Inventory turnover rate is an accurate way of measuring inventory levels as well as inventory costs. Inventory turnover is the ratio showing how frequently a business has replaced and sold inventory over a defined period. The inventory turnover ratio helps a business to determine whether their current sales mix is sufficient to cover the required inventory needs over a one-to-three-year period. A business can then divided by the days in the defined period by the inventory turnover ratio to calculate how many days it actually takes to sell all the inventory on hand. The higher the inventory turnover ratio, the more fast the business must keep up with replenishing inventory and lowering inventory costs. Low inventory turnover ratios result in higher inventory costs because there are fewer days when the firm sells its inventory.
A key indicator of inventory turnover is the average inventory turnover level or turnover percentage. The sales mix will affect inventory turnover in a major way. Firms that have a high inventory turnover need to work on reducing operational efficiency or else they will incur costly inventory cost. A company with high inventory turnover should look into ways of improving operational efficiency and streamlining processes to achieve improved inventory turnover. Streamlining processes could include simplifying order processing, eliminating or streamlining repetitive functions and improving inventory tracking and re-selling capabilities.
The cost per turn and the inventory turnover cost per turn are the most important indicators of operational efficiency. The two inventory turnover indicators are not directly related but have strong relationships. The cost per turn is generally quoted in raw material costs per turn or costs of raw materials sold per turn. For example, if a firm sells $100 million in merchandise annually and the average inventory turnover is 15 million then the annual cost per turn is $0.15. In the industrial and manufacturing sector the cost per turn is significantly higher because of the high level of customization required in many of the product offerings.
The inventory turnover ratio, also known as the turnover ratio, compares the number of units sold during a given period to the total number of units purchased. The lower the inventory turnover ratio, the better the value of the firm's merchandise. The value of the goods sold or the revenue earned can be affected by many factors such as product price change, consumer preferences, market penetration and brand name recognition. It is based on these assumptions and historical data and hence it cannot be predicted from a single data point. However, if the factors analyzed are significant then it can provide an accurate reflection of the quality of the goods sold.
The inventory holding costs or the cost of holding replaced goods is the cost of purchasing new goods that would have otherwise been sold to the customers if inventory turnover did not exceed the amount of new inventory purchased. The most important thing for analyzing the holding costs is to determine the average number of new units sold per new holding capacity per year. This is important because firms have to plan for the possibility of losing some of their goods to dead stock. Also, it is important to know if the capital cost of producing goods at a new factory is greater than the amount of the capital cost of purchasing goods from the outside market.
The efficiency of the firm also increases if the inventory turnover shows a positive rate. In inventory turnover shows if the average sale price of the product bought by customers per unit sold is greater than the average purchase price per unit. Also, the firm can assess the productivity of the firm by analyzing the average sales per day, average delivery time and average wait time. Analysis of the inventory also helps firms to adjust the inventory mix to meet fluctuating demand in a timely manner.
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