Inventory Turnover Formula or Stock Turnover Ratio
The inventory turnover formula or stock turnover ratio is defined as the rate at which inventory is used over a measurement period. This is an important measurement, for many businesses are burdened by an excessively large investment in inventory, which can consume their available cash. Inventory turnover is typically measured on a trend line or in comparison to the industry average to judge how well a company is performing in this area.
The following issues can impact the amount of inventory turnover:
- Seasonal build. Inventory may be built up in advance of a seasonal selling season.
- Obsolescence. Some portion of the inventory may be out-of-date and so cannot be sold.
- Cost accounting. The costing method used, combined with changes in prices paid for inventory, can result in significant swings in the reported amount of inventory.
- Flow method used. A "pull" system that only manufactures on demand requires much less inventory than a "push" system that manufactures based on estimated demand.
When there is a low rate of inventory turnover, this implies that a business may have a flawed purchasing system that bought too many goods, or that stocks were increased in anticipation of sales that did not occur. In both cases, there is a high risk of inventory aging, in which case it becomes obsolete and has little residual value.
When there is a high rate of inventory turnover, this implies that the purchasing function is tightly managed. However, it may mean that a business does not have the cash reserves to maintain normal inventory levels, and so is turning away prospective sales. The latter scenario is most likely when the amount of debt is unusually high and there are few cash reserves.
To calculate inventory turnover, divide the ending inventory figure into the annualized cost of sales. If the ending inventory figure is not a representative number, then use an average figure instead. The formula is:
Annual cost of goods sold
You can also divide the result of this calculation into 365 days to arrive at days of inventory on hand, which may be a more understandable figure. Thus, a turnover rate of 4.0 becomes 91 days of inventory.
A more refined measurement is to exclude direct labor and overhead from the annual cost of goods sold in the numerator of the formula, thereby concentrating attention on just the cost of materials.
There are several ways in which the inventory turnover figure can be skewed. For example:
- Cost pools. The contents of the cost pools from which overhead costs are allocated to inventory may be altered. For example, some items that were charged to expense as incurred are now allocated.
- Overhead allocation. The method for allocating overhead to inventory may change, such as from using direct labor hours as the basis of allocation to using machine hours used.
- Standard costs. If standard costing is used, the standard cost applied to an inventory item may diverge from its actual cost.
Example of Inventory Turnover
The Hegemony Toy Company is reviewing its inventory levels. The related information is $8,150,000 of cost of goods sold in the past year, and ending inventory of $1,630,000. Total inventory turnover is calculated as:
$8,150,000 Cost of Goods Sold
-------------------------------------- = 5 Turns Per Year
The 5 turns figure is then divided into 365 days to arrive at 73 days of inventory on hand.
The inventory turnover formula is also known as the inventory Turnover ratio and the stock turnover ratio.