Proper inventory management is essential to ensure that a company has sufficient inventory on hand to meet the needs of both its customers and its operations. However, an excessive amount of inventory on hand ties up cash and increases expenses such as insurance costs, property taxes, and additional storage costs. In addition, excess inventory held too long can become obsolete and lose value which could significantly reduce inventory value. Two measures that are helpful in evaluating the efficiency of inventory management are inventory turnover and the number of day's inventory is held.
Inventory Turnover
The inventory turnover ratio measures how many times, on average, inventory is sold during the year. It is calculated by dividing the cost of goods sold by the average inventory. In order to determine average inventory, it may be necessary to use the inventory balance at the beginning of the year plus the inventory balance at the end of the year and divide by two for an average inventory figure.
For example, if a company had an inventory balance of $283,000 at the beginning of the year and a $261,200 inventory balance at the end of the year, the average inventory is $272,100 ($283,000 + $261,200/2). If the cost of goods sold at the end of the year is $953,200, the inventory turnover ratio is 3.5 ($953,200/$272,100).
Generally, the higher the inventory turnover, the better. However, differences across companies and industries are too great to make a general statement on what is a good inventory turnover. A fast-food restaurant would have a much higher inventory turnover than a company that sells jewelry because food is perishable, and obviously jewelry is not. However, industry standards can be found for comparison purposes for almost every business.
Days Inventory Held
The number of day's inventory is held measures the average numbers of days it takes to sell the average inventory held. It is calculated by dividing the average inventory by the average daily cost of goods sold. For this analysis, the average inventory can be calculated the same way that it was calculated for inventory turnover-adding the beginning inventory balance to the ending inventory balance and dividing by two.
In order to arrive at an average cost of goods sold, it is a simple matter of taking the cost of goods sold figure and dividing by 365. For example, cost of goods sold at the end of the year is $953,200; therefore average daily cost of goods sold is $2,611 ($953,200/365). If the average inventory is $272,100 and the average daily cost of goods sold is $2,611 the number of days inventory is held is 104 days ($272,100/$2,611).
Generally, a low number of days inventory is held are a sign of efficient management. The faster that inventory sells the less cash that is tied up in inventory. However, it is important that inventory is not too low because this could indicate under stocking of inventory, which could lead to loss of sales and revenue. Again, it is difficult to make a general statement about what is a good measure of efficiency for every industry, but a comparison to previous years and similar firms would be useful in assessing overall inventory management.
Diane White - Diane White is the founder and owner of Expert Bookeeping & Tax Service, LLC. She developed her accounting expertise during the ...
