator to the industry benchmark to assess whether a company is successfully managing its inventory.

An item whose inventory is sold or rotated once a year has a higher maintenance cost than one that rotates two or three times more in that time. Inventory turnover also indicates the agility of the business.

Purchases vs sales

This indicator is important because turnover depends on two main components of performance.

The first component is the purchase of inventory. If larger amounts of inventory are purchased during the year, the company will have to sell larger amounts of inventory to improve its turnover.

If the company is unable to sell these larger amounts of inventory, it will incur warehousing and other holding costs.

The second component is sales. They must match inventory purchases, otherwise inventory will not work effectively. That is why the purchasing and sales departments must be in tune with each other.

Inventory turnover shows whether the purchasing and sales departments of a company are in sync. Ideally, inventory should match sales.

Examples

Walmart

For fiscal year 2017, Wal-Mart reported annual sales of $ 485.14 billion, an annual average inventory of $ 43.04 billion, and an annual cost of merchandise sold of $ 361.25 billion. Walmart's inventory turnover is equal to:

$ 361.25 billion / $ 43.04 billion = 8.39.

Your inventory of days is equal to: (1 / 8.39) x 365 = 43 days.

This indicates that Walmart sells all of its inventory within a 43-day period, which is quite impressive for such a large global retailer.

Sales divided by average inventory

Suppose Company A has $ 1 million in sales and $ 250,000 in cost of merchandise sold per year. The average inventory is $ 25,000.

Using the sales approach, the company has $ 1 million in sales volume divided by $ 25,000 in average inventory. This equates to 40 rotations per year.

Convert this to days by dividing 365 by inventory turns, being 9,125 days. This means that inventory rotates 40 times a year and is available for approximately nine days.

Cost of merchandise sold divided by average inventory

Using the second approach, inventory turnover is calculated as cost of merchandise sold divided by average inventory. In this example it would be $ 250,000 divided by $ 25,000, equal to 10.

The number of inventory days is then calculated by dividing 365 by 10, which is 36.5. Using this approach, inventory rotates 10 times a year and is available for approximately 36 days.

This approach provides a more accurate measure, because it does not include the market price.

References

1. Investopedia (2018). Inventory Turnover. Taken from: investopedia.com.
2. Ryan Fuhrmann (2018). How to calculate the inventory turnover ratio? Investopedia. Taken from: investopedia.com.
3. Wikipedia, the free encyclopedia (2018). Inventory turnover. Taken from: en.wikipedia.org.
4. Tradegecko (2018). How to calculate inventory turnover: Inventory turnover formula. Taken from: tradegecko.com.
5. Matthew Hudson (2018). What Is Inventory Turnover? The Balance Small Business. Taken from: thebalancesmb.com.
6. My Accounting Course (2018). Inventory Turnover Ratio. Taken from: myaccountingcourse.com.