Inventory Turnover Ratio
What is Inventory Turnover?
Inventory turnover is the rate at which a company sells its inventory. Inventory Turnover refers to the movement of material into and out of an organization. It is in the best interest of the organization to compare the turnover of different types of and grades of material as a measure of detecting stock which does not move regularly thereby minimizing capital investment in undesirable stock.
Inventory Turnover Ratio
Inventory Turnover Ratio can be calculated by comparing the balance of stores with total issues or withdrawals during a particular period of time.
Inventory/material turnover ratio (also known as stock turnover ratio or rate of stock turnover) is the number of times a company turns over its average stock in a year. It shows how fast the stock moves in and out of the company.
Formula to calculate Inventory Turnover Ratio
Inventory turnover ratio/rate of stock turnover is arrived at by using the following formula:
Average stock can be calculated by adding opening and closing stocks and then divided by two or it may be put like this:
Average Stock = (Opening stock + Closing stock) / 2
Inventory turnover ratio indicates that the material items are fast moving and exhaust easily and investment in that item can be kept a minimum. On the other hand, the low inventory turnover ratio in relation to a particular item indicates its slow movement and alarms the organization to avoid over-stocking of that item in the stores and immediate disposal of such item is in the best interest of concern.
How to calculate Cost of goods sold using inventory turnover ratio?
If the average stock and inventory/material turnover ratio are known, we can obtain cost of goods sold as follows:
Cost of goods sold = Average stock at cost × Inventory turnover ratio
If the average stock of a business is high in relation to its annual sales, obviously its inventory turnover ratio would be lower. Similarly, if the average stock is low, the inventory turnover ratio would be high.
A high inventory/material turnover ratio means efficiency in the use of funds invested in the stock. However, it also has its drawbacks. It might lead to frequent stock-outs, inability to provide adequate choice to customers, failure to meet sudden increases in demand, etc. Most industries have a norm as to what is a reasonable rate of stock turnover. Certain industries like automobiles carry a very low inventory turnover ratio like only 3 or 4 times per year. In other words, their average stock is one-third or one-quarter of their annual cost of sales.
Certain other businesses have a much faster inventory turnover ratio like petroleum companies who may carry stock of no more than three days requirements at any given time. The reason is simple. They are able to maintain an efficient system of distribution and get replenishment on daily or several times a day basis. Thus they can meet their customers’ need without having to have large stocks. Very often every industry has an acceptable average inventory turnover ratio and most businesses operating in the industry try to stay as close as possible to that industry average.
Classification of Inventory turnover:
Inventory turnover indicating slow-moving items have been classified in the following three categories:
(a) Slow-moving Material
These indicate the items which exhaust at a very slow speed. An attempt should be made to minimize the stock of such items in the store.
(b) Dorment Items
Such material items do not have any demand in present and represent zero turnover ration. Such stock may regain its demand in the future. Store-keeper and other officials of concern should site together and decide whether to retain or to dispose of such items in order to save further storing or handling the cost.
(c) Obsolete items
Such material items are no longer in demand and represent a zero turnover ratio. Obsolete items should be immediately scrapped or discarded and profit or loss should be transferred or Costing Profit and Loss Account.
The John Trading Concern provides you the following data for the year 2016:
Opening stock: $570,000
Closing stock: $630,000
Purchases made during the year: $3,660,000
Calculate and interpret inventory/material turnover ratio (i.e., rate of stock turnover or stock turnover ratio) for John Trading Concern.
Calculation of the rate of stock turnover (or stock turnover ratio):
Before computing the inventory turnover ratio of John Trading Concern, we need to compute the average stock and cost of sales.
Average stock = (Opening stock + Closing stock)/2
= ($570,000 + $630,000)/2
Cost of sales = Opening stock + Purchases – Closing stock
= $570,000 + $3,660,000 – $630,000
Inventory or material turnover ratio = $3,600,000/$600,000
= 6 times a year; or once every 2 month
For a trading concern, an inventory/material turnover ratio of 6 times is not very high. One would expect a trading company to have a faster rate of stock turnover. However, it is difficult to pass judgment without knowing the exact type of goods that John Trading Concern is dealing in and the norms prevailing in the market for that type of goods. For that purpose knowing an industry average is helpful to truly appreciate the efficiency or otherwise of stock management exercised by the company.
The following figures are taken from the books of John (Pvt) Ltd. for the year ending 31 March 2019. The valuation of Inventory is $1 per kg. or Litre.
|Items||Opening Stock||Purchases||Closing Stock|
|Material X||700 kg.||11,500 kg.||200 kg.|
|Material Y||200 Litres||11,000 Litres||1,200 Litres|
|Material Z||1,000 kg.||1,800 kg.||1,200 kg.|
Calculate the inventory/material turnover ratio of the above material items and express in number of days the average inventory is held.
First of all, cost of materials consumed pertaining to each item is to be calculated:
Material consumed = opening stock + purchases – closing stock
Consumption of X material = 700 + 11,500 – 200 = 12,000 kg
Consumption of Y material = 200 + 11,000 – 1,200 = 10,000 Litres
Consumption of Z material = 1,000 + 1,800 – 1,2000 = 1,600 kg.
Let us now ascertain the Average Inventory of each material item.
Average Inventory = (Opening Stock + Closing Stock) / 2
Average Inventory of X = (700 + 2000) / 2 = 450 kg
Average Inventory of Y = (200 + 1,200) / 2 = 700 Litres
Average Inventory of Z = (1,000 + 1,200) / 2 = 1,100 kg.
Inventory/Material Turnover Ratio = Value of Materials Consumed during the period / Value of Average Inventory held during the period
Inventory/Material Turnover Ratio of:
Material X = 12,000 / 450 = 26.67 Times
Material Y = 10,000 / 700 = 14.29 Times
Material Z = 1,600 / 1,100 = 1.45 Times
The Inventory Turnover as expressed in days can be calculated by applying the following formula:
= (Value of average inventory x Total No. of days during the period) / Material consumed
= Total No. of days during the period / Inventory/Material Turnover
Material X = 450 x 365 / 12,000 = 365 / 26.67 = 14 days (approx.)
Material Y = 700 x 365 / 10,000 = 365 / 14.29 = 26 days (approx.)
Material Z = 1,100 x 365 / 1,600 = 365 / 1.46 = 250 days.
In the above problem inventory/Material Turnover Ratio is highest in case of material X and lowest in case of Material Z. similarly consumption rate in case of material X is more as compared to Z which is the lowest as indicated by the No. of days calculated. It is suggested that purchase of Z material should be made in limited quantity as and when the need arises, whereas frequent purchases are suggested in case of Material X and moderate in purchases in case of material Y.