Inventory turnover is a way to find out how many times in a certain period a company sells its inventory. Companies use inventory turnover to assess their ability to face competition, plan operating profits, and generally know how well they are performing their company's activities. Unlike employee turnover, high inventory turnover is generally viewed as a good thing because it means that their inventory sells out relatively quickly before it becomes unsaleable. In general, inventory turnover is calculated by the formula Inventory Turnover = Cost of Goods Sold (HPP)/Average Inventory.
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Method 1 of 2: Calculating Inventory Turnover Ratio
Step 1. Determine the time period for the calculation you are going to perform
Inventory turnover is always calculated on the basis of a certain period of time - this period can be one day to a fiscal year - it can even be calculated with the period during which the company operates. However, inventory turnover cannot reflect the instantaneous state of the company's achievements. Although the value of the company's inventory can be calculated at a certain time, the cost of goods sold does not describe the condition of the company if its value is calculated at a certain time, so this calculation must be done within a certain time period.
This calculation will be easier to do by using case examples to continue this discussion. For example, suppose we are the owner of a wholesale company that sells coffee. For this example, we will use the time range one year as the coffee company's operating period. For the next steps, we will calculate the inventory turnover during this one year period.
Step 2. Calculate the cost of inventory for this one-year period
After determining the time period, you must first calculate the cost of goods sold (or "COGS") during this period. The COGS consists of the direct costs you incur to produce the goods that you are going to sell. Usually, direct costs are the costs of producing the goods you are going to sell plus the labor costs directly related to the process of producing these goods.
- HPP does not include costs such as shipping and distribution costs that are not directly related to the production process of these goods.
- In the example we discussed, let's say we want to earn a high profit from coffee sales during the year, by purchasing $3 million in seeds, pesticides, and other costs associated with caring for the coffee tree, and $2 million in labor costs since planting. coffee seeds. In this case, our COGS is $3 million + $2 million = $5 million.
Step 3. Divide this COGS value by the average value of your inventory
Next, divide the COGS value by the average inventory value over the time period you are analyzing. The average value of your inventory is the average of the prices of all items in your warehouse and shelves in your store that have not been sold during the specified period. The easiest way to calculate the average value of this inventory is to add the value of the inventory on hand at the beginning of the period to the value of the inventory at the end of the period, then divide by two. By using some additional data during this period, you will get a more accurate average inventory value. If you use more than two pieces of data to calculate the average, add up all the data and then divide by how much data you used.
- For example, in the example we're considering, at the beginning of the year we had $0.5 million in stock in our warehouse for coffee beans. At the end of the year, we have a stock of coffee beans worth $0.3 million. So the average value of our coffee bean supply is ($0.5 million + $0.3 million)/2 = $0.4 million.
- Next, divide the COGS by the average inventory value to calculate our inventory turnover. In this example, the COGS amount is $5 million and the average inventory amount is $0.4 million, so our annual inventory turnover is $5 million/$0.4 million = 12, 5. This number is a ratio and has no units.
Step 4. Use the Turnover = Sales/Inventory formula just to get a quick estimate
If you don't have enough time to calculate with the basic equations described above, this quick method can give you an estimate of how much your inventory turnover will be. However, many companies prefer not to use this method of calculation because the results are not very accurate. Because sales are recorded at the price charged to consumers, while inventory is recorded at a lower value than its selling price, this formula can provide results that make your inventory turnover appear higher than it actually is. As a rule, this formula should only be used to make quick estimates-but use the former if you need this calculation for more important things.
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In this example, let's say we achieved sales of $6 million over the past year. To calculate inventory turnover with the second formula above, we must divide this sales figure by the ending inventory value mentioned above of $0.3 million. So if we calculate our inventory turnover with this second formula, then the result is $6 million/$0.3 million =
Step 20.. This number is much higher than the number 12.5 we get if we use the basic equation earlier.
Method 2 of 2: Understanding the Meaning of Calculation Results
Step 1. Use some inventory value data to get a more accurate calculation result
As stated above, if you calculate the average inventory using only the beginning and ending inventory values, you can still find out the average of your inventory values, but this value does not take into account fluctuations in inventory values during the calculation period. Use additional data to get more accurate values.
- When determining the amount of data, make sure the data you use is data that is taken evenly covering the entire current period and has regular intervals. For example, if you want to calculate the average inventory for a year, don't use the twelve numbers in January alone. However, use one number from the beginning of each month.
- Suppose our inventory at the beginning of the year of our company's operations is $20,000 and our ending inventory is $30,000. Using the basic formula above, we will get an average value of $25,000. However, the addition of one number can make us see a different picture. For example, let's say we also have an inventory figure taken from the middle of the year of $40,000. In this case, the average value of our inventory would be ($20,000 + $30,000 + $40,000)/3 = $30,000 - slightly higher (and more representative of the true average) than the previous calculation.
Step 2. Use the formula Inventory Period = 365 days/Turnover to calculate the average period for selling your inventory
With an additional calculation, you can calculate how long on average it will take you to sell all of your inventory. First, calculate your annual inventory turnover as usual. Then divide 365 days by the ratio you get from the inventory turnover calculation. Your answer is the average number of days it will take you to sell your entire inventory.
- For example, let's say we have an inventory turnover ratio of 8.5 during the current period. By calculating 365 days/8, 5 we will get the result 42, 9 days. This means, on average, that we sell our entire inventory in nearly 43 days.
- If you're calculating your inventory turnover for a time period other than one year, replace the 365 days number in the formula with the number of days for the period you want to calculate. For example, if you have an inventory turnover of 2.5 during the month of September, you should calculate the average sales period for your inventory in the way 30 days/2, 5 = 12 days.
Step 3. Use this inventory turnover information to get an idea of efficiency
Usually (though not always) companies want to sell their inventory quickly, rather than slowly. Therefore, the inventory turnover rate of a company can be used as an indication of the efficiency level of the company's operations, especially when compared to competitors. However, you should note that there must be an understanding of the business conditions in making this comparison. Low inventory turnover is not always bad and high inventory turnover is not always good.
For example, luxury sports cars usually don't sell quickly because their market is relatively small. So it's only natural that sports car salespeople have relatively small inventory turnovers - because they may not be able to sell all of their inventory in one year. On the other hand, if this car salesman suddenly has a rapidly surging inventory turnover, this could be very good, but it may also mean that something is not right, depending on the circumstances - this may result in a lost opportunity to sell
Step 4. Compare your inventory turnover to the industry average
One of the best ways to determine the efficiency level of your company's operations is to compare it to the average turnover ratio of other companies in the same industry. Some financial publications (written and aloud) provide company ratings based on average inventory turnover according to the industry sector, which you can use as material to conduct a general comparative study so that you can measure the level of achievement of your company. You can get information about this ranking through the company's ranking site. However, you should keep in mind that these numbers represent an industry average, and under certain circumstances, you should consider whether your inventory turnover should be significantly lower or higher than the published figures.
Another source of information that can help you compare your company's inventory turnover to the industry average is through the inventory turnover calculator site. This site provides the facility to select an industry field, then you can create a hypothesis in calculating the inventory turnover ratio by entering the COGS and average inventory figures from your company, then compare them with the average value of the industry you choose
Tips
- Look for information based on statistical data specific to your industry so you can see how your company ranks in terms of inventory turnover compared to competitors and companies in the same field. Recommendations suggested by the company's accounting department who have the closest conditions to your company's condition may be very useful in revealing whether your company's inventory turnover rate is able to bring your company to success in its field.
- Ensure that cost of goods sold and average inventory are determined using the same calculation basis. For example, if your company is a multinational company, use the same currency units. Since these two numbers are total values, this calculation will show a correlation and give accurate results.
