Inventory Turnover Period is ratio determines for how many days inventory is held by the entity before it is eventually sold to the customer. As inventory is a primary resource for entity’s revenue, keeping inventory in check is important. This ratio comes with different names; days of inventory on hand, days inventory withheld, days of inventory, days inventory outstanding, days inventory held etc.
Inventory turnover ratio and Inventory turnover period measures:
- management’s efficiency – by measuring the turnover period i.e. converting inventory to sales
- management’s effectiveness – cash tied up in inventory in terms of inventory investment i.e. purchase price and carrying cost.
To be efficient and effective in terms of inventory management, the turnover days needs to be as less as possible. Shorter the turnover period, faster the sales frequency thus higher the profit. And also lesser the carrying cost.
Days inventory outstanding or Inventory turnover period ratio is calculated using following formula:
DOH = Number of days in the period / Inventory turnover ratio
Nikon started production of new DSLR camera with model name D750. Cost of goods sold for the year ended is 1,000,000. The year ended inventory of D750 is 300,000. Nikon started the year with 200,000 units of D750 in inventory. Nikon considers 360 days year for calculation purposes.
Average inventory = [200,000 + 300,000] / 2 = 250,000
Inventory turnover ratio = 1,000,000 / 250,000 = 4
Inventory turnover days = 360 / 4 = 90 days
Analysis and Interpretation
We cannot make any judgement regarding inventory turnover days unless we have a benchmark. Benchmark can be entity’s own last year’s performance, industry average, competitor’s turnover period etc.
For understanding purpose lets assume that industry average is 65 days.
Looking at numbers we can say that entity’s turnover period is quite long and things can get even worse if market leader in terms of turnover period has significantly shorter period. Longer turnover period may indicate obsolete inventory resulting in lesser cost of sales (because of lesser sales) and units piling up in store.
On the other hand, the reason for high turnover period might be the result of inventory build up prior to product’s commercial launch. To avoid delays to customers or backorders Nikon might have produced large amount of D750 units and as sales have just started that are expected to grow therefore we need to check indicators of relevant areas and industry growth forecasts for such products.
In case of raw material inventory, one reasonfor such a high turnover period can be the result of large amount of inventory purchases as suppliers are giving bulk order discounts or simply because ordering cost has went up.
In short, to understand the picture better, one might need to check other relevant factors affecting the inventory management decisions