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.