Monday, August 11, 2008

Inventory management- evaluation ratios

The periodic use of ratio analysis to monitor the performance of your inventory is a highly recommended practice. The two main ratios for evaluating how well you manage your inventory are the Inventory Turnover Ratio and the Average Number of Days of Inventory:
  • Inventory Turnover Ratio (ITR): The ITA measures the number of times your business "turns over" its inventory in a year. It is a measure of the operating efficiency of your business. The more frequent the inventory turnover, the greater the ratio. A higher ratio is preferable. To calculate inventory turnover, divide Cost of Goods Sold (COGS) by Average Inventory. Use only finished inventory to simplify the calculation. A low turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing effort. However, in some instances, a low rate may be appropriate; that is, when higher inventory levels have occurred in anticipation of rapidly rising prices or shortages. A high turnover rate may indicate inadequate inventory levels, which may lead to a loss in business.
  • Average Number of Days of Inventory (ANDI): ANDI measures the number of days it takes, on average, to sell your finished goods inventory. This ratio is simply the inverse of the Inventory Turnover Ratio. To calculate the ANDI, divide the number of days in a year (365) by the ITR. The fewer the number of days that finished goods sit on the shelves, the better.
Monitoring your Inventory Turnover Ratio and Average Number of Days of Inventory helps you to improve inventory management and to avert write-offs associated with stale inventory.

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