Inventory Turnover Ratio
The inventory turnover ratio measures how many times a company sells and replaces its inventory over a specific period.
The inventory turnover ratio is a financial metric that shows the rate at which a company's inventory is sold and replenished. It is calculated by dividing the Cost of Goods Sold (COGS) by the average inventory value for the same period. This ratio helps assess the efficiency of inventory management and sales performance.
A high inventory turnover ratio generally indicates strong sales or effective inventory management. It means products are not sitting in storage for long, which reduces holding costs and minimizes the risk of obsolescence. A low ratio suggests weak sales or excess inventory. This can tie up working capital, increase storage expenses, and lead to waste if products expire or become outdated.
On the shop floor, managers use this ratio to make decisions about production scheduling and purchasing. For example, a contract furniture manufacturer might track the turnover for different product lines. If a specific desk model has a low turnover, it signals a need to reduce its production volume or analyze sales data. Conversely, a high turnover for a new chair design might prompt an increase in its production schedule to meet demand.
A medical device manufacturer had a Cost of Goods Sold of $2,500,000 last year. Their average inventory value during that time was $500,000. Their inventory turnover ratio is 5, meaning they sold and replaced their entire inventory five times that year.
What is a good inventory turnover ratio?
A good ratio varies by industry. Companies selling perishable goods, like food packaging, have high ratios (e.g., above 10), while manufacturers of heavy machinery or aerospace components have lower ratios (e.g., 2-4).
How can we improve our inventory turnover ratio?
You can improve the ratio by increasing sales without increasing inventory, or by reducing inventory levels. Methods include adopting just-in-time (JIT) production, improving demand forecasting, and discontinuing slow-moving products.
What is the difference between inventory turnover and days of inventory on hand (DOH)?
Inventory turnover shows how many times inventory is sold in a period. Days of inventory on hand (365 / inventory turnover ratio) shows the average number of days it takes to sell the inventory.
Should I calculate turnover for raw materials, WIP, and finished goods separately?
Yes, calculating turnover for each inventory type gives more specific insights. It can help identify production bottlenecks with WIP or highlight poor sales of specific finished goods.
What does a low inventory turnover ratio indicate?
A low ratio often points to overstocking, declining sales, or obsolete products. This situation ties up cash in unsold goods and increases costs for storage and insurance.
Cost of Goods Sold
COGSCost of Goods Sold (COGS) represents the direct costs of producing the goods sold by a business.
Economic Order Quantity
EOQEconomic Order Quantity (EOQ) is the ideal order size a company should purchase to minimize its total inventory costs, including holding and ordering costs.
Just-In-Time
JITJust-In-Time is a production strategy where items are created or delivered only as they are needed, minimizing inventory.
Safety Stock
Safety stock is extra inventory kept on hand to reduce the risk of a stockout caused by supply and demand volatility.
Work in Progress
WIPWork in Progress (WIP) is the inventory of partially finished goods waiting for completion and final inspection.