Inventory Turnover Ratio : Definition,Reasons of using etc.

What is Inventory Turnover?

Inventory Turnover is the overall movements of the inventory which indicates the number of times the inventory is turned over,i.e bought and consumed during a particular period. It is usually expressed a ratio and the ratio helps to identify slow-moving, dormant and obsolete. It is measure the rate of materials that are consumed.

Formula of Inventory Turnover

The Inventory ratio formula is calculated by using the following formula:

Inventory Turnover Ratio = Cost of Materials consumed during a period/ Average Inventory held during the period.

Here, Average inventory is the average values of the opening and closing stock of materials.

Reasons of using Inventory Turnover ratio

A high inventory turnover indicates a low stock and a low inventory turnover indicates a high stock in relation to usage. A high inventory turnover reduces the chances of materials deterioration, or obsolescence, excessive holding costs i.e. interest on capital and it may reduce the costs of excessive storage space for the unused materials.

A low inventory turnover may enhance the possibility of high holding cost, materials deterioration, or obsolescence chances, blocking the capital for a long time.

However, low inventory may have also some advantages which is materials may be acquired at a cheap prices, reduces the chance of production disruption, stock cost minimize and lowering the ordering costs.

Limitation of Inventory Turnover Ratio

  • Management have to decide how many ratio should be calculated. Ratio should be calculated for each item of materials which is really time consuming.
  • Fluctuations in store price may hamper for calculation of Inventory Turnover ratio.
  • Average may not give accurate result because the calculation can be done in a number of ways which may have chance of misleading.

Examples of Inventory Turnover Ratio

The following are the particulars relating to two items of stock X and Y in a period of one year comprising of 365 days:

ParticularsMaterials – XMaterial – Y
Stock as on 01.01.2012$ 3,000$ 3,000
Purchase made during the year$ 30,000$ 4,500
Stock as on 31.12.2012$ 1,000$ 2,500

Solution :

The Turnover ratio are calculated as follows:

Firstly, we have to calculate Material Consumption during the period:

ParticularsMaterials – XMaterials – Y
Opening Stock 3,0003,500
Add : Purchases30,0004,500
Raw Materials available for consumption33,0008,000
Less : Closing Stock1,000 2,500
Raw Materials Consumed32,0005,500

Secondly, We have to calculate Average Inventory:

Particulars Materials – X Materials – Y
Average Inventory(3,000+1,000)/2 = $ 2,000(3500+2500)/2 = $ 3,000

*** Average Inventory = (Opening Inventory + Closing inventory)/2

Finally, Turnover Ratio will be calculated:

Particulars Materials – X Materials – Y
Turnover Ratio32,000/2000 = 165,500/3000 = 1.833

*** Turnover Ratio = Material Consumption/Average Inventory

Again, Fast moving and Slow moving item determination is another important task in inventory management. Now, we will calculate Fast moving and Slow moving items of Inventory.

No. of days the average inventory is held:

Material – X = 365 days/ Turnover Ratio = 365/16 = 22.81 daysFast Moving item
Material – Y = 365 days/Turnover Ratio = 365/1.83 = 199.45 daysVery Slow Moving.