Inventory Turnover

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  Inventory Turnover is the number of times your inventory cycles or turns over in a year or other defined period.  Inventory turnover can help an organization understand how efficiently their inventory is supporting sales.  The inventory turnover number implies how often inventory was bought and sold throughout the year or other defined period.  Put another way, inventory turnover is an indicator of how well a business is using their inventory.  For example, how many dollars of sales from a cost perspective are being supported by each dollar of inventory.

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​  Low inventory turnover numbers often hint at overstocking, obsolescence or unstable processes.   A high inventory turnover can also be dangerous if it is depleting reserves too quickly, but generally points towards strong sales and effective inventory management for an organization.
Inventory Turnover Ratio
  Put very simply the ratio tells us the number of times that inventory is sold and replenished or turned over in a defined time period.  With this in mind, many organizations also use the ratio to help them understand how long it will take to sell the inventory they have on hand.  The Inventory ratio divides two numbers, which are cost of goods sold and average inventory.  The output of this formula tells an organization how many times inventory turns over in a specific period of time.  As you might have guessed, a higher turnover ratio means that you cycle inventory much more often and as mentioned before is good evidence of strong sales and effective inventory management.  It is important to note that engineer to order companies and make to order companies may have lower inventory turnover ratios as the products are much more customizable and not usually made in large volumes.  Nonetheless, if an organization has a low turnover ratio, inventory analysis is needed to find the cause.
How The Inventory Ratio Works
  As mentioned earlier, turnover is calculated by dividing the cost of goods sold by the average inventory.  Average inventory is used to smooth out the peaks and valleys of inventory and give you a more stable consistent metric to work with.  This also helps to smooth out seasonal fluctuations. Such as holidays.​

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How to calculate
  Inventory turnover is calculated by dividing the cost of goods sold by the average amount of inventory.

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As we’ve mentioned Inventory turnover is calculated by dividing the cost of goods sold by the average amount of inventory.

1. First we start by getting our average inventory.  The most common way to do this is by adding your beginning inventory  and your ending inventory for a defined period and dividing that by two.
2. Now that we have our average inventory we need to gather our total cost of goods sold for the period.  This can generally be found in accounting on the Income Statement but you may need to do some calculations to find it.
3. Once you have your cost of goods sold, we are ready to calculate our inventory turnover.  To do this we divide the cost of goods sold by the average amount of inventory.
   

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Example

• Let’s say we have a company called K&K manufacturing.  K&K has posted a cost of goods sold of $1500 and an average inventory amount of $500 on hand for the fourth quarter.  We would then divide $1500 by $500 which gives K&K an inventory turnover ratio of 3.

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Example

• In the second example, we’ll use the same company.  But this time compute the average inventory period, or, how long it will take to sell the inventory currently on hand using inventory turnover. We already know the inventory turnover ratio is 3. To calculate how many days it will take to sell the inventory on hand we simply divide 365 days in the year by 3, which equals 121.67 days or 122 days if we round our answer.  We now know how long it will take to sell inventory.

Challenge:

• Let’s say K&K posts data for the next quarter.  This quarter they have an average inventory of $2000 and a Cost of Goods Sold of $1100.  What is their inventory turnover and what does this number indicate or reveal to you about how their inventory has changed?  Share your thoughts in the comments section below and receive a coupon to one of Lean Strategies International LLC's courses.

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