BUS202: Principles of Finance

Inventory turnover is a measure of the number of times inventory is sold or used in a time period, such as a year.

TERM

• holding cost

  In business management, holding cost is money spent to keep and maintain a stock of goods in storage.

Inventory Turnover

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.

Inventory Turnover Equation

• The formula for inventory turnover:

Inventory turnover = Cost of goods sold/Average inventory

• The formula for average inventory:

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

• The average days to sell the inventory is calculated as follows:

Average days to sell the inventory = 365 days / Inventory turnover ratio

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 expected market shortages.

Conversely, a high turnover rate may indicate inadequate inventory levels, which may lead to a loss in business as the inventory is too low. This often can result in stock shortages.

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 a 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 cost. The organization spends less money on rent, utilities, insurance, theft, and other costs of maintaining a stock of good to be sold.
• Reducing holding cost increases net income and profitability as long as the revenue 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.

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 a 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.