If your business deals with any kind of merchandise, inventory control can greatly influence the success of your operation. The inventory period measures how many times the business sells or turns over the inventory within a specified time period. Typically, companies determine inventory turnover on a quarterly, bi-annually or yearly basis. The formula used to calculate the inventory turnover is the cost of the goods sold divided by the average inventory.
A business needs to consider both the turnover rate for inventory and the gross margins received on the sale of the inventory. The gross margin you receive will determine the success of your inventory turnover period. The lower the gross margin on your inventory, the higher the turnover your business will require to generate sufficient profits to justify the business. On the other hand, if your gross margin is high, a business can typically afford to have lower turnover rates.
Assessing Inventory Period
A higher inventory turnover does not necessarily mean the business generates higher profits or performs better. You must evaluate the complete picture of the business’s financial operations and make sure the business’s operational cost of moving inventory generates a profit and benefits the business. Inventory that is not moving typically costs the business money because non-moving inventory does not produce revenue and has a cost associated with continued maintenance.
Types of Inventory
The type of inventory will help dictate an acceptable inventory turnover period. For example, you will typically need to turn over perishable inventories faster then inventories of raw materials. Businesses also commonly use different ratio variations to calculate the turnover period of their inventory. If the business calculates turnover on a monetary basis, the business should use the cost of goods sold, not sales, as the numerator.
Many factors can cause inventory to not turn over fast enough to generate acceptable profits. For example, a business should evaluate the market and ensure it is operating in the best market available for the inventory currently on hand. A business should also analyze its supply chain and customer base. A primary objective of inventory management is to make the inventory process as lean as possible. This typically benefits everyone in the supply chain, from the supplier of the product to the customers.