The inventory turnover formula measures the rate at which inventory is used over a measurement period. One can use the formula to see if a business has an excessive inventory investment in comparison to its sales level, which can indicate either unexpectedly low sales or poor inventory planning. 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 Some portion of the inventory may be out-of-date and so cannot be sold.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 inventory accounting 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.
- Purchasing practices. The purchasing manager may advocate purchasing in bulk to obtain volume purchase discounts. Doing so can substantially increase the investment in inventory.
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 also 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.
Inventory Turnover Formula
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 ÷ Inventory
Inventory Turnover Period
You can also divide the result of the inventory turnover 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. This is known as the inventory turnover period.
Inventory Turnover Refinements
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.