If Company A has an inventory of five widgets and Company B has an inventory of fifty widgets, which company has an oversized inventory?
This question can only be answered if you are offered more information. If last year Company A only sold one widget, then an inventory count of five widgets is inflated inventory. Company B, on the other hand, sold two hundred widgets last year and therefore fifty widgets might not be enough inventory.
A better way to answer this question is to measure the inventory turnover ratio. The inventory turnover ratio is usually expressed in terms of the cost of the inventory items. The cost of an item is the cost of purchasing and/or manufacturing it. So the inventory turnover ratio is defined as:
The cost of items sold over a period, divided by the average cost of the inventory for that same period.
At this rate of sale, it would take Company A five years to sell off its inventory while Company B will use up its entire inventory every three months. What does this mean? That Company B is doing a better job of parts inventory management.
A low inventory ratio could mean that sales and purchasing are out of sync. Sales may be good, but purchasing may be acquiring too much inventory, in turn tying up too much capital and incurring other costs associated with holding inventory. A low turnover ratio could also mean that sales suddenly plummeted and remained low for the entire year, leaving the company stuck with inventory that can’t be moved.
A high ratio can be good, as it can mean that sales are good and inventory levels are well matched with the sales. It is also possible for it to be bad, however, if the cause is that more orders are coming in than there is inventory to fill them, resulting in backorders.
In addition, a good inventory turnover ratio in one industry may not be a good ratio for another. Some items, such as cars, take longer to sell than others, such as food. Food is perishable and stores that sell food will have a higher turnover rate than stores that don’t sell food. To assess whether your turnover rate is positive or negative, you should always compare it to the average for your industry.
To calculate an accurate inventory turnover ratio, you will need accurate data. Cooperation between purchasing and sales is essential for having a good turnover ratio. If this sounds confusing and/or you’re unsure of how to turn your inventory turnover ratio from low to high, contact Acumen Information Solutions today.
