Inventory turnover
Encyclopedia
In accounting
, the Inventory turnover is a measure of the number of times inventory is sold or used in a time period such as a year. The equation
for inventory turnover equals the cost of goods sold divided by the average inventory
. Inventory turnover is also known as inventory turns, stockturn, stock turns, turns, and stock turnover.
The formula for average inventory:
Alternatively, the average days to sell the inventory may also be calculated as follows:
Some compilers of industry data (e.g., Dun & Bradstreet
) use sales as the numerator instead of cost of sales. Cost of sales yields a more realistic turnover ratio, but it is often necessary to use sales for purposes of comparative analysis. Cost of sales is considered to be more realistic because of the difference in which sales and the cost of sales are recorded. Sales are generally recorded at market value, i.e. the value at which the marketplace paid for the good or service provided by the firm. In the event that the firm had an exceptional year and the market paid a premium for the firm's goods and services then the numerator may be an inaccurate measure. However, cost of sales is recorded by the firm at what the firm actually paid for the materials available for sale. Additionally, firms may reduce prices to generate sales in an effort to cycle inventory. In this article, the terms "cost of sales" and "cost of goods sold" are synonymous.
An item whose inventory is sold (turns over) once a year has higher holding cost than one that turns over twice, or three times, or more in that time.Stock turnover also indicates the briskness of the business. The purpose of increasing inventory turns is to reduce inventory for three reasons.
However high turns may indicate that the inventory is too low. This often can result in stock shortages.
In practice this tends to be confusing and can give misleading results if averaged out over a department.
Also, stock turn rates are sometimes based on annual sales at retail divided by average inventory at retail. This measurement, sometimes available in computer systems, is based on the value that your customer perceives the product has (actual selling price which may include markdowns) and the value of your inventory. These computer systems can devalue inventory as markdowns occur even before they are sold. One valid reason for using retail for these calculations is that if a $100 retail-priced item (that was $50 at cost) is now only worth $80, then the retailer would find it difficult to pay $50 for an item only worth $80 to customers.
Retail-calculated stock turns rates tend to be lower than those calculated at cost.
The important issue is that any organization should be consistent in the formula that it uses.
Accountancy
Accountancy is the process of communicating financial information about a business entity to users such as shareholders and managers. The communication is generally in the form of financial statements that show in money terms the economic resources under the control of management; the art lies in...
, the Inventory turnover is a measure of the number of times inventory is sold or used in a time period such as a year. The equation
Equation
An equation is a mathematical statement that asserts the equality of two expressions. In modern notation, this is written by placing the expressions on either side of an equals sign , for examplex + 3 = 5\,asserts that x+3 is equal to 5...
for inventory turnover equals the cost of goods sold divided by the average inventory
Inventory
Inventory means a list compiled for some formal purpose, such as the details of an estate going to probate, or the contents of a house let furnished. This remains the prime meaning in British English...
. Inventory turnover is also known as inventory turns, stockturn, stock turns, turns, and stock turnover.
Inventory Turnover Equation
The formula for inventory turnover:
The formula for average inventory:
Alternatively, the average days to sell the inventory may also be calculated as follows:
Application in Business
A low turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing effort. However, in some instances a low rate may be appropriate, such as where higher inventory levels occur in anticipation of rapidly rising prices or shortages. A high turnover rate may indicate inadequate inventory levels, which may lead to a loss in business. Assume cost of sales is $70,000, beginning inventory is $10,000, and ending inventory is $9,000. The inventory turnover equals 7.37 times ($70,000/$9500).Some compilers of industry data (e.g., Dun & Bradstreet
Dun & Bradstreet
Dun & Bradstreet is a Fortune 500 public company headquartered in Short Hills, New Jersey, USA that provides information on businesses and corporations for use in credit decisions, B2B marketing and supply chain management...
) use sales as the numerator instead of cost of sales. Cost of sales yields a more realistic turnover ratio, but it is often necessary to use sales for purposes of comparative analysis. Cost of sales is considered to be more realistic because of the difference in which sales and the cost of sales are recorded. Sales are generally recorded at market value, i.e. the value at which the marketplace paid for the good or service provided by the firm. In the event that the firm had an exceptional year and the market paid a premium for the firm's goods and services then the numerator may be an inaccurate measure. However, cost of sales is recorded by the firm at what the firm actually paid for the materials available for sale. Additionally, firms may reduce prices to generate sales in an effort to cycle inventory. In this article, the terms "cost of sales" and "cost of goods sold" are synonymous.
An item whose inventory is sold (turns over) once a year has higher holding cost than one that turns over twice, or three times, or more in that time.Stock turnover also indicates the briskness of the business. The purpose of increasing inventory turns is to reduce inventory for three reasons.
- Increasing inventory turns reduces holding costHolding costIn business management, holding cost is money spent to keep and maintain a stock of goods in storage.The most obvious holding costs include rent for the required space; equipment, materials, and labor to operate the space; insurance; security; interest on money invested in the inventory and space,...
. The organization spends less money on rent, utilities, insurance, theft and other costs of maintaining a stock of good to be sold.
- Reducing holding costHolding costIn business management, holding cost is money spent to keep and maintain a stock of goods in storage.The most obvious holding costs include rent for the required space; equipment, materials, and labor to operate the space; insurance; security; interest on money invested in the inventory and space,...
increases net incomeNet incomeNet income is the residual income of a firm after adding total revenue and gains and subtracting all expenses and losses for the reporting period. Net income can be distributed among holders of common stock as a dividend or held by the firm as an addition to retained earnings...
and profitabilityProfit (accounting)In accounting, profit can be considered to be the difference between the purchase price and the costs of bringing to market whatever it is that is accounted as an enterprise in terms of the component costs of delivered goods and/or services and any operating or other expenses.-Definition:There are...
as long as the revenueRevenueIn business, revenue is income that a company receives from its normal business activities, usually from the sale of goods and services to customers. In many countries, such as the United Kingdom, revenue is referred to as turnover....
from selling the item remains constant.
- Items that turn over more quickly increase responsiveness to changes in customer requirements while allowing the replacement of obsolete items. This is a major concern in fashion industries.
However high turns may indicate that the inventory is too low. This often can result in stock shortages.
- When making comparison between firms, it's important to take note of the industry, or the comparison will be distorted. Making comparison between a supermarket and a car dealer, will not be appropriate, as supermarket sells fast moving goods such as sweets, chocolates, soft drinks so the stock turnover will be higher. However, a car dealer will have a low turnover due to the item being a slow moving item. As such only intra-industry comparison will be appropriate.
Note
Some computer programs measure the stock turns of an item using the actual number sold.In practice this tends to be confusing and can give misleading results if averaged out over a department.
Also, stock turn rates are sometimes based on annual sales at retail divided by average inventory at retail. This measurement, sometimes available in computer systems, is based on the value that your customer perceives the product has (actual selling price which may include markdowns) and the value of your inventory. These computer systems can devalue inventory as markdowns occur even before they are sold. One valid reason for using retail for these calculations is that if a $100 retail-priced item (that was $50 at cost) is now only worth $80, then the retailer would find it difficult to pay $50 for an item only worth $80 to customers.
Retail-calculated stock turns rates tend to be lower than those calculated at cost.
The important issue is that any organization should be consistent in the formula that it uses.
See also
- Cost accountingCost accountingCost accounting information is designed for managers. Since managers are taking decisions only for their own organization, there is no need for the information to be comparable to similar information from other organizations...
- InventoryInventoryInventory means a list compiled for some formal purpose, such as the details of an estate going to probate, or the contents of a house let furnished. This remains the prime meaning in British English...
- Inventory management softwareInventory management softwareInventory management software is a computer-based system for tracking product levels, orders, sales and deliveries. It can also be used in the manufacturing industry to create a work order, bill of materials and other production-related documents. Companies use inventory management software to...
- Throughput accountingThroughput accountingThroughput Accounting is a principle-based and comprehensive management accounting approach that provides managers with decision support information for enterprise profitability improvement. TA is relatively new in management accounting...
Further reading
- Business Mathematics, 10th Edition, Chapter 7, § 4, ISBN 0321277821