Why Is it Important to Control Inventory Turnover?
Controlling inventory turnover is one of the fastest ways to get more money out of a business without having to increase sales. It's also a key way to grow a business faster. High inventory turnover means less money required for future growth. And inventory turnover creates discipline in that it reduces the odds of bad products staying on the shelves or in the warehouse for too long.
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Definition
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Inventory turnover is the ratio of sales to average inventory over any particular time period -- most often a year. If a store has $200,000 of inventory at any given time and $1,000,000 in sales per year, the ratio is $1,000,000 to $200,000, or five to one. This is a simple calculation, but it can be complicated if inventory changes during the year. For example, a candy store might stock up ahead of Valentine's Day, but not have as much inventory the next month. To account for this variation, it's best to average inventory over the time period in question.
Variation by Industry
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Some industries have very high inventory turnover. Some have extremely low turnover. Many wholesale companies have extremely high inventory turnover. For example, a produce processing firm might buy and sell a warehouse full of goods each week. Their turnover would be 52 in that case. Meanwhile, an art gallery might keep the average painting on hand for several years before making a sale. In their case, inventory turnover could be .5 ($1 in sales for every $2 in inventory) or even lower.
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High Turnover and Cash Flow
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Raising inventory turnover usually means one of two things: higher sales on about the same amount of inventory or the same level of sales with less inventory. Either of these can be good news for a business owner. Higher sales usually means higher profits, while earning higher profits on the same investment is good news. But earning the same amount of sales on a lower inventory base is also an accomplishment. If a store can sell the same $1,000,000 of goods with only $100,000 in inventory on hand instead of $200,000, the business owner has just freed up $100,000 in cash to be used for other purposes. It's essentially extra money with no income taxes.
Turnover and Growth
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A higher inventory turnover rate can lead to higher growth. For most businesses, growth is determined by a return on investment. A higher inventory turnover means a lower investment for the same level of profits. If a business owner is reinvesting money for growth, that directly increases the growth rate. For example, if the store mentioned before requires $500,000 in total investment (including $200,000 in inventory), lowering the inventory investment by $100,000 means lowering the whole investment by 20 percent. A 20 percent lower investment for the same profits means a 25 percent higher return on investment, which adds up.
Turnover and Discipline
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Inventory turnover also promotes more realistic assessments of which products are selling. A store with a turnover rate of four has products on the shelf for an average of three months each. If that inventory turnover rate is 12, the products are on the shelf for about 30 days. This makes it more obvious when one particular kind of product isn't selling and can encourage business owners to replace it. A used bookstore owner or art gallery owner might have to wait a decade before realizing there wasn't demand for a given product, while a grocery store owner will know in a few days that a particular item is not selling.
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References
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