Excerpt
Learn about the meaning of the inventory turnover rate, how to calculate it, and its importance for companies. Discover the connection between the flow of goods in warehouses and the profitability and success of companies by reading our article.
If you want to measure the extent of your company’s success in marketing its products and controlling the market, then the inventory turnover rate is your most effective measure. Companies produce goods to boost sales and revenue, so keeping them in stock doesn’t serve as a reliable indicator. At the same time, the insufficiency of goods and their exit from the warehouse at a rapid pace, with no stock available, indicates the necessity of making new decisions regarding the prices of products, the movement of manufacturing them, or renewing their purchases. In this regard, we explain to you why the company’s inventory turnover ratio is an indication of the strength of its financial assets and its chances of future success. We also talk about the equations for calculating inventory movement and ways to apply them.
What is the inventory turnover rate?
The company calculates the inventory turnover rate or ratio by dividing the annual costs of producing and selling goods by the average value of goods stored in the same year. Measuring inventory movement is a crucial aspect of company efficiency, as it serves as an equation that gauges the value of the company’s most significant financial asset, the inventory of goods. It also conveys the speed at which companies sell and renew their products and goods. The arrival of goods for their consumers indicates the volume of production and its efficiency in satisfying their needs.
Given the above, we find that it is preferable to have a high inventory movement rate because it indicates a favorable turnover of production and sales operations, and it also helps in making decisions that contribute to the company’s success in the market.
What are the types of inventory?
The larger the company and its influence in the market, the more diverse its inventory becomes, and the process of measuring its inventory’s rate of movement becomes more necessary. The following are some of the most important types of accounting inventory:
- The company relies on raw materials to produce the goods it takes out to market.
- Goods that are still on the production line, have gone through manufacturing stages, and are missing other stages to be completed and ready for sale.
- The company sells ready-made products to consumers without intervening in their production.
- Excess stock of goods.
The importance of inventory turnover
This measure determines the extent to which the company achieves its main objectives and facilitates the effective conduct of its financial transactions. The most prominent uses for inventory movement and turnover rate are the following:
Facilitate the stocktaking process.
Stocktaking is a step that precedes inventory management. Its goal is to determine the value of the company’s profits and ensure the strength of its financial position. By calculating the inventory turnover rate, you can determine which goods you must replenish periodically to keep the buying and selling movement active, positively affecting the buying and selling movement.
Adjust sales methods.
It is essential to identify products that are susceptible to damage or obsolescence in warehouses and to come up with new ideas for marketing and selling them because remaining in warehouses for a long time causes their loss, in addition to losing more significant costs for storing them.
Improving the level of production
Calculating the production turnover rate enables you to identify unwanted goods and reduce their production. It also allows you to know the required and popular types of goods to raise the level of production while improving it over time, satisfying the needs of consumers so that they do not search for alternatives.
Increase cash flow.
This means maintaining a high turnover of the company’s inventory, which will only be done by keeping a compatible level of production and marketing to help deliver the commodity to its consumers without storing it for a long time.
Detect dead stock.
The term “dead stock” refers to unsold and discarded products, such as seasonal goods or those produced at specific times of the year, which can result in significant losses if not promptly disposed of.
How is the inventory turnover rate calculated?
We calculate the inventory turnover rate by determining two primary factors: the cost of the goods sold and the average inventory. To reach the required ratio, the following data must be known:
Cost of goods:
It refers to the total cost of acquiring, shipping, and manufacturing raw materials, as well as the cost of preparing a good for sale.
Average inventory:
It is the period of time the goods spend in the warehouse between their arrival and their shipment to the sales department.
Rate calculation equations
- The average inventory can be determined based on cost using the equation (beginning inventory balance + ending inventory balance) ÷2.
- To find the average storage period based on the selling price, we use the equation (average storage costs x the reciprocal of the cost of sales ratio).
- Time basis for calculating inventory: When the turnover rate is calculated daily, the equation (inventory x 360 ÷ cost of sales) is used.
- While the calculation is performed on an annual basis, it is based on the equation (cost of sales ÷ average inventory value).
Here is an example of how to calculate the inventory turnover ratio.
Let’s assume that Company A operates in the children’s clothing trade and we wish to calculate its inventory turnover rate using the following data.
| The value of the beginning inventory of the year | 450 thousand riyals. |
| End-of-year inventory value | 200 thousand riyals. |
| The cost of goods sold | 350 thousand riyals. |
Based on the above data, we begin to apply the equation according to the following steps:
- Average inventory = (beginning inventory value + ending inventory value) ÷ 2.
- So average inventory = (450,000 + 200,000) ÷ 2 = 325,000 riyals.
- Hence, we find that inventory turnover ratio = cost of goods sold ÷ average inventory = 350,000 ÷ 325,000 = 1.07.
Optimal inventory turnover rate
The most straightforward statement through which we can explain the idea of optimal inventory turnover is that the longer a product remains in stock, the more it costs the company and the higher the chances of losing it. Therefore, it is necessary to achieve a high rate to be an indicator of the company’s ability to sell its products effectively and efficiently, which renews its financial capacity to reinvest in business development. But pay attention to the availability of goods and their adequacy for the market and not run out of them while the demand for them is still high, because this will indicate that the company is losing its marketing plans.
Implications of inventory turnover ratios
Applying the equations for calculating a company’s daily or annual inventory movement yields numbers that represent the frequency of product sales over a given period. Therefore, the final output, for certain products, should not be less than 3 or more than 4, as it signifies the following:
- An inventory turnover rate lower than 3 indicates that the product will remain in stock for a long time, which means it may spoil, stagnate, or increase the cost of storing it.
- Low product turnover indicates the company’s need to update its marketing and sales policies and find innovative ways to sell its products while studying them to understand what needs to be marketed faster.
- A low inventory movement rate also indicates the importance of reconsidering the amount of production, which may be more than the market needs.
- A score greater than 3 when measuring inventory turnover indicates that the item is selling more effectively and that customers are in demand for it.
- The company needs to improve the production of the commodity, increase its quantity, and distribute it in the market according to demand.
- Suppose the ITR rate for measuring the movement of goods is higher than 4. In that case, the company threatens to lose its customers because it indicates its inability to provide the required quantities of the commodity.
Strategies to improve the rate of movement of goods
Several economic strategies succeed in reading a better ITR for commodity stocks, including:
Demand planning
It entails analyzing the market and comprehending the needs of consumers to create a product that fulfills the market’s specifications in the required quantities. If the product is in high demand, the marketing process accelerates, thereby boosting the stock product’s turnover rate. Interestingly, some companies offer customers the option to place an initial order for the product, which they then produce based on demand.
Just in Time strategy
A type of strategy that organizes the receipt of resources so that quantities over what is needed are not received. This reduces the chances of product damage and obsolescence, enhances marketing rates, and increases sales.
Product analysis strategy
This means that you start studying your products and make sure that you choose the product that is in high demand, with high sales and profits, and adopt it as your primary product. Thus, you achieve excellent inventory turnover rates and reduce the chances of the products remaining in stock for a long time.
Study of production process prices
This strategy refers to analyzing the costs incurred for marketing goods and the prices of goods offered to consumers to determine the degree to which they benefit from them. It also involves analyzing purchase prices from suppliers and requesting discounts or reductions on them or purchasing from other suppliers who offer better prices so that the price of the product is reduced, which increases demand for it.
Conclusion
The company’s success is based on the higher the inventory turnover rate and the availability of goods to cover the percentage of demand. To calculate the percentage of inventory movement in your company, contact Qoyod, which provides you with a free trial for a full 14 days so that you can analyze your inventory and determine the reasons for the strength of your company’s financial position. You can steer clear of the factors contributing to decreased sales and extended storage of goods in warehouses.
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