Inventory turnover is a measure of how efficiently a company can control its merchandise, so it is important to have a high turn. This shows the company does not overspend by buying too much inventory and wastes resources by storing non-salable inventory. It also shows that the company can effectively sell the inventory it buys.
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.
How to Calculate Inventory Turnover ?
Inventory Turnover = Sales / Average Inventory
Average Inventory = (Opening Inventory + Closing Inventory) / 2
This ratio is important because total turnover depends on two main components of performance. The first component is stock purchasing. If larger amounts of inventory are purchased during the year, the company will have to sell greater amounts of inventory to improve its turnover. If the company can’t sell these greater amounts of inventory, it will incur storage costs and other holding costs.
The second component is sales. Sales have to match inventory purchases otherwise the inventory will not turn effectively. That’s why the purchasing and sales departments must be in tune with each other.
A good example can be seen in the fashion business. Such companies 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.
Let’s look into the limitations of Inventory Turnover Ratio.
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 sold by a supermarket. Trying to manipulate inventory turnover with discounts or closeouts is another consideration, as it can significantly cut into return on investment and profitability.
So in a nutshell,
- Inventory turnover shows how many times a company has sold and replaced inventory during a given period.
- This helps businesses make better decisions on pricing, manufacturing, marketing, and purchasing new inventory.