A tight economy demands high performance in all areas, which is why it pays to keep tabs on your inventory, one of your company’s largest investment. How you manage your inventory can be the ticket to soaring profits — or the anchor that pulls you under.
What is Inventory Turnover?
Turnover equals the cost of goods sold over a period of time (a year, for example) divided by the average inventory for that time period. It is a key performance indicator (KPI) for product-based companies — one of many measures of financial management — and it is also a contributing factor to overall return on investment (ROI).
Inventory is an investment in your future. Your purchase and stock of materials or products enables current and future fulfillment of sales. Here’s the key, though: The way you purchase your inventory affects your ability to operate and expand your business. For example, two companies each sell $50,000 of product (at cost) per year and each makes a $20,000 gross profit for that year. Company A purchases its entire inventory at the beginning of the year, investing $50,000 to make $20,000. However, Company B purchases $10,000 of product at the beginning of the year and makes four similar purchases to replenish their stock as it is sold. Company B invests $10,000 to make $20,000. The money Company B saved by making smaller more frequent purchases was available for new product lines, marketing initiatives, or other areas to foster company growth—and it probably avoided significant interest costs and the risk caused by additional debt.
Calculating Your Inventory Turnover
To calculate your Inventory Turnover for the year, divide the Cost of Goods Sold (COGS) from sales of inventory by the Average Inventory investment for the year.
For ease of calculation, let’s assume that both companies replenished their inventory on the last day of the year — so that Company A ended with $50,000 in inventory and Company B with $10,000. Average Inventory is Beginning Inventory plus Ending Inventory divided by 2. In our example, Company A turned its inventory one time ($50,000 COGS divided by $50,000 Average Inventory ((50K+50K)/2) = 1). Company B turned its inventory five times ($50,000 COGS divided by $10,000 Average Inventory ((10K+10K)/2) = 5).
How Frequently Should You Measure Your Inventory Investment?
The greater your inventory requirements, the more frequently you should measure your inventory investment. Some companies maintain a small value of inventory and can monitor their investment annually. Companies with a high value of inventory, particularly if seasonal in nature, should calculate the value of all items on hand monthly. For consistency, make your calculations on the same day each month and use the same cost basis (average or last cost for example) on both COGS and inventory investment.
What is the Optimal Turnover Rate?
Although the average for your industry may be a guide, as always, there are many other factors to consider in determining an optimal turnover rate for your company: procurement and storage costs, quantity discounts, whether your inventory is centralized or dispersed, impact of inventory shortages, variability of product demand, whether stock is readily available or subject to large prices variances, and maturity of the product you sell are a few. Stated simply, in order for your company’s inventory to perform at optimal levels, you must keep enough inventory on hand in order to effectively meet customer needs and make sales while minimizing your investment in inventory.
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