The inventory turnover ratio cannot be used to predict the profitability of a business. A further concern with low inventory turnover is that goods not being sold are taking up valuable shelf space that could be more profitably taken up by other products with better sales potential. It is also likely that there will be inventory obsolescence costs associated with goods that can no longer be sold, as well as damage to inventory items while they are held in storage. These costs include the cost of storage space, depreciation on storage racks and forklifts, insurance, utilities, and compensation for the materials management staff.

Generally, low inventory turnover is to be avoided, because it imposes inventory holding costs on the seller. However, low turnover can also indicate that management has committed to the practice of fulfilling all customer orders immediately, which calls for a larger investment in inventory. It is a strong indicator of poor inventory control practices, such as purchasing in excessive volumes and not selling off obsolete inventory before it loses all of its value. This can indicate that much of the inventory is obsolete or that the firm has acquired more inventory than it can sell within a reasonable period of time. When the inventory turnover ratio is low, it indicates that a business has too much inventory on hand. It is also possible that the company has installed excellent inventory management systems it may be using a just-in-time production system that requires minimal inventory levels, and it may be exercising tight control over its obsolete inventory. In the latter case, customers may be experiencing long wait times before their orders are shipped to them, because the company must wait for new deliveries from suppliers. However, rapid turnover can also indicate that the business does not have sufficient working capital to support a larger inventory. This can indicate that its products are popular with customers, are being sold at a competitive price, or are being bolstered by a strong marketing campaign. When the inventory turnover ratio is high, it indicates that a business is selling off its inventory at a rapid rate. If ABC could somehow double its inventory turnover while maintaining sales at the same level, then its inventory investment would drop to $1,000,000, thereby saving it $1,000,000 of cash that it can use elsewhere. To continue the example, ABC International is investing an average of $2,000,000 in inventory (based on the ending inventory number). The common management perception is that inventory turnover should be extremely high, since this means that you are operating a business with a smaller cash investment in inventory. The averaging calculation can cover a relatively lengthy period of time, to reduce the impact of seasonality on the outcome.įor example, if ABC International had $10,000,000 in cost of goods sold in its most recent fiscal year, and the ending inventory was $2,000,000, then its inventory turnover was 5:1, or 5x. Alternatively, if the company has a perpetual inventory system, it may be possible to compile a daily inventory value, from which an average inventory figure can be derived. Average inventory may be derived by adding together the beginning and ending inventory values and dividing by two. If the ending inventory figure is not representative of the typical inventory balance during the measurement period, then an average inventory figure can be used instead. This cost includes all direct materials, direct labor, and factory overhead associated with the construction of the finished goods or services that were sold. In the calculation, the cost of goods sold refers to the cost of the finished goods or services delivered to customers. The formula is as follows:Īnnual cost of goods sold / Ending inventory = Inventory turnover The cost of goods sold figure is used instead of sales, because the sales figure includes a markup that is irrelevant to the calculation, and artificially inflates the turnover figure. Inventory turnover is calculated by dividing the cost of goods sold for the year by ending inventory. Low turnover equates to a large investment in inventory, while high turnover equates to a low investment in inventory. Continual monitoring of inventory turnover is good management practice, in order to maintain a relatively low investment in this area. Inventory turnover is the average number of times in a year that a business sells and replaces its inventory.

Inventory turns ratio