By Nathanael Mion, Joannes Vermorel, February 2012
The inventory turnover is the number of times the inventory must be replaced during a given period of time, typically a year. It is one of the most commonly used ratio in inventory management, as it reflects the overall efficiency of the supply chain, from supplier to customer. This ratio can be computed for any type of inventory (materials and supplies, work in progress, finished products or all combined), and it can be used for retail as well as manufacturing.
The ratio is computed by dividing the cost of good sold (COGS) by the average aggregate inventory value (AAIV):
Inventory turnover = COGS / AAIV
The Cost of Goods Sold (COGS), sometimes referred to as cost of revenue. is the annual cost for a company to deliver goods sold to customers. However, this cost includes neither the selling nor the administrative expenses. The Average aggregate inventory value (AAIV) is the value of all items held in inventory for the company, valued at cost.
Companies also frequently express their inventory as days or weeks of supply. The main benefit of this approach is that it produces values that are rather intelligible and provides an immediate point of comparison with the lead time. In this case, another ratio, derived from the first, indicates how many days worth of inventory is available in the system - or how many days will it takes to sell the inventory.
Days of supply = (AAIV/COGS) x 365 days = 365 / turnover
When this ratio is applied to invidual products, it is frequently called the stock cover.
Example: If the cost of goods sold during the year has been $1 million and the average inventory value for the year has been $100,000, then the inventory turns is 10. It takes 365/10= 36,5 days on average to cycle the whole inventory.
An underlying assumption, when computing inventory turnover, is the use of the "First-in, first-out" method (FIFO ) to value inventory. This method considers that the first unit arriving in the inventory is the first to be sold or processed. The value of the average inventory used in the ratio varies accordingly.
The use of the ending balance instead of the average inventory may lead to misleading ratios (under or over estimating storage needs) and should be avoided.
Turnover is one of the most commonly used metric of supply chain efficiency.
- Low inventory turnover is frequently associated with excess inventory, overstocking and the presence of dead inventory (non-moving inventory). Low turns also entails liquidity problems,
with increased pressure on working capital.
- High inventory turnover is generally positive as it indicates goods are being sold rapidly. It may result from good inventory management, but may also hint at insufficient safety stock .
Strategic sourcing decisions such as choosing close or distant suppliers have a massive impact on turnover, as the turnover is typically highly correlated to the lead time.
Variation between industries
Grocery chains, who sell perishable goods, typically have very high inventory turnovers, around 100, for those goods. Products have to be sold quickly, as they expire rapidly. Write-offs caused by expired products can incur significant costs. See the discussion about Perishable food on our article about service level .
On the other hand, manufacturing firms have much lower turnover values, between 5 and 10. As their products can be stored longer, a low inventory turnover does not necessarily point at inadequate inventory management: a car does not become obsolescent when stored for 2 months. A company must thus benchmark its inventory turnover by comparing it with its industry's standards, in order to make sense of this indicator.
Limits of turnover as a static indicator
Inventory turnover is an average. It does not necessarily reflect the fluctuations of inventory and activity during a year, or over several years. For instance, in prevision of seasonal sales peaks, high inventory levels can be built up. Such pattern inflates annual inventory turnover, however it's necessary in order to avoid stock-outs during the peak.
Over longer periods, inventory turnover is most useful as a trend indicator. An increasing trend indicates that less money is required per dollar of cost of goods sold, i.e. the supply chain efficiency is improving. However, this is only true if this increase is not mitigated by an corresponding increase of stock-outs.
How to improve inventory turnover?
The three main levers to improve turnover are:
- Sourcing. by choosing new suppliers that offer shorter lead time, or by *negotiating* shorter lead time with existing suppliers.
- Service level. by tuning the acceptable frequency of stock-outs (zero stock-out is not a reasonable option for most industries).
- Forecasting. by refining the accuracy of the demand forecasts, so that safety stock can be lowered without increasing stock-outs.
Of all the options to improve turnover, we believe that forecasting is typically a quick-win for most companies. Improving forecasts require no heavy investments, no revision of the sourcing strategy, and no extra risk when opting for more stock-outs. In particular, we have developed an inventory optimization app that delivers optimized reorder points based our forecasting technology.