The inventory or inventory turnover index is a system for measuring how many times a company sells its inventories in a given period of time. Companies use it to assess their competitiveness, to make profit forecasts, and more generally to assess whether they are doing well within their reference sector. Unlike staff turnover, high inventory turnover is usually seen as a positive indicator, as it means that assets are being sold quickly enough and before they can deteriorate. The inventory turnover rate is usually calculated with the formula Rotation = Cost of Sales (CdV) / Average of the Warehouse.
Steps
Part 1 of 2: Calculating the Inventory Rotation Rate
Step 1. Choose a time period against which to calculate
Inventory turnover is always calculated with reference to a certain period of time (it can be any period, from a single day to a full year) or even to the entire life of the activity in question. However, inventory rotation cannot be viewed as a snapshot of a company's performance. While it is possible to determine the inventory value of an asset at a given moment, the cost of goods sold is a meaningless entity if considered as a value referring to a precise instant, so it is necessary to define a specific time frame to refer to.
Here is an example to solve during the discussion of this chapter. Suppose you own a wholesale coffee production company. For our example we choose a time period of one year of activity of this company. In the next steps we will calculate the inventory turnover for this exercise.
Step 2. Calculate the cost of sales over the reporting period
After determining the reference time period, the first step is to calculate the cost of goods sold (or "CdV") during that time period. The CdV represents the direct cost of production of the goods produced. Usually, this means that it is determined by the sum of the cost of manufacturing the goods plus the cost of labor directly attributable to their production.
- The CdV does not include costs such as shipping and distribution costs that are not directly attributable to the production of the goods.
- In our example, let's say we had a high-yield year in the coffee industry, and we spent € 3 million on seeds, pesticides, and other costs related to growing coffee beans, and € 2 million on costs of labor for plant cultivation. In this case, we could say that our CdV is equal to 3 million + 2 million = 5 million euros.
Step 3. Divide the sales force by the average inventory
Then, the CdV must be divided by the average value of the warehouse in the period of time being considered. This is the average monetary value of all the goods deposited in the warehouse and on the shelves of the points of sale, which were not sold in the period under consideration. The simplest way to find this value is to add the inventory value at the beginning of the period to the value at the end of the period, and then divide by two. However, using other values at additional intermediate reference dates helps to obtain a more accurate average value. If you use more than two reference dates, sum all the inventory values, and then divide by the number of reference dates to find the average.
- Let's say in our example at the beginning of the year we had coffee beans in stock worth 0.5 million euros. At the end of the year we had a value of 0.3 million. (0.5 million + 0.3 million) / 2 = an average of 0, 4 million euros in stock.
- Then, to calculate the turnover of the warehouse, divide the CdV by the average of the warehouse. In our example, the CdV is 5 million euros and the average inventory is 0.4 million euros, so our inventory cycle for the year in question is 5 million / 0.4 million = 12, 5. This figure is a ratio so it has no unit of measurement.
Step 4. The Rotation = Sales / Warehouse formula is only used for very fast evaluations
If you don't have the time to do the normal equation described above, this shortcut can give you an approximate value to get an idea of inventory turnover. However, most companies prefer to avoid using this formula, as the results it provides are too approximate. This formula can result in inventory turnover looking higher than it actually is, due to the fact that sales are accounted for at the price they are offered to customers, while inventory is accounted for only at wholesale costs plus bass. As a general rule, this formula should only be used for quick assessments; for more important purposes use the first more complete formula.
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In our example, let's say we achieved 6 million euros in sales in the last financial year. To calculate the turnover of the warehouse with the above mentioned alternative formula, we should divide this turnover by the value of the warehouse at the end of the year, or by 0.3 million euros; 6 million / 0, 3 million =
Step 20.. The result is significantly higher than the actual value of 12.5 we got with the normal formula.
Part 2 of 2: Mastering the Formula
Step 1. Numerous inventory values recorded on different dates are used for more reliable results
As mentioned before, calculating the average inventory value from the initial and final values returns an approximate average value of the inventory, however this value does not take into account the variations that occur during the time period taken as a reference. Using further intermediate measurements a more realistic result is obtained.
- When choosing the intermediate dates to be considered, care must be taken to consider regular and uniform time intervals within the entire reporting period. For example, if you are calculating the average inventory over a year, you don't have to consider twelve values starting in January. Rather, the inventory values recorded on the first day of each month should be considered.
- Let's take the example that the value of our warehouse at the beginning of the year for a full year of activity is equal to 20,000 euros and that at the end of the year is 30,000 euros. Using the normal system above we would have had an average inventory of 25,000 euros. However, even a single further interim survey could outline a different scenario. For example, let's say we want to use the inventory value at an intermediate date exactly in the middle of the year which was 40,000 euros. In this case, our average inventory will have been (20,000 + 30,000 + 40,000) / 3 = 30,000 euros - a slightly higher value (and more representative of the real average) than before.
Step 2. To calculate the average time it takes to sell inventory, use the formula Time = 365 days / rotation
With just one more operation you can calculate how long it takes on average to sell all inventory. First, the turnover of the warehouse is calculated with the normal formula, then the 365 days are divided by the ratio obtained as the turnover of the warehouse. The result will be the number of days it takes on average to sell all inventory.
- For example, let's assume we have an inventory turnover of 8.5 for a given year. Making the ratio 365 days / 8, 5 is obtained 42, 9 days. In other words, on average, it takes about 43 days to sell all inventory.
- If you have calculated inventory turnover referring to a period of time other than the year, just substitute the number of days in the period in question to the numerator. For example, if you have determined that for the month of September the inventory turnover was equal to 2.5, you will find the average time it takes to sell all the inventory making 30 days / 2.5 = 12 days.
Step 3. The inventory rotation is used as a rough measure of efficiency
Usually (though not always) companies want to sell their inventory in the shortest possible time, rather than over long periods of time. Because of this, a company's inventory rotation can be used as a clue to how much the company itself is working, particularly by comparing this indicator with that of other competitors. However, it is vital to remember that context is very important in this type of comparison. Low inventory turnover isn't always a good index, and high inventory turnover isn't always a good thing.
For example, luxury sports cars don't usually sell very quickly because they have a rather small market. Thus, an import sports car dealership can be expected to have a fairly low inventory turnover rate - they may not even be able to sell their stocks in even a full year. On the other hand, if the same dealer suddenly experiences a spike in inventory turnover, it might be a good sign, but it might not be, depending on the context - for example, such an event could result in a lack of stock assortment. which in turn could result in the loss of other sales
Step 4. Compare the company's inventory turnover index with the industry average
A useful way to judge the operational efficiency of a company is to compare its inventory turnover index with the average of companies operating in the same sector. Some financial publications (both in print and on the internet) publish rankings relating to the average inventory turnover by sector, which can constitute an approximate benchmark with which to compare company performance. However, even in this case, it is important to remember that these values represent a sector average, and that in certain contexts it may be preferable to have a much lower (or higher) inventory turnover than the published values.
Another practical (but in English language) tool for comparing companies' inventory turnover is the inventory turnover calculator provided by the BDC. This tool allows you to choose a sector, then to calculate a hypothetical inventory turnover index by entering the CdV of a company (COGS is the English acronym for "Cost Of Goods Sold", or cost of goods sold) and the its average inventory value, and finally compares the index with the average of the chosen sector
Advice
- To see how your company's inventory turnover ranks relative to its competitors and similar companies, check out industry-specific statistics. Business accounting professionals recommend comparing only situations that are as similar as possible to each other, in order to correctly estimate the degree of effectiveness with which the inventory turnover indices reveal the degree of success of the company within its sector of reference.
- Make sure that both the cost of goods sold and the average inventory value are based on the same estimation criteria. For example, if yours is a multinational company, make sure that the currency you are using is the same for all the quantities used in the calculation. Since both of these numbers express a total value, they will be correlated and will give an accurate result.
