Inventory control is not just about what products you have on hand at any given time. Good inventory control should also consider how quickly that inventory stock moves into and out of your business.
Sales revenue alone is not enough to measure the success of a business if expenses exceed your revenue, then the business is far from prosperous. Therefore, organisations need to understand the importance of accurate stock taking for measuring inventory turnover and how it can positively or negatively impact the profitability of their business.
Measuring inventory turnover
The rate at which a company can sell inventory stock is a crucial measure of a business’s performance. Measuring inventory turnover will enable the business to gauge how quickly inventory stock is sold.
Knowing your stock turnover numbers is important because a low turnover implies you may be holding excess inventory stock or that your sales are weak. Alternatively, a high turnover suggests either strong sales or insufficient inventory stock.
An inventory turnover ratio is used as a key measure of efficiency, used to measure how many times your company sells inventory stock as a percentage of its total inventory, within a given period. The ratio indicates to investors how liquid a company’s inventory is because the measurement shows how easily a company can convert its inventory into cash.
Inventory assets are often used as collateral for loans therefore, bankers and creditors are interested in knowing how easy the inventory stock can be sold.
Inventory turnover ratio
The first task in establishing your inventory turnover ratio is to choose the timeframe to be measured. Depending on the business this may be weekly, monthly or if necessary, using daily cycles.
The ratio is then calculated dividing sales by the average inventory for this period. Average inventory is used to calculate the ratio because if reflects any seasonal variances. The simple calculation adds the beginning inventory to the end inventory and divides by two.
(beginning inventory + end inventory)/2
Alternately, the ratio can be calculated using the cost of goods sold (COGS). This is seen as a more accurate measure of profitability because in addition to purchase price, it includes any carrying cost of goods sold including conversion costs, overheads and labour costs accrued within the defined period.
The COGS are subtracted from sales revenue to ascertain the businesses gross margins.
(beginning inventory + inventory purchases) – end inventory
Under the periodic accounting system, cost of goods sold is not determined until the end of the accounting cycle while in a perpetual accounting system, cost of goods sold are determined when a sale is made.
Accurate stock taking
The importance of accurate stock taking cannot be understated when it comes to measuring inventory turnover. Efficient and accurate stock taking needs to be achieved to ensure the amount of stock that you have recorded is the actual stock you have available.
If you are using stock records to determine your inventory turnover ratio and those records don’t accurately reflect the physical inventory available, it could significantly skew the measure of inventory performance. Accurate stock taking is crucial for measuring inventory turnover to get an accurate picture of how well your business is performing.
Accurate stock taking will also help to determine if there is any shrinkage or waste in your inventory stock. Shrinkage can be caused through administrative errors or employee theft, shoplifting and supplier fraud.
A physical stock count will also help to identify damaged items or obsolete stock taking up valuable storage space. This stock should be cleared out and inventory records adjusted accordingly for greater accuracy when measuring inventory turnover.