Why is Inventory turnover important?

If you are a retailer or a wholesaler, your biggest investment is more than likely your inventory.  Turning that inventory over quickly is critical to your success. So it makes sense for you to monitor this measure and do what you can to improve your performance.  In general, the higher your Inventory Turnover Ratio, the better.  A higher Inventory Turnover Ratio means that you have less cash tied up in inventory to support a given level of sales.

Like any other Key Performance Measure (KPI), you have to achieve a balance. If you reduce your inventory dramatically, it could be that you lose sales because of stockouts.  So rather than saying to yourself, “let me shoot for the highest possible Inventory Turnover Ration no matter what”, you really want to shoot for the highest possible Inventory Turnover Ratio without losing sales or otherwise disrupting your operations.  That is where your judgment comes in, and why you get paid the big bucks.

Say you sell $10,000 worth of a product (at cost) each year. Total revenue received from sales of the product is $12,500. If we bought the entire $10,000 worth of the product on January 1st, at the end of the year we would have made a $2,500 gross profit on an investment of $10,000. But do we have to buy the entire $10,000 worth of the product at one time? What if we bought $5,000 worth of the product on January 1st. Then, just before running out of stock, we bought an additional $5,000 worth of the product with part of the revenues received from selling the first shipment. At the end of the year we’ve still sold $10,000 worth of the product, still made $2,500 gross profit, but on an investment of about $5,000.

Could we make the same gross profit on an even smaller investment? What if we were to buy $2,500 dollars worth of material? Sell most of it. Buy another $2,500 dollars worth of the product. Sell most of that shipment and then repeat the process two more times before the end of the year. The annual gross profit of $2,500 is now generated with an investment of about $2,500.

There are several things to keep in mind when calculating turnover rates:

• Only consider cost of goods sold from stock sales which are filled from warehouse inventory. Non-stock items and direct shipments are not included. Sure, these sales are important, but don’t involve your warehouse stock (i.e. your investment in inventory).

• The cost of goods sold figure in the formula includes transfers of stocked products to other branches and quantities of these products used for internal purposes such as repairs and assemblies.

• Inventory turnover is based on the cost of items (what you paid for them) not sales dollars (what you sold them for).

Inventory turnover depends on the average value of stocked inventory. To determine your average inventory investment:

• Calculate the total value of every product in inventory (quantity on-hand times cost) every month, on the same day of the month. Be sure to be consistent in using the same cost basis (average cost, last cost, replacement cost, etc.) in calculating both the cost of goods sold and average inventory investment.

• If your inventory levels tend to fluctuate throughout the month, calculate your total inventory value on the first and fifteenth of every month.

• Determine the average inventory value by averaging of all of inventory valuations recorded during the past 12 months.

You have limited funds available to invest in inventory. You cannot stock a lifetime supply of every item. In order to generate the cash necessary to pay your bills and return a profit, you must sell the material you’ve bought. The inventory turnover rate measures how quickly you are moving inventory through your warehouse. Combined with other measurements such as customer service level and return on investment, inventory turnover can provide an accurate barometer of your success.