A tight economy demands high performance in all areas, which is why it pays to keep tabs on your inventory, one of your company’s largest investments. How you manage your inventory can be the ticket to soaring profits — or the anchor that pulls you under.
Your inventory affects your ability to operate and expand your business. For example, two companies each sell $50,000 of product (at cost) per year and each makes a $20,000 gross profit for that year. Company A purchases its entire inventory at the beginning of the year, investing $50,000 to make $20,000. However, Company B purchases $10,000 of product at the beginning of the year and makes four similar purchases to replenish their stock as it is sold. Company B invested $10,000 to make $20,000. The money Company B saved by making smaller more frequent purchases was available for new product lines, marketing initiatives, or other areas to foster company growth—and it probably avoided significant interest costs and the risk caused by additional debt.
Calculate your inventory turnover with a simple equation.
To calculate your inventory turnover for the year, divide the Cost of Goods Sold (COGS) from sales of inventory by the Average Inventory investment for the year. For ease of calculation, let’s assume that both companies replenished their inventory on the last day of the year — so that Company A ended with $50,000 in inventory and Company B with $10,000. Average Inventory is Beginning Inventory plus Ending Inventory divided by 2. In our example, Company A turned its inventory one time ($50,000 COGS divided by average inventory of (50k + 50k) / 2 = $50,000). Company B turned its inventory 5 times ($50,000 COGS divided by average inventory of (10k + 10k) / 2 = $10,000).
How frequently should you measure your inventory investment?
Some companies maintain a small value of inventory and can monitor their investment annually. Companies with a high value of inventory, particularly if seasonal in nature, should calculate the value of all items on hand monthly. For consistency, make your calculations on the same day each month and use the same cost basis (average or last cost for example) on both COGS and inventory investment.
What is the optimal turnover rate?
Although the average for your industry may be a guide, as always, there are many other factors to consider in determining an optimal turnover rate for your company: procurement and storage costs, quantity discounts, whether your inventory is centralized or dispersed, impact of inventory shortages, variability of product demand, whether stock is readily available or subject to large price variances, and maturity of the product you sell are a few. Stated simply, in order for your company’s inventory to perform at optimal levels, you must keep enough inventories on hand in order to effectively meet customer needs and make sales while minimizing your investment in inventory.
What might your inventory turnover say about your company?
Low turnover can point to potential problems such as overstocking, products approaching obsolescence, improper purchasing practices, weakening product demands, or ineffective marketing and sales efforts.
However, a low turnover rate can also be a result of stocking up to take advantage of rising prices, to serve growing or seasonal customer demands, or to avoid shortages. High turnover can indicate that your company’s inventory is at peak performance. A very high turnover rate, however, can indicate that your company has ineffective purchasing practices or is encountering frequent shortages that reduce sales, weaken production efficiency, and erode profits.
Many inventory product lines and parts to manage?
If you maintain a high degree of commonality of parts or ingredients among your products, you may be able to monitor turnover across the entire product line. But for parts inventory that are highly product-specific, you may want to calculate the turnover by product or product line. Actively managing turnover may be most effective on a subset of inventory items that are high-value, perishable, and/or most subject to obsolescence.