How hard is the money you have invested working for you? You’ve probably been asked that question several times by stock brokers or “investment counselors.” No, I’m not going to try to sell you mutual funds. This article isn’t about how you are managing your personal investments. Instead, we are going to look at the performance of your company’s largest asset: inventory.
The Concept of Inventory Turnover
Say you sell $10,000 worth of a product (at cost) each year. Total revenue received from sales of the product is $12,500. If we bought the entire $10,000 worth of the product on January 1st, at the end of the year we would have made a $2,500 gross profit on an investment of $10,000.
But do we have to buy the entire $10,000 worth of the product at one time? What if we bought $5,000 worth of the product on January 1st. Then, just before running out of stock, we bought an additional $5,000 worth of the product with part of the revenues received from selling the first shipment. At the end of the year we’ve still sold $10,000 worth of the product, still made $2,500 gross profit,
but on an investment of about $5,000.
Could we make the same gross profit on an even smaller investment? What if we were to buy $2,500 dollars worth of material. Sell most of it. Buy another $2,500 dollars worth of the product. Sell most of that shipment and then repeat the process two more times before the end of the year. The annual gross profit of $2,500 is now generated with an investment of about $2,500.
Which investment option is better? Selling $10,000 worth of a product (and making $2,500 gross profit) with an investment of $10,000, $5,000 or $2,500? The best option is $2,500. Investing $2,500 (rather than $10,000) frees up $7,500 that can be used for other purposes… such as stocking other products that have the potential of generating additional profits.
Every time we sell an amount of a product, product line, or other group of items equal to the average amount of money we have invested in those items, we have “turned” our inventory. The inventory turnover rate measures the number of times we have turned our inventory during the past 12 months. Here is a list of the turnover rates from our example: