What is a limitation of the inventory turnover ratio?

Definition of Inventory Turnover Ratio

The inventory turnover ratio is often calculated by dividing a company's cost of goods sold for a recent year by the average amount of inventory during that year. The result is the average number of times that the company's inventory had been sold. The goal is to have an inventory turnover ratio as large as possible without losing sales and/or customers.

Example and Limitations of the Inventory Turnover Ratio

As an example, assume that in its recent year a company had sales of $7 million, cost of goods sold (COGS) of $5 million, and an average inventory cost of $1 million. This means the company's inventory turnover was on average 5 (or 5 times) calculated by dividing the COGS of $5 million of cost of goods sold by $1 million of inventory cost. (This indicates that on average the company turned its inventory every 72 days.)

A limitation of the inventory turnover is that it is an average, which means that some important details may be hidden. For instance, what if four inventory items make up 40% of the company's sales but make up only 10% of the inventory cost? These fast selling items will have a turnover ratio of 20 (40% of the COGS = $2 million divided by $100,000, which is 10% of $1 million). This means that the remaining items in inventory will have a cost of goods sold of $3,000,000 and their average inventory cost will be $900,000. As a result, the majority of the items in inventory will have an average turnover ratio of 3.3 ($3,000,000 divided by $900,000). In other words, the fast selling items are turning every 18 days (365 days/20) and the majority of the items are turning on average every 109 days (365/3.3). That information is being hidden when the focus is on the average of 72 days. It is also likely there is another group of inventory items that are turning even less than 3.3 times during the year.

People within the company can overcome the shortcomings described above by computing the inventory turnover ratio and the days' sales in inventory for each and every item in inventory. By reviewing the turnover ratio for each item, the slow moving items cannot be hidden by the overall turnover ratio.

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