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Inventory Turnover
Description: Inventory turnover is the number of times that inventory is used during a measurement period (usually a year). Inventory is frequently the largest component of a company’s working capital, so if inventory is not being used up by operations at a reasonable pace, then a company has invested a large part of its cash in an asset that may be difficult to liquidate in short order. Accordingly, keeping close track of the rate of inventory turnover is a significant function of management. Here are the implications of different levels of inventory turnover:
- Low rate of inventory turnover. Implies that a company has either over-purchased goods (signifying a flawed purchasing process) or that sales have declined since the goods were purchased. If sales have declined since the goods were purchased, then there is a significant risk that the company will not be able to sell all of the inventory, and so will eventually record a charge for obsolete inventory.
- High rate of inventory turnover. This can imply that purchasing is tightly managed, but it can also mean that the company does not have sufficient cash to keep ordinary inventory levels on hand, and so is foregoing possible sales. If cash levels are low and/or debt levels are high, this implies that the company has significant cash problems, and is deliberately keeping inventory levels lower than they should be.
This section describes several variations on the inventory turnover measurement, which may be combined to yield the most complete turnover reporting for management to peruse. In all cases, these measurements should be tracked on a trend line in order to see if there are gradual reductions in the rate of turnover, which can indicate to management that corrective action is required in order to eliminate excess inventory stocks.
Formula: The most simple turnover calculation is to divide the period-end inventory into the annualized cost of sales. One can also use an average inventory figure in the denominator, which avoids sudden changes in the inventory level that are likely to occur on any specific period-end date. The formula is as follows:
Cost of Goods Sold
Inventory
A variation on the preceding formula is to divide it into 365 days, which yields the number of days of inventory on hand. This may be more understandable to the layman; for example, 43 days of inventory is more clear than 8.5 inventory turns, even though they represent the same situation. The formula is as follows:
Cost of Goods Sold
365 / -----------------------
Inventory
The preceding two formulas use the entire cost of goods sold in the numerator, which includes direct labor, direct materials, and overhead. However, only direct materials costs directly relate to the level of raw materials inventory. Consequently, a more clean relationship is to compare the value of direct materials expense to raw materials inventory, yielding a raw materials turnover figure. This measurement can also be divided into 365 days in order to yield the number of days of raw materials on hand. The formula is as follows:
Direct Materials Expense
Raw Materials Inventory
The preceding formula does not yield as clean a relationship between direct materials expense and work-in-process or finished goods, since these two categories of inventory also include cost allocations for direct labor and overhead. However, if these added costs can be stripped out of the work-in-process and finished goods valuations, then there are reasonable grounds for comparing them to the direct materials expense as a valid ratio.
Example: The Rotary Mower Company, maker of the only lawn mower driven by a Wankel rotary engine, is going through its annual management review of inventory. Its CFO has the following information:
|
Balance Sheet Line Item |
Amount |
|
Cost of goods sold |
$4,075,000 |
|
Direct materials expense |
$1,550,000 |
|
Raw materials inventory |
$388,000 |
|
Total inventory |
$815,000 |
To calculate total inventory turnover, the CFO creates the following calculation:
$4,075,000 Cost of Goods Sold
-------------------------------------- = 5 Turns Per Year
$815,000 Inventory
To determine the number of days of inventory on hand, the CFO divides the number of turns per year into 365 days, as follows:
Cost of Goods Sold
365 / -----------------------
Inventory
=
$4,075,000 Cost of Goods
= 365 / --------------------------------- = 73 Days of Inventory
$815,000 Inventory
The CFO is also interested in the turnover level of raw materials when compared to just direct materials expenses. He determines this amount with the following calculation:
Direct Materials Expense
Raw Materials Inventory
=
$1,550,000 Direct Materials Expense
--------------------------------------------- = 4 Turns Per Year
$388,000 Raw Materials Inventory
The next logical step for the CFO is to compare these results to those for previous years, as well as to the results achieved by other companies in the industry. One result that is probably not good in any industry is the comparison of direct materials to raw materials inventory, which yielded only four turns per year. This means that the average component sits in the warehouse for 90 days prior to being used, which is far too long if any reliable materials planning system is used.
Cautions: The turnover ratio can be skewed by changes in the underlying costing methods used to allocate direct labor and especially overhead cost pools to the inventory. For example, if additional categories of costs are added to the overhead cost pool, then the allocation to inventory will increase, which will reduce the reported level of inventory turnover – even though the turnover level under the original calculation method has not changed at all. The problem can also arise if the method of allocating costs is changed; for example, it may be shifted from an allocation based on labor hours worked to one based on machine hours worked, which can alter the total amount of overhead costs assigned to inventory. The problem can also arise if the inventory valuation is based on standard costs, and the underlying standards are altered. In all three cases, the amount of inventory on hand has not changed, but the costing systems used have altered the reported level of inventory costs, which impacts the reported level of turnover.
A separate issue is that the basic inventory turnover figure may not be sufficient evidence of exactly where an inventory overage problem may lie. Accordingly, you can subdivide the measurement, so that there are separate calculations for raw materials, work-in-process, and finished goods (and perhaps be subdivided further by location). This approach allows for more precise management of inventory-related problems.