Inventory is a term used to account for the raw materials, parts or finished products that a business sells or uses for production. Entrepreneurs ought to learn inventory management as part of their business skills to be able to foresee stock shortages while always ensuring that inventory levels remain optimal.
“Inventory” in the verb form could also mean listing or counting items. However, in the accounting space, inventory is a current asset that refers to a company’s stock used in production at various stages. Items that are still in production (works in progress) and finished goods are all part of the inventory and as such, they’re treated as current business assets.
Manufacturers, wholesalers, and retailers can maintain inventory and continue to sell products or mold new ones out of the stock. Inventory is a vital asset for any business since it is the basis for deriving sales or further production. Reflected in the balance sheet section of a company’s financials, too much inventory can be detrimental since it could tie down capital for far too long leading to product redundancies.
Lest we delve too much into accounting technicalities, let’s discuss a crucial inventory concept – inventory turnover.
What is Inventory Turnover?
Inventory turnover refers to the number of times a business sells and replaces its stocks within a specific period. This turnover shows a company how fast or slow their products are moving in the market. Businesses use the turnover ratio to make important decisions regarding their products, sometimes resulting in having to improve quality, review prices and purchase schedules, product promotions, and so on.
Businesses operating in the perishable goods space will especially appreciate the inventory turnover concept. Stocking too much produce or fashion items today could result in dead stock and financial losses in the future. Additionally, when stock is tied up in the warehouses, it increases holding or storage costs further eating into the business profits.
How to calculate Inventory Turnover Ratio
This ratio was mostly associated with accounting work but with the rise in solopreneurs, we thought it wise to unpack it to you in the simplest form possible to help make sense of your inventory information.
As earlier indicated, the turnover ratio is used to understand the movement and replenishment of inventory items.
Turnover ratio: Cost of goods sold/average inventory.
The cost of goods sold is the total cost of producing a product including the labor used. Average inventory is evaluated by adding the inventory at the beginning of a particular period such as a month or year to the inventory at the end of that period then dividing the result by two.
This is how the formula will appear: Inventory turnover ratio = cost of goods sold ÷ average inventory.
Consider this example:
Bob sells printed t-shirts wholesale on his Turis B2B e-store. His income statement shows that his cost of goods is $2,000 for April. At the beginning of April, Bob had inventory worth $6,000 and $7,000 by the end of the same month. His inventory turnover for April will be calculated as follows:
Step 1: Find the average inventory for the month (6,000 + 7,000)/2 = $6,500
Step 2: Calculate the ratio: Inventory turnover ratio = cost of goods sold/average inventory
(2,000/6,500) = .31 turnover.
Step 3: Interpret the ratio. A turnover of .31 means that in April, Bob sold about a third of his inventory, crossing with almost 70% stock to the following month.
Now, with that information, Bob can make key decisions regarding his inventory including cutting down on purchases, reworking his pricing strategy, conducting product promos, maintaining the current operations, among other things.
But then begs the question, “what is a good inventory turnover?”
Generally, the higher the percentage of sold stock, the better for any business. As a point of reference, you want to target a stock replenishment of 1 – 2 times every month. This means that ideally, you should focus on selling and replacing your inventory at least once every month to maintain a good inventory turnover ratio.
In summary, we understand that inventory issues can be complex and might sometimes need the input of an expert. Nonetheless, with the right business tool, you can easily make sense of your inventory data without necessarily engaging an accountant. Turis offers you exactly that – summarized yet simplified insights on your inventory to help you make the crucial decisions we mentioned above. Schedule a free session with one of our representatives to talk about all your inventory needs. Better yet, you can always book a demo!