The goal of this article is to educate the reader in 1) understanding the fundamentals of inventory turnover, 2) how to properly calculate the rate and 3) how to apply the formula in business.
The formula is stated as:
Inventory Turnover Fundamentals
Inventory turnover rate is one of several activity group ratios. The activity group of ratios analyzes business operational performance. Ideally inventory should be instantaneous. Think of fresh bread at the retail store. It is delivered in the morning and completely sold out by night time. In business this concept is referred to as ‘Just in Time Delivery’ (JIT). Many modern day manufacturing facilities use this JIT inventory system. Of course it is easier when large volumes of production runs occur with a consistent pattern. In effect, the manufacturer is taking advantage of economies of scale to time delivery of inventory while awaiting the sale of the product. Basically large retailers with huge volumes of sales have a lower cost of working capital per dollar unit sold than the Mom and Pop retailer.
To gain an understanding of inventory turnover the reader must understand the core elements of the formula. The formula is:
Inventory Turnover Rate = Cost of Goods Sold for the Period
. Average Cost of Inventory During the Period
The numerator is defined as cost of good sold for the period. So two different elements exist in the numerator. The first element to understand is ‘Period’ as it is relatively straight forward and defined as the accounting period. The most common is one fiscal year. For most businesses this is the calendar year. Periods can also be shorter such as one month or a quarter. Small businesses usually use one month as the traditional interim accounting period.
The more complicated element is the actual cost of goods sold. Its formula is:
The denominator for the inventory turnover rate is the average cost of inventory. The key word is average. So for very high volume activity businesses such as retail average is easy to compute, whereas low volume operations tend to have greater volatility in computing average. If the average is distorted, the formula outcomes become distorted too.
So lets look at a simple example:
ABC BATTERY OUTLET WORLD
Marty owns a battery retail center in town. The store stocks every kind of battery with a few exceptions. As batteries are purchased, Marty restocks them by purchasing replacements. During a single accounting period (one month) Marty sells $73,000 (cost) of batteries. On average Marty’s cost basis for his inventory is $54,000. Marty wants to know his inventory turnover rate. So Marty prepares the formula:
So is 1.35 good or bad? The answer is neither. Remember earlier that the inventory turnover rate is an activity ratio. It is designed to measure performance. Performance is measured by identifying whether the activity is improving or declining. The proper method of measurement is change over time. In effect management needs more periods of performance to measure or identify change. So here is Marty’s inventory turnover rate for the entire year by month:
Jan 1.31 It is apparent that Marty’s inventory
Feb 1.35 turnover rate is increasing; even
March 1.34 if December’s rate is excluded
April 1.37 (Christmas Sales distort the rate).
May 1.41 As the rate increases Marty is
June 1.39 selling more volume of inventory
July 1.47 against the existing pool. Which
August 1.52 is good.
THE KEY TO INVENTORY TURNOVER RATE IS TO IMPROVE THE VOLUME OF INVENTORY TURNS OVER SEVERAL PERIODS OF TIME. THE HIGHER THE RATE THE BETTER THE PERFORMANCE OF THE BUSINESS.
Again, the fundamental interpretation of the formula is if the rate is increasing from one period to the next; then the business performance is improving. The calculation is simple – cost of goods sold divided by average cost of inventory. But is the formula really this simple?
Proper Rate Calculation
With the example of the battery retailer the application of the formula is straight forward. But most businesses do not calculate cost of goods sold in such simplistic terms. Cost of goods sold is a retailing term. Cost of sales is more universal and encompasses many of the business sectors and their corresponding terms. Look at the following table:
Industry Sector Cost of Sales Term
Retail Cost of Goods Sold
Food Service Cost of Meals Served
Manufacturing Costs Production
Construction Costs of Construction
Service Cost of Labor
Non-Profit Delivery of Program(s)
In general, academia teaches that cost of goods sold is a specific term. In reality it is very complex. As identified in Cost of Sales, cost of goods sold, meals served, construction etc. include the following underlying types of costs:
Even in traditional retail, cost of goods sold includes products, retail labor, warehouse labor, supplies, and shipping. But the denominator is restricted to the inventory component of the balance sheet. There is no inventory of labor or shipping yet these two attributes are included in the formula for cost of goods sold. So how does a reader of ratios, specifically the inventory turnover ratio address this cost of goods sold model? Well to clarify, let’s see the results under two different scenarios.
Continuing with the battery outlet store, Marty includes his hourly retail labor, packaging supplies and shipping in his cost of sales. His cost of sales for October is reported as follows:
The inventory turnover rate is:
Cost of Goods Sold
Average Cost of Inventory
The average cost of inventory is beginning inventory plus ending inventory divided by two.
$54,000 + 53,700 = $107,900 = $53,950
The 1.646 is an all inclusive rate. What is the rate if restricted to product sold?
There is a significant difference between a fully inclusive rate and a restricted rate. So which one is better to use?
In general, it doesn’t matter. But the user must be consistent with which method they use. Also remember this is an activity ratio and therefore management is looking at a pattern. However, I will caution the reader to think this through. Labor has an impact on the formula. This impact can greatly distort the results. Same situation, same store, same month. Marty decides to hire his daughter part time for October. Lets see what happens if there is $600 less in product sales and $1,400 more in labor costs. All other attributes are the same including beginning and ending inventory.
COST OF SALES
. Beginning Inventory $54,200
. Purchases 79,080 ($600 less)
. Ending Inventory (53,700)
. Product Sold $79,580 ($600 less)
Labor (Fully Costed) 7,890 ($1,400 more)
Total Cost of Sales (Goods Sold) $89,620
In the limited (product only) calculation the rate decreases from 1.486 to 1.475. This is clearly a negative business performance indication. It makes sense, Marty sold less product. However calculating the result including all other costs drives the rate higher from 1.646 to 1.661, a clear improvement. Yet Marty’s actual gross profit decreases because of the costs of his daughter’s labor.
So in reality, does it still matter whether the formula uses product only or can labor and other cost of sales expenditures be included? This answer is based on volatility. In Marty’s case, an additional $1,400 of labor greatly affects overall costs. But if his store sold more, let’s say at a factor of 10 times this amount, the resulting rates would not be impacted or even noticeable for her labor costs. Look at this illustration.
Cost of sales without her labor, factor of 10 = $884,800
Inventory Turnover Rate = $884,800/$539,500 = 1.640
Cost of sales with her labor, factor of 10 for all other costs = $886,200 ($1,400 more)
Inventory Turnover Rate = $886,200/$539,500 = 1.6426
The difference is 2.6/1,000ths of an increase. Not enough to warrant using the limited version of inventory turnover rate (product only).
For smaller businesses it is indeed better and more accurate to limit the costs of goods sold to the product portion only of cost of goods sold. Once cost of goods sold heads toward a million dollars per month, it becomes easier to switch over to using the entire cost of sales value as reported on the income statement as the numerator. Unfortunately for smaller operations, it is wiser to restrict the formula to actual product sold. It is more work to determine this value but definitely more accurate.
Are there any other issues in applying the formula?
Proper Application of the Inventory Turnover Rate
Based on the fundamentals explained and how the formula is used there are several inherent restrictions in applying the turnover rate.
Rule # 1 – Internal Performance Gauge
Novice businessmen and even sophisticated businessmen misuse this performance tool. They will often use it to compare different industries to each other. You can NOT compare an auto dealership inventory turnover rate to a grocery store. In fact, you should not even compare one dealership to another. This tool is strictly limited to use as a performance gauge for internal (one single business) evaluation only. That is, gauging the change in performance from one accounting period to another.
Rule # 2 – Similar Conditions
Taking Rule number one even further, the conditions for sales and product must be similar, almost identical. With the battery outlet retail rate schedule earlier, notice how much better December’s rate is in comparison to other months? For this business operation the owner can compare December of one year to December of another year, but not December to any other month.
In addition to seasonal issues, don’t use the inventory turnover rate to compare when changes in product lines occur, worse yet temporary changes. Again using the battery outlet store, what if the store sells marine batteries (deep draw high amperage batteries) during the summer months. Marine batteries are significantly more expensive than watch batteries and can greatly distort both the numerator and denominator in the formula.
When using the tool for comparison conditions must be similar and include:
* Similar Product Lines
* Identical Marketing/Advertising Programs
* No Changes in Retail Floor Space
* Operational Hours (affects sales volume which affects cost of sales)
* No Third Party Impact (weather, natural disasters, governmental law, etc.)
Rule # 3 – Not Always the Best Performance Gauge
There are some retail operations whereby this activity ratio has no bearing on evaluating real performance. In business the best gauge of performance is gross profit in real dollars.
Management’s focus should be on making money and not necessarily improving a particular rate. A good example is a violin retail outlet. For those of you not familiar with this business, selection is key to success. The store will have instruments in a wide array of quality, sound and value. The retail price points are different for the consumer. Two extremes exist between a parent desiring to purchase a starter violin for their child at a price point of $300 and a symphony player looking at a $28,000 restored instrument. To satisfy all potential customers there must be selection. This causes inventory average cost to be high and cost of sales will vary greatly from one accounting period to the next.
Selection is important in certain retail environments:
– Customized Products (autos, woodwork, musical instruments)
– Farming Equipment/Livestock
– Women’s Fashion (especially fine products like furs and wedding dresses)
– Outdoor Recreation (hunting, fishing, boating)
Overall these rules limit the use of the ratio to a homogeneous retail environment like grocery stores, clothing outlets, auto parts, hardware, lumber, housewares, linens, etc. Any deviation in use can have erroneous results with its application.
Summary – Inventory Turnover Rate
The inventory turnover rate is used to evaluate internal performance of a business. The formula uses the product cost in the cost of goods sold as the numerator. The denominator is the average cost of inventory. Inventory turnover measures how often the inventory is turned over during an accounting period. It is an ideal activity performance measurement tool in a homogeneous retail environment. It should never be used to compare one industry sector to another nor two similar industries. Its primary value is evaluating a trend line of performance with a single store. The higher the turn rate the better. 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.