First, let’s define “inventory turnover.” Turnover is the number of times you sell your average investment in inventory each year. Turnover is calculated with the following formula:
Average Inventory Investment during the Past 12 Months
For example, if a company has total annual sales (at cost) of $12,000,000 and its average inventory value is $3,000,000, its inventory turnover is four turns per year (12,000,000 ÷ $3,000,000). If the results of the inventory turnover equation are to accurately reflect the performance of a firm’s investment in stock inventory, we must take great care in determining the values for both cost of goods sold and the average inventory value. Let’s look at these two components.
Cost of Goods Sold
The value appearing in the numerator of the equation should reflect the cost of goods sold from stock over the previous 12 months. For example, if we are calculating turnover at the end of August, 1999, turnover should be based on the total cost of goods sold from September, 1998 through August, 1999. Direct and drop shipments (i.e. sales of material sent directly from a vendor to a customer) are not included because the material never passes through your warehouse, and as a result is not reflected in the average inventory value appearing in the denominator of the equation – that is, we have not made an investment in inventory in order to generate these sales.
Special order items (i.e. products ordered for a specific customer order that are not normal inventory items) are also not included in turnover calculations because they do not remain in inventory for a significant period of time. They normally are shipped to customers within several days of their receipt from the supplier. Including the cost of special order items in the cost of goods sold used in the equation tends to exaggerate turnover.
The cost of goods sold figure is not always accurately calculated. For example, some companies compute turnover by considering year-to-date cost of goods sold, and compute an annual figure based on this amount. For example, August is the eighth month of the year. At the end of this month, we’re two-thirds the way through the year. If a company’s cost of goods sold through the end of August is $8,000,000, that company may feel that this will be two-thirds of the annual cost of goods sold ($12,000,000). But this method assumes that sales are consistent throughout the year. If a company experiences any seasonal fluctuations (e.g. a slowdown during the Christmas season) this method will not result in an accurate cost of goods sold amount. As a result, the calculated turnover will not reflect actual inventory performance.
If you are considering turnover for the company, you should only include the cost of goods sold of items delivered to customers. This would include amounts sold to customers as well as quantities used for repairs and in assemblies. Including transfers in the calculation of overall corporate inventory turnover produces exaggerated results. After all, a company could continually transfer material from one location to another without ever selling it to a customer. If we were to include transfers in turnover, the company would have incredibly high inventory turnover, but no sales!
However, if you are calculating the inventory turnover for a central warehouse, you should include transfers in the calculation of inventory turnover. Central warehouses are facilities that serve as the normal source of supply for other company locations. These branches are customers of the central warehouse. If we don’t consider transfers in the inventory turnover of a central warehouse, the results of the calculation will fall short of actual turnover for that facility.
Most companies use average cost in the calculation of the cost of goods sold. You may use another cost basis (e.g. last cost, FIFO, LIFO, etc.) as long as you are consistent from month to month. Also, be sure that the cost basis used for the cost of goods sold in the numerator is the same cost basis used for the average inventory value in the denominator of the equation.
Average Inventory Value
This is the average value of stock inventory over the previous 12 months – that is, the same 12 months used in determining the cost of goods sold previously discussed. It should include all material in your warehouse, even the dead stock.
Companies that manufacture and assemble products may also have to consider factors other than the cost of raw materials (or components) in turnover calculations. If the cost of goods sold amount in the numerator includes any labor or other charges necessary for producing or assembling finished goods inventory, the average inventory value should include the same non-inventory charges for both the current work in progress (WIP) inventory as well as the finished goods inventory. If the cost of goods does not include any labor or non-material charges, the average inventory value should only include the actual cost of the components or raw material. Again, we’re trying to use a consistent cost basis in the numerator and denominator of the equation.
As we said at the beginning of the article, inventory turnover measures the number of times you sell your average investment in inventory each year. To put it another way, it is the number of opportunities you have to have to earn a profit on the money you have invested in stock inventory. It is a crucial measurement that must be calculated accurately.