In this article, we cover the inventory turnover ratio formula and its importance in inventory management. We will also walk you through our real-world examples on how to calculate it. Read on to learn more.
The inventory turnover formula measures how frequently a company sells and replaces its inventory over a specified period. Inventory turnover is calculated by dividing the cost of goods sold by the average inventory held during a period.
Example: In 2019, Walmart reported an inventory turnover of 8 times, meaning they sold and replenished their inventory approximately every 45 days. This demonstrates Walmart's effective supply chain management and consistent sales volume.
Understanding the components of the formula for inventory turnover is crucial for gauging a company's operational efficiency.
Formula: Inventory Turnover = Cost of Goods Sold (COGS) / Average Inventory.
To break this down:
Cost of Goods Sold (COGS): This represents the direct costs involved in producing the goods that a company sells, encompassing elements like raw materials and direct labor.
Average Inventory: This component provides an average perspective on inventory levels during that time. The formula to calculate it is as follows:
Average Inventory = (Beginning Inventory + Ending Inventory) / 2
Suppose in a given year, Nike reported a Cost of Goods Sold (COGS) of $15 billion. At the start of the year, their inventory was valued at $2 billion, and by the end, it was $3 billion.
First, calculate the Average Inventory:
Average Inventory = (Beginning Inventory + Ending Inventory) / 2
Average Inventory = ($2 billion + $3 billion) / 2
Average Inventory = $2.5 billion
Now, plug this into the Inventory Turnover formula:
Inventory Turnover = COGS / Average Inventory
Inventory Turnover = $15 billion / $2.5 billion
Inventory Turnover = 6 times
Thus, Nike's inventory turned over 6 times that year, indicating they sold and replaced their inventory six times over the year.
Suppose in a specific year, Samsung reported a Cost of Goods Sold (COGS) of $120 billion. At the beginning of the year, their inventory was valued at $10 billion, and by the end, it had risen to $15 billion.
First, calculate the Average Inventory:
Average Inventory = (Beginning Inventory + Ending Inventory) / 2
Average Inventory = ($10 billion + $15 billion) / 2
Average Inventory = $12.5 billion
Now, apply this to the Inventory Turnover formula:
Inventory Turnover = COGS / Average Inventory
Inventory Turnover = $120 billion / $12.5 billion
Inventory Turnover = 9.6 times
This means that Samsung's inventory turned over 9.6 times that year, indicating they sold and replenished their inventory nearly ten times over the year.
In a given year, Pfizer reported a Cost of Goods Sold (COGS) of $18 billion. At the beginning of the year, their inventory was valued at $3 billion. However, due to certain regulatory changes and research breakthroughs, by the end of the year, they had reduced their inventory to $2 billion.
First, calculate the Average Inventory:
Average Inventory = (Beginning Inventory + Ending Inventory) / 2
Average Inventory = ($3 billion + $2 billion) / 2
Average Inventory = $2.5 billion
Now, using the Inventory Turnover formula:
Inventory Turnover = COGS / Average Inventory
Inventory Turnover = $18 billion / $2.5 billion
Inventory Turnover = 7.2 times
This indicates that Pfizer turned over its inventory 7.2 times during the year, suggesting they efficiently managed stock levels amidst changing industry dynamics.
Inventory turnover is a vital metric for businesses that illuminates aspects of operations that may otherwise go unnoticed. Here are some key reasons why it’s important:
Efficiency Assessment: The inventory turnover ratio provides insights into how effectively a company manages its stock. A high turnover rate can indicate optimal inventory levels and strong sales.
Financial Health Indicator: A low turnover may suggest overstocking, tying up capital, or potential obsolescence. Conversely, a high ratio might indicate strong demand or efficient stock management.
Profitability Insights: Holding excessive inventory can increase costs like storage, insurance, and potential write-offs. Efficient turnover helps minimize these expenses, boosting profitability.
Cash Flow Implications: Quick inventory turnover often leads to faster cash inflows. This enhanced liquidity can be crucial for meeting financial obligations.
Competitive Benchmarking: Comparing turnover ratios with industry peers helps businesses identify their standing. It can highlight areas needing improvement or validate efficient operations.
Demand Forecasting: Regular analysis of inventory turnover can help in predicting product demand. Accurate demand forecasts aid in inventory planning and reduce surplus or shortage scenarios.
We hope this article has given you a better understanding of the inventory turnover formula and how to calculate it.
If you enjoyed this article, you might also like our article on raw materials inventory or our article on inventory to sales ratio.
