What is inventory turns (inventory turnover)?
Why is inventor turnover important?
The concept of an inventory turnover provides a number that symbolizes a measure of units sold compared to units on hand, or how well a company is managing inventory and generating sales from that inventory. It's an important component of effective supply chain management.
Inventory turns are an especially important measurement for retailers and companies that sell physical goods. Reducing inventory holdings can lead to reduced overhead costs and improved enterprise profitability.
How to calculate inventory turnover
The calculation for inventory turns for finished goods, literally, how often inventory "turns over" is as follows:
Cost of goods sold (COGS) ÷ average inventory (beginning inventory + ending inventory)/2
In some cases, companies use the ending inventory number, which is not ideal, but for companies with fairly stable levels of inventory from one year to the next, this may cause only a minor inaccuracy.
Inventory turnover example
Here's an example:
Company X has sales of $12 million, with a COGS of $10 million, and an average inventory of $5 million. The inventory turnover would be 2.
$10 million ÷ $5 million = 2
This inventory turnover ratio of 2 indicates that the company sells through its stock of inventory in six months. Since inventory turns determine whether performance costs and margin are keeping up with sales, or how much inventory is sold over a given amount of time, typically a higher inventory ratio is more ideal, since that indicates more sales are occurring in relationship to a certain amount of inventory.
The inventory turnover ratio also provides a context for an increase or decrease in sales. For example, starting with Company X's example above, if the company increased sales to $18 million, with a COGS of $15 million and an average inventory increase of $3 million (to $8 million), the calculation for inventory turns would be as follows:
$15 million ÷ $8 million = 1.875
In this case, although sales rose, inventory turns actually went down, signifying that performance costs, margin, and company inventory retention is worse in comparison to its previous level. On the other hand, if sales were $15 million, but inventory was reduced, the inventory turnover would be higher, indicating overall performance and margin improvements.
Still, an ideal target for inventory turns across industries and markets does not exist. Instead, each has challenges and requirements that determine the best level. Typically companies look to industry averages as a touchstone of whether they're gaining a competitive edge.
Two points are worth noting in relationship to inventory turnover:
- Although generally an increase in the inventory turnover ratio signifies more optimized operations, sometimes a very high inventory ratio could result in lost sales, since there may not be enough inventory to meet demand. This is one area where industry average benchmarks are particularly useful.
- Finished goods as compared with raw materials and components support different objectives. These should be measured separately.