Inventory turnover is an indication of how frequently a company sells its physical products. The turnover rate tells the business if its products sell quickly or slowly. That information, in turn, helps the company make business decisions.
Inventory turnover can help a company understand a number of specifics, including whether:
- Product pricing should be adjusted
- Purchasing schedules should change
- Manufacturing volumes should change
- Promotions are needed to sell excess inventory
The inventory turnover rate is particularly important with perishable products such as produce and fashion, which is ever-changing. Too many “jeggings” today could mean unsold inventory (also known as dead stock) and a financial loss tomorrow.
In addition, storing inventory costs money that the inventory isn’t generating when it sits in a warehouse or elsewhere. Unsold inventory can eventually be obsolete and unsellable, making it a potential financial liability for a company.
How to calculate inventory turnover ratio
Accountants use a simple formula to calculate the turnover rate or ratio: Cost of goods sold divided by average inventory. The cost of goods sold, which is usually reported on the income statement, is the cost of materials for the product plus labor. Average inventory is determined by adding together the inventory for the first month in a given period to the last month in the period and dividing it by two.
Here’s the equation: Inventory turnover ratio = cost of goods sold ÷ average inventory.
Let’s say a self-published author named Bob sells printed copies of his book on his website, at online book retailers, and in-person. His cost of goods on his income statement is $1,000. His beginning inventory is $3,000 and his ending inventory for the period is $4,000 (averaging to $3,500). Applying the formula, his ratio is 1,000 ÷ 3,500 = .29 turnover. That means he sold almost a third of his inventory in that period.
Is that number good or bad? It depends on Bob’s goals for book sales and industry patterns.
Applying inventory turnover ratio to a business
A low inventory turnover could mean that the product isn’t priced properly, that there isn’t much demand for the product, or that it isn’t positioned properly.
A high inventory turnover might mean that the product is priced too low, that the company could sell even more of them if they had them to sell, or that the company didn’t buy or manufacture enough to meet demand.
A high turnover rate is better than a low rate except when it means you can’t keep the product in stock, so you lose sales opportunities. Any shopper who has been frustrated by an empty spot on a store shelf where the product they want to buy usually sits understands that concept.