Solutionīefore calculating the inventory turnover ratio, we need to compute the average stock and cost of sales.Īverage stock can be calculated as follows: Required: Calculate and interpret the company's inventory/material turnover ratio (i.e., rate of stock turnover or stock turnover ratio). Purchases made during the year: $3,660,000.John Trading Concern has provided you with the following data for the year 2016: Obsolete items should be immediately scrapped or discarded and the profit or loss should be transferred to the costing profit and loss account. Such material items are no longer in demand and represent a zero turnover ratio. Therefore, storekeepers and other officials should deliberate on whether to retain or dispose of such items in order to save further storing or handling costs. Stock of this kind may regain demand in the future. Such materials do not have any demand at present and represent a zero turnover ratio. It is important to minimize the stock of such items in the store. These indicate the items that exhaust at a very slow speed. Inventory turnover indicating slow-moving items can be classified into the following three categories: 1. Most businesses operating in a specific industry typically try to stay as close as possible to the industry average. Oftentimes, each industry will have an acceptable average inventory turnover ratio. The reason for this is simple: these companies can maintain an efficient system of distribution and receive stock replenishments on a daily basis (or even several times a day).Ĭonsequently, they can meet customer needs without having to hold large stocks. These organizations may carry stock of no more than three days requirements at any given time. Other businesses have a much faster inventory turnover ratio, examples of which include petroleum companies. In other words, their average stock is one-third or one-quarter of their annual cost of sales. Most industries have norms and clear expectations about what constitutes a reasonable rate of stock turnover.įor example, certain industries, including the automobile industry, have a very low inventory turnover ratio (e.g., only 3 or 4 times per year). However, it is also associated with several limitations.įor example, a high inventory/material turnover ratio may lead to frequent stock-outs, the inability to provide adequate choices to customers, or a failure to meet sudden increases in demand. Similarly, if the average stock is low, the inventory turnover ratio will be high.Ī high inventory/material turnover ratio reflects the company's efficiency in the use of its funds invested in the stock. If the average stock of a business is high in relation to its annual sales, its inventory turnover ratio will be low. To do this, you can use the following formula:Ĭost of goods sold = Average stock at cost × Inventory turnover ratio If the average stock and inventory/material turnover ratio are known, it is possible to calculate the cost of goods sold.
Calculating Cost of Goods Sold Using Inventory Turnover Ratio On the other hand, a low inventory turnover ratio in relation to a particular item indicates its slow movement.Īs such, it indicates to the organization that over-stocking should be avoided for that item and, in certain cases, that immediate disposal is the best option. The inventory turnover ratio shows which material items are fast-moving, and so it provides valuable information that can guide investments in that item. In other words:Īverage stock = (Opening stock + Closing stock) / 2 Inventory turnover ratio = Value of materials consumed during the period / Value of average stock (or inventory held during the period)Īverage stock can be calculated by adding opening closing stocks and then dividing by 2. The inventory turnover ratio is arrived at using the following formula:
Formula to Calculate Inventory Turnover Ratio
It shows how fast the stock moves in and out of the company. The inventory/material turnover ratio (also known as the stock turnover ratio or rate of stock turnover) is the number of times a company turns over its average stock in a year. The inventory turnover ratio can be calculated by comparing the balance of stores with total issues or withdrawals over a particular period. In this way, capital investment can be minimized in undesirable stock. It is in the best interest of the organization to compare the turnover of different types of (and grades of) material as a measure of detecting stock that does not move regularly. As such, inventory turnover refers to the movement of materials into and out of an organization. Inventory turnover is the rate at which a company sells its inventory.
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