Inventory Turnover : Formula & Calculation

What Is Inventory Turnover?

Inventory turnover is a financial ratio showing how many times a company has sold and replaced inventory during a given period. A company can then divide the days in the period by the inventory turnover formula to calculate the days it takes to sell the inventory on hand.

Calculating inventory turnover can help businesses make better decisions on pricing, manufacturing, marketing, and purchasing new inventory.

Inventory Turnover Formula and Calculation

Inventory Turnover = COGS Average Value of Inventory where: COGS = Cost of goods sold \begin{aligned} &\text{Inventory Turnover} = \frac{ \text{COGS} }{ \text{Average Value of Inventory} } \\ &\textbf{where:} \\ &\text{COGS} = \text{Cost of goods sold} \\ \end{aligned} Inventory Turnover=Average Value of InventoryCOGSwhere:COGS=Cost of goods sold

Average Inventory = (Beginning Inventory + Ending Inventory) / 2

Companies can also calculate inventory turnover by:

1. Calculating the average inventory, which is done by dividing the sum of beginning inventory and ending inventory by two.
2. Dividing sales by average inventory.

As you can see above, there are two main methods to calculate inventory turnover: one using the cost of goods sold (COGS) and the other using sales. Analysts divide COGS by average inventory, instead of sales, for greater accuracy in the inventory turnover calculation because sales include a markup over cost. Dividing sales by average inventory inflates inventory turnover. In both situations, average inventory is used to help remove seasonality effects.

What Inventory Turnover Can Tell You

Inventory turnover measures how fast a company sells inventory. A low turnover implies weak sales and possibly excess inventory, also known as overstocking. It may indicate a problem with the goods being offered for sale or be a result of too little marketing.

A high ratio, on the other hand, implies either strong sales or insufficient inventory. The former is desirable while the latter could lead to lost business.

Sometimes a low inventory turnover rate is a good thing, such as when prices are expected to rise (inventory pre-positioned to meet fast-rising demand) or when shortages are anticipated.

The speed at which a company can sell inventory is a critical measure of business performance. Retailers that move inventory out faster tend to outperform. The longer an item is held, the higher its holding cost will be, and the fewer reasons consumers will have to return to the shop for new items.

A good example can be seen in the fast fashion business. Companies such as H&M and Zara typically limit runs and replace depleted inventory quickly with new items. Slow-selling items equate to higher holding costs compared to the faster-selling inventory. There is also the opportunity cost of low inventory turnover; an item that takes a long time to sell prevents the placement of newer items that may sell more readily.

Nusha Ashjaee {Copyright}, Investopedia, 2019.

Inventory Turnover and Dead Stock

Inventory turnover is an especially important piece of data for maximizing efficiency in the sale of perishable and other time-sensitive goods. Some examples could be milk, eggs, produce, fast fashion, automobiles, and periodicals.

An overabundance of cashmere sweaters may lead to unsold inventory and lost profits, especially as seasons change and retailers restock with new, seasonal inventory. Such unsold stock is known as obsolete inventory or dead stock.

Inventory Turnover and Open-to-Buy Systems

Some retailers may employ an open-to-buy system as they seek to manage their inventories and the replenishment of their inventories more efficiently. Open-to-buy systems, at their core, are software budgeting systems for purchasing merchandise. Such a system can be used to monitor merchandise and may be integrated into a retailer's financing and inventory control processes.

It can help small retailers better manage decisions on how much inventory to buy, how to evaluate how inventory is performing, and assist with future inventory procurement. Such software may be tailored to some degree but may not be useful for all types of merchandise. For example, it may work best with seasonal merchandise and fashion, but may not be a good fit for fast-selling consumer goods or basic items and staples.

Example of How to Use Inventory Turnover

Assume Company ABC has $1 million in sales and $250,000 in COGS. The average inventory is $25,000. Using this information, we can see that the company has an inventory turnover of 40 or $1 million divided by $25,000. In other words, within a year Company ABC tends to turn over its inventory 40 times.

Taking it a step further, dividing 365 days by the inventory turnover shows how many days on average it takes a company to sell its inventory. In the case of Company ABC, it’s 9.1.

Alternatively, using the other method — COGS / average inventory — the inventory turnover is 10, or $250,000 in COGS divided by $25,000 in inventory. Inventory is on hand for 36.5 days under this approach, or 365 / 10.

Inventory Turnover vs. Days Sales of Inventory

Inventory turnover shows how quickly a company can sell (turn over) its inventory. Meanwhile, days of inventory (DSI) looks at the average time a company can turn its inventory into sales.

DSI is essentially the inverse of inventory turnover for a given period, calculated as (inventory / COGS) * 365. Basically, DSI is the number of days it takes to turn inventory into sales, while inventory turnover determines how many times in a year inventory is sold or used.

Special Considerations

When comparing or projecting inventory turnover, one must compare similar products and businesses. For example, automobile turnover at a car dealer may turn over far slower than fast-moving consumer goods (FMCG) sold by a supermarket (snacks, sweets, soft drinks, etc.).

Trying to manipulate inventory turnover with discounts or closeouts is another consideration, as it can significantly cut into return on investment (ROI) and profitability.

How Do you Calculate Inventory Turnover?

Inventory turnover is a measure of how quickly a company sells its inventory in a year and is often used as a metric of overall operational efficiency.

There are two popular ways of calculating inventory turnover. The first method consists of dividing the company’s annual sales by its average inventory balance, whereas the second method divides the annual cost of goods sold (COGS) by average inventory. In either case, the average inventory balance is often estimated by taking the sum of beginning and ending inventory for the year and dividing it by 2.

What Is a Good Inventory Turnover?

What counts as a “good” inventory turnover will depend on the industry in question. As a general rule, industries stocking products that are relatively inexpensive will tend to have higher inventory turnovers, whereas more expensive items — where customers usually take more time before making a purchase decision — will tend to have lower inventory turnovers.

For instance, a company selling cheap products might sell the equivalent of 30 times their inventory in a year, whereas a company selling large industrial machinery might only cycle through their inventory 3 times. Inventory turnover ratios, therefore, need to be assessed relative to a company’s industry and competitors in order to tell whether they are good or bad.

Is High Inventory Turnover Good or Bad?

Companies will almost always aspire to have a high inventory turnover. After all, a high inventory turnover reduces the amount of capital they have tied up in their inventory, thereby improving their liquidity and financial strength. Moreover, keeping a high inventory turnover reduces the risk that their inventory will become unsellable due to spoilage, damage, theft, or technological obsolescence.