How would your employees respond if you asked them what Inventory Turnover means? Inventory turnover is often a misunderstood term. Let’s call it “Opportunity to Make a Profit”. Without Inventory you don’t have the opportunity.
Here’s an example
You sell $50,000 worth of a product at cost in a year. Total revenue received from sales is say $60,000. If we bought the entire $50K’s worth on the 1st July, at the end of the year we would have made a gross profit of $10,000.
Do we want to buy the $50,000 worth of product at one time? What if we bought $25,000 worth on the 1st July, then just before we ran out bought some more? At the end of the year we would have still sold $50,000 at cost, made a gross profit of $10,000, but at any one time we would have had a maximum of $25,000 invested in inventory.
Could we make the same amount of money with less invested? What if we were to buy $12,500 of inventory, then do the same – sell most of it and buy some more as we sell our stock level down? The GP would be the same, $10,000 but we would have had a maximum of $12,500 invested in inventory at one time.
Which option is better? Making $10,000 GP with $50,000 invested in inventory or making $10,000 with $12,500 invested in inventory? The best option is $12,500 invested of course. This option releases $37,500 to be invested in other inventory that has the potential of generating extra profits.
Every time we sell a level of stock that is equal to the amount of money we have invested in that stock line we have “turned” our inventory. The inventory turnover rate measures the number of times we have turned inventory in the past year.
|Annual Cost of Goods Sold||Amount Purchased at a time||Annual Inventory Turns|
|$50,000||$50,000||1 – 2|
|$50,000||$25,000||2 – 4|
|$50,000||$12,500||4 – 8|
I have used a range of Inventory Turns because we aren’t actually going to have zero stock on the day the new shipment arrives and we may have extra safety stock, so as this is really an indicator rather than an actual hard number, there will always be a range.
Calculate your inventory turns by this formula
- Cost of Goods Sold from Stock in the last 12 months
- Average Inventory Investment during the last 12 months
If you are shipping goods from a central warehouse to supply your other sales locations include the value of those transfers in the cost of goods sold. The same applies where you are using the items in stock for repairs of assembly, include those in the cost of goods figure as well. That will give you the Inventory Turnover figure for that particular warehouse.
For your whole company’s Inventory Turns figure – you need a different calculation, which includes only the cost of goods sold by your entire company. Don’t include Non Stock Items and Direct Ships. Inventory Turns is based on the inventory cost, not the sales value. If your cost of goods fluctuate wildly consider doing the calculation based on cubic or weight.
Inventory Turnover depends on the average value of a particular inventory item.
To determine your average inventory investment:
Calculate the total value of every product in your inventory (quantity x cost) every month, on the last day.
If your inventory fluctuates during the month then calculate the total inventory on the 15th of the month and then on the last day of the month.
Determine the average value of inventory by averaging all the inventory valuations recorded during the last 12 months.
What would be a good turnover goal? Margins vary, let’s say you have 20% – 30% gross margins then you should strive to achieve an overall turnover rate or 6 – 8 turns per year. Companies with lower margins require higher stock turns, companies with higher margins can get away with lower inventory turns.
Calculate the turnover separately for each vendor line in each warehouse every month. This allows you to identify situations where your inventory isn’t giving you adequate return on your investment. Your inventory turnover will improve as you start buying the “best buy” amount for each product line and liquidate your inventory of dead stock.