…it measures how hard your
inventory investment is working
by Jon Schreibfeder
Say you sell $10,000 worth of a product (at cost) each year. Total revenue received from sales of the product is $12,500. If we bought the entire $10,000 worth of the product on January 1st, at the end of the year we would have made a $2,500 gross profit on an investment of $10,000.
But do we have to buy the entire $10,000 worth of the product at one time? What if we bought $5,000 worth of the product on January 1st. Then, just before running out of stock, we bought an additional $5,000 worth of the product with part of the revenues received from selling the first shipment. At the end of the year we’ve still sold $10,000 worth of the product, still made $2,500 gross profit, but on an investment of about $5,000.
Could we make the same gross profit on an even smaller investment? What if we were to buy $2,500 dollars worth of material. Sell most of it. Buy another $2,500 dollars worth of the product. Sell most of that shipment and then repeat the process two more times before the end of the year. The annual gross profit of $2,500 is now generated with an investment of about $2,500.
Which investment option is better? Selling $10,000 worth of a product (and making $2,500 gross profit) with an investment of $10,000, $5,000 or $2,500? The best option is $2,500. Investing $2,500 (rather than $10,000) frees up $7,500 that can be used for other purposes… such as stocking other products that have the potential of generating additional profits.
Every time we sell an amount of a product, product line, or other group of items equal to the average amount of money we have invested in those items, we have “turned” our inventory. The inventory turnover rate measures the number of times we have turned our inventory during the past 12 months. Here is a list of the turnover rates from our example:
Annual Cost of | Inventory | Annual |
$10,000 | $10,000 | 1 |
$10,000 | $5,000 | 2 |
$10,000 | $2,500 | 4 |
The Inventory Turnover Formula
Inventory turnover is calculated with the following formula:
Cost of Goods Sold from Stock Sales during the Past 12 Months
Average Inventory Investment during the Past 12 Months
There are several things to keep in mind when calculating turnover rates:
1. Only consider cost of goods sold from stock sales which are filled from warehouse inventory. Non-stock items and direct shipments are not included. Sure, these sales are important, but don’t involve your warehouse stock (i.e. your investment in inventory).
2. The cost of goods sold figure in the formula includes transfers of stocked products to other branches and quantities of these products used for internal purposes such as repairs and assemblies.
3. Inventory turnover is based on the cost of items (what you paid for them) not sales dollars (what you sold them for).
Inventory turnover depends on the average value of stocked inventory. To determine your average inventory investment:
a. Calculate the total value of every product in inventory (quantity on-hand times cost) every month, on the same day of the month. Be sure to be consistent in using the same cost basis (average cost, last cost, replacement cost, etc.) in calculating both the cost of goods sold and average inventory investment.
b. If your inventory levels tends to fluctuate throughout the month, calculate your total inventory value on the first and fifteenth of every month.
c. Determine the average inventory value by averaging of all of inventory valuations recorded during the past 12 months.
Turnover Goals
As you determine your inventory turnover goals, consider the average gross margin you receive on the sale of products. Most distributors who have 20% – 30% gross margins should strive to achieve an overall turnover rate of five to six turns per year. Distributors with lower margins require higher stock turnover. If your company enjoys high gross margins, you can afford to turn your inventory less often.
A turnover rate of six turns per year doesn’t mean that the stock of every item will turn six times. The stock of popular, fast moving items should turn more often (up to 12 times per year). Slow moving items may turn only once, or not at all.
Finally, calculate inventory turnover separately for every product line in every warehouse. This will allow you to identify situations in which your inventory is not providing an adequate return on your investment. To improve inventory turnover, consider reducing the quantity you normally buy from the supplier. Inventory turns improve when you buy less of product, more often.
You have limited funds available to invest in inventory. You cannot stock a lifetime supply of every item. In order to generate the cash necessary to pay your bills and return a profit, you must sell the material you’ve bought. The inventory turnover rate measures how quickly you are moving inventory through your warehouse. Combined with other measurements such as customer service level and return on investment, inventory turnover can provide an accurate barometer of your success.
