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What is Inventory Turnover? Inventory turnover is used to indicate how many times a company sells its complete inventory in any given period of time. This measures the briskness of the business.
Inventory Turnover Formula
Inventory turnover = Cost of Goods Sold / Average Inventory
Average Inventory = (Beginning Inventory + Ending Inventory) / 2
A high inventory turnover may indicate a company that is doing brisk sale. In extreme cases, it may also indicate a company that maintains inadequate amounts of inventory to meet demand, and therefore the company may not be able to keep up with the business.
A low inventory turnover could point to potential problems of obsolescence, overstocking, or ineffectual marketing department.
Many companies try to turn their inventory faster by holding a smaller amount of inventory at any given point of time. If managed properly, this reduces the inventory holding costs for the company (rent, utilities, less spoilage, etc). Many manufacturing companies such as automotive or computers have implemented a Just in Time (JIT) inventory management system where the part comes into the inventory when it is needed in the assembly process. Until then, the inventory may be held by the supplier, often close to the assembly line. This improves the operational efficiency, speeds up the inventory turns, reduces the holding costs, etc.
Benefits of a Fast Turning Inventory
When inventory turns faster, it not only reduces the inventory carrying costs, but it also shortens a company’s cash cycle. This means that the time between the cost incurred to buy inventory to build and the revenues from the final product shipment is now shorter. This ties up less of a company’s capital for a shorter time, thereby reducing the size of the working capital needed.
This can also allow the company to leverage its inventory and achieve faster growth rates.
Since inventory is used up relatively quick, it is less likely to become obsolete or spoil in storage.
Disadvantages of a Fast Turning Inventory
Specifically the Just in Time systems have brought with them a certain disadvantage – a simple problem can stop the production line as there may not be readily available buffer of parts.
JIT requires suppliers to work very closely with the manufacturer, often on the manufacturer’s premises. Since the manufacturer carries bare minimum in inventory, in a way it has traded off some buyer power in return for expediency and cost savings. Suppliers can and often exercise their supplier power and have the ability to shut down a production line.