What is inventory turnover
Inventory turnover rate refers to the number of times inventory must be replaced within a specific time period (usually one year). It is one of the most commonly used ratios in inventory management, as it reflects the overall efficiency of the supply chain from suppliers to customers. This ratio can be calculated for any type of inventory (materials and supplies, work in progress, finished products, or all combinations), and it can be used for retail and manufacturing.
The ratio of the revenue formula is calculated by taking the cost of good cost of sales (COGS) from the average aggregated inventory value (AAIV):
Inventory turnover=COGS/AAIV
The cost of sales (COGS) of the product, sometimes referred to as revenue expenses, is the annual expense provided by the company to sell the product to customers. However, this expense does not include sales expenses or management expenses. The average total inventory value (AAIV) is the value of all items held by the inventory holding company at cost.
The company often represents its inventory as days or weeks of supply. The main advantage of this method is that it produces values that are quite easy to understand and provides a direct comparison point for delivery time. In this case, the other ratio derived from the first one represents how many days of inventory are available in the system - or how many days are needed to sell inventory.
Days of supply=(AAIV/COGS) x 365 days=365/turnover
When this ratio is applied to a product, it is commonly referred to as inventory cover.
Example: If the cost of goods sold during the year is $1 million and the average inventory value for that year is $100000, then the inventory turnover rate is 10. It takes an average of 365/10=36.5 days to cycle the entire inventory.
FIFO assumption
A basic assumption when calculating inventory turnover is to use the "first in, first out" method (FIFO) to estimate inventory. This method assumes that the first unit arriving at the inventory is the first unit sold or processed. The average inventory value used in this ratio changes accordingly.
Using ending balances instead of average inventory may lead to misleading rates (lower or higher than estimated storage requirements) and should be avoided.
Performance indicators
Revenue is one of the most commonly used indicators of supply chain efficiency.
Low inventory turnover is usually related to inventory surplus, inventory backlog, and dead inventory (non inventory inventory). Low turns also bring liquidity issues and increase working capital pressure.
A high inventory turnover rate is usually positive as it indicates that the goods are selling rapidly. This may be due to good inventory management, but it may also imply insufficient safety stock.
Strategic procurement decisions such as choosing close or distant suppliers can have a significant impact on revenue, as revenue is often highly correlated with delivery cycles.
Differences between industries
Grocery chains that sell perishable goods typically have inventory turnover rates of around 100% for these products. Products must be sold quickly because they will expire quickly. The cancellation caused by expired products may incur significant costs. View the discussion on perishable foods in our article on service levels. On the other hand, the revenue of manufacturing companies is much lower, ranging from 5 to 10. Due to the longer storage time of their products, low inventory turnover does not necessarily indicate inadequate inventory management: cars will not become outdated after being stored for 2 months. Therefore, the company must determine its inventory turnover rate by comparing it with industry standards in order to understand this indicator.
The limit on revenue as a static indicator
Inventory turnover rate is the average value. It may not necessarily reflect fluctuations in inventory and activity over a year or several years. For example, high inventory levels can be established during expected seasonal sales peak periods. This model will increase the annual inventory turnover rate, but it is necessary to avoid stockouts during peak periods.
Over a longer period of time, inventory turnover rate is the most useful trend indicator. The growth trend indicates that the less capital is required to sell one dollar of goods, the higher the efficiency of the supply chain. However, this situation only occurs when the corresponding shortage increase does not alleviate this increase.
How to improve inventory turnover rate?
Purchase by selecting new suppliers that offer shorter delivery cycles, or by negotiating to shorten delivery times with existing suppliers.
Service level, by adjusting the acceptable frequency of stockouts (zero stockouts is not a reasonable choice for most industries).
Prediction, by refining the accuracy of demand forecasting, enables the reduction of safety stock without increasing inventory shortages.
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