Inventory turnover is the average number of times in a year that a business sells and replaces its inventory. Low turnover equates to a large investment in inventory, and high turnover equates to a low investment in inventory.
Turnover is calculated by dividing the cost of goods sold for the year by the ending inventory. For 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.
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. To continue the example, ABC International is investing an average of $2,000,000 in inventory (based on the ending inventory number). 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.
The rate of inventory turnover is driven by a number of factors, including:
- Length of distribution channel. If suppliers are located far away, companies tend to keep more safety stock on hand.
- Fulfillment policy. If management wants to fulfill most customer orders at once, this requires the maintenance of a larger amount of stock on hand.
- Materials management system. A push system, such as material requirements planning, tends to require more inventory than a pull system, such as a just-in-time system.
- Consignment. Some companies retain ownership of their goods at consignee locations, which increases the amount invested in inventory.
- Purchasing policy. A company may buy raw materials in large quantities in order to obtain lower bulk rates, though this increases its inventory investment.
- Product versions. If there are many product versions, each one is typically kept in stock, which increases inventory levels.
- Drop shipping. A seller can arrange with its supplier to ship goods directly to a customer. By using such a drop shipping arrangement, the seller maintains no inventory levels at all.
While a high level of inventory turnover is an enticing goal, it is quite possible to take the concept too far. For example, if you are a high-end Internet retailer with a reputation for fulfilling all customer orders within 24 hours of receipt, this can be pretty difficult if you have shrunk the inventory to such an extent that most orders are backlogged until you can get them from a supplier (which is precisely how many Internet retailers with minimal cash on hand operate). Thus, there is a natural limit to the amount of inventory turnover that your customers will tolerate, just based on the duration of order backlogs.
Inventory turnover can be legitimately increased through the use of just-in-time manufacturing systems, where inventory is only produced when there is a customer order in hand, and little inventory is maintained anywhere in the system. It can also be increased simply by rooting through the warehouse and disposing of any inventory items that have not been selling. Another option for increasing inventory turnover is to purchase raw materials more frequently, but in smaller quantities per order (which increases the cost per order, so there is a limit to how far this approach can be taken). Yet another method is to have shorter production runs, which reduces the amount of finished goods inventory.
Inventory turnover can also vary during the year if a business is locked into a seasonal sales cycle. For example, a snow shovel manufacturer will likely produce shovels all year, with inventory levels gradually rising until the Fall sales season, when sales occur and inventory plummets. This is simply the manner in which a company must build its products in order to meet demand, and it results (in the example) in declining inventory turnover as inventory levels rise, with a sudden acceleration in the turnover rate when the sales season arrives and the company sells off all of its inventory.