Specialized inventory tracking systems that are both computerized and operated by man-power have become exceedingly important to companies that have a large amount of inventory. The reason for this is that they increase the accuracy and efficiency of maintaining the perfect amount of inventory all the time. Having too much or too little of it on hand can affect the profit margin, stock price, and ability of a company to get a loan from a bank. This is because it lowers the inventory turnover formula.
Read on to find out more about this financial calculation and what it can do to ease your company’s workload.
What Is the Inventory Turnover Formula?
An inventory turnover formula is a special formula that is in use to find out how fast a company’s inventory is moving for a specific period . To calculate it, you must first determine the average amount of inventory. So the beginning amount of inventory adds together with the ending amount of inventory. Then, this number is divided by two. Next, the cost of goods sold is divided by the average amount of inventory.
Inventory turnover formula = Cost of goods sold / Average inventory.
- This is possible because the cost of goods sold reflects of the amount of money that a company is spending on the products.
- The higher that the ending number is, the better that the company is doing. This is because it shows that the average amount of inventory that the company sells repeatedly throughout the year.
- The amount of inventory to expect is industry specific though. For example, some industries with high-priced items naturally don’t sell their entire inventory over and over.
Who Needs to Use an Inventory Turnover Formula?
All companies should be tracking their inventory turnover formula. But it is especially important to those who are struggling to maintain the proper amount of inventory. They are changing all their product lines or just starting out in a new industry.
It also matters for those who want to attract investors or get a loan from a bank.
How Can You Apply the Result of the Inventory Turnover Ratio?
- Perhaps, a company sees that they only have an inventory ratio of one or two for an entire fiscal year. This shows them that they are stocking more products than they can realistically sell for that period of time. So, they must either reduce their inventory by decreasing their production or make other changes that will increase their sales volume.
- Another way that you can apply the ratio is in the process of setting sales goals. All a company has to do is divide their ratio by 365. They will, then, get a daily look at the amount of inventory that is moving. This amount can then multiply by seven to set a minimum weekly sales goal or by 30 to get a monthly goal.
- The inventory turnover formula can also be useful as a comparison tool for tracking the progress of certain lines of products. It has to be slightly adjusted though. Only the portion of the inventory that relates to the products can be divided by the correlating amount of the cost of goods sold. While this may sound complex, it is commonly possible with large projects or machines. The trick is to be sure to allocate each of the expenses to the individual products that they go to. And each product line must have a new general ledger code. That way, you can easily grab off the numbers of a financial statement.
How Much Does It Cost to Keep the Inventory Turnover Ratio?
It costs nothing for a company to do a quick calculation of their inventory turnover ratio. But it takes thousands of dollars per year to keep an accurate inventory. Most of this money goes on counting all of the products and ordering and receiving them. A significant amount of time also is necessary paying attention to making the appropriate accounting entries regarding the sales and other adjustments to the current stock and cost of goods sold.
But the highest expense of all is the money that you might lose when the ratio is too low. Investors will sell their stocks in the company since it doesn’t look like it is turning a profit. Also, banks will decline loans because it will appear that the products that the company is offering are not attractive enough for consumers to buy.
3 Ways to Use the Inventory Turnover Ratio Spending on the Long Run
The cost of an accurate inventory turnover ratio is very high. Therefore, it helps to use the following tips to lower your spending on the process:
- Hire employees for the sole purpose of working on the accuracy of the inventory. The job is simply too big for a person to try to do in between their other job assignments. Also, forcing someone to do that much multi-tasking will lead to expensive mistakes.
- Track the inventory turnover ratio regularly. Don’t wait until it has to be done for a bank or investor. That way, you will be able to continuously work on improving it.
- Do an analysis of your company’s inventory turnover ratio. But focus on it in comparison to other companies that are in the same industry. This will offer an example to go by for those who are not sure what kind of inventory or sales goals they should set.
To the Sum
Hopefully, you found this information helpful. The inventory turnover ratio is a valuable tool that helps a company with a large amount of inventory know how many times that they can sell their average amount of inventory in a specific amount of time.
But it can be easy to forget how to calculate it. So, be sure that you keep a copy of this article handy at all times.
The images are from depositphotos.com.