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An Explanation of Inventory Turnover

A relationship exists between inventory and sales.  This is referred to as ‘Inventory Turnover’ or ‘Turnover Ratio’.  It is simply the number of days it takes to turn over the dollar value of the inventory.  This relationship is important because as the retailer, you would want this number has high as possible.  You should not use this ratio to compare yourself to another similar store for various reasons, use it to compare yourself to the industry as a whole or to compare to past performances from the same store.  It is a mere standard for internal comparison only; it is not a gauge of value.  But if properly implemented and utilized, the retail store owner can maximize profits. 

There are three components to the formula.  One is the sales, usually the annual dollar sales associated with the inventory element, i.e. don’t include services rendered in the sales value.  Secondly, you would need the average dollar value of your inventory for the same period of time at retail value.  The third number is the ratio or number of turns of the inventory in that period of time.  Naturally the number is a relationship using the following formula:

                         Sales/Avg Inventory = Inventory Turnover

So let’s assume you own an auto parts store.  Total sales in the year were 2.3 million and your average inventory runs around $237,000 at retail value, then your inventory turnover is 9.7.  By knowing two of the pieces of the formula, you can derive the third.  The formula is used to evaluate trends or performance of sales staff.  A lower turnover rate with a similar sized inventory would mean lower sales.  A higher turnover rate does imply better sales but it could identify poor stock levels.  That is you may be losing out on some lost sales.

You cannot compare this number to another store for several reasons.  First off, you may not have the same retail markup or the same type of customer.  What if you sold only parts to hot rods?  Your customer is significantly different than those for a Honda only parts supplier or a general parts supplier.  Also, you may not be involved in the same line of products, yours could be non-body types of parts with an emphasis on exhaust systems whereas the other party could be maintenance based (filters, oil, lubricants, light bulbs). 

There are a multitude of other factors that impact the final turnover ratio.  Many organizations use Cost of Goods Sold divided by the average cost of inventory to calculate the number of turns.  Whatever you do to calculate this number, you must use the same formula each period of time for evaluation purposes. 

So what is this formula used for in business? 

This formula is used to evaluate performance of your store to the industry as a whole.  Do not use the formula to compare your store to another store, even if you own two stores in different parts of town.  Unless you had the exact same customers, same vendors with same markups etc. you are not comparing apples to apples.  This is really a wonderful tool to evaluate the sales performance in the company from one period to the next.  It also will allow you to experiment at times with product lines or shifting trends.  The sidebar illustrates a real life reason to not rely on the ratio too much. 

By understanding the formula, it’s purpose, and how to implement it in your store, you can begin to increase the actual dollars of profit.  Act on Knowledge.

If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org.  I would love to hear from you.  If interested in my help as an accountant or consultant, contact me through the ‘My Services’ page in the footer.  

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One of my former clients owned an RV Parts Supplies store.  Back in the late 80’s, many of the campgrounds installed electricity at the sites.  It wasn’t long before RV Campers were bringing their household window AC units on their camping trips.   The industry responded by building custom made A/C units to fit on Pop-ups and trailers.

His parts manager relied on the inventory ratio for comparison purposes.  He didn’t want to carry too many of these A/C units in inventory because the cost was high and the margins were low.  Thus the turnover ratio would go down.  The problem was that when the store sold an A/C unit the profit increased significantly that day.  However, there were many days buyers had no A/C units in stock to choose from in the inventory.  On one day, four customers sought A/C units at another store.

Sounds like a lost sale to me.

It took me about a year to convince the owner to stratify the inventory into groups and use ratios for the groups to evaluate performance.  By doing this, he was able to increase the margin in whole dollars but it did change his overall turns.  The turn rate decreased slightly for whole inventory, but his margin went up.  I reminded him that at the end of the day, it is about making money, not complying to some formula.

About David J Hoare (420 Articles)
I spent 12 Years as a Certified Public Accountant, Over 20 Years of Practice in Accounting and Consulting, Controller in Management of Closely Held Operations, Masters of Science in Accounting, Prepared over 1,000 Business Tax Returns and Hundreds of Individual Returns

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