Divide Cost of Goods Sold by Average Inventory

Inventory turnover is a ratio showing how many times a company’s inventory is sold and replaced over a period.

This is usually calculated as sales divided by average inventory.  A better way to calculate it is to divide cost of goods sold by average inventory because inventory is usually recorded at cost, not market value.

So for example, if we sell $120,000 worth of product during a year and the cost of goods relating to those sales was $100,000 and the average inventory was $25,000 then the inventory turnover would be 4.  If the inventory level averaged $50,000 then the inventory turnover would be 2.

Inventory turnover is important because it is a measure of investment productivity.  A good way to evaluate that is GMROI or gross margin return on inventory investment.  In the above example, when our inventory turnover 4, the GMROI was $20,000/$25,000 or  80%.  When the inventory turnover was 2, the GMROI was $20,000/$50,000 or 40%.

It’s much better to make an 80% return than a 40% return which shows how important inventory turnover is.

Source: Inventory Turnover

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