Inventory Turnover Formula
The inventory turnover formula is a calculation that businesses use to understand how efficiently they’re managing their inventory. It provides an insight into how many times a business sells and replaces its inventory over a given period.
The inventory turnover formula is:
Inventory Turnover = Cost of Goods Sold (COGS) / Average Inventory
Let’s break down the components of the formula:
- Cost of Goods Sold (COGS): This is the total cost of all goods that the company sold during a specific period. It includes the cost of materials and labor directly used to produce the goods, but not indirect costs like distribution or sales force costs.
- Average Inventory: This is the average amount of inventory the company had on hand during the same period. It’s usually calculated as the average of the inventory levels at the start and end of the period.
The resulting figure is the number of times the company’s inventory has “turned over” or been sold and replaced. A higher inventory turnover is generally better, indicating strong sales, effective inventory management, and less money tied up in unsold goods. However, if the ratio is too high, it may suggest that inventory levels are too low, which could lead to lost sales if the company runs out of stock. Conversely, a low inventory turnover may suggest weak sales and excess inventory.
Example of the Inventory Turnover Formula
Let’s consider a hypothetical electronics store, Best Electronics.
Suppose in the past year, Best Electronics had a Cost of Goods Sold (COGS) of $2,000,000. This is the total cost of all the electronics (like TVs, smartphones, laptops, etc.) that the store sold during that year.
The inventory at the start of the year was valued at $500,000 and at the end of the year, the inventory was valued at $400,000.
First, calculate the average inventory for the year. Add the beginning inventory to the ending inventory and divide by 2:
Average Inventory = ($500,000 + $400,000) / 2 = $450,000
Next, apply the values to the inventory turnover formula:
Inventory Turnover = COGS / Average Inventory
For Best Electronics:
Inventory Turnover = $2,000,000 / $450,000 = 4.44
So, Best Electronics has an inventory turnover of 4.44. This means that over the course of the year, Best Electronics sold and replaced its inventory approximately 4.44 times.
This figure can help Best Electronics assess the efficiency of its inventory management, compare itself to other businesses in its industry, and identify areas where it may be able to improve its operations. For example, if the industry average turnover is significantly higher, Best Electronics might need to look into ways of selling its inventory more quickly, or it might need to carry less inventory. Conversely, if its turnover is much higher than the industry average, it might need to ensure it’s not at risk of stockouts that could lead to lost sales.
