Much of small-business success is a function of inventory management. Demand is one thing, but if you aren't good at managing the flow of inventory it could affect everything from customer retention to cash flow. In general, the fewer weeks inventory is on hand, the better you are at turning that inventory over, or selling it. The first step in optimizing the flow of inventory is measuring the average number of weeks inventory is on hand.
Inventory turnover is a commonly used metric for analyzing the movement of inventory. It is calculated by dividing the cost of goods sold by average inventory over a given time period. The time period is dictated by the cost of good sold, which can be found on the income statement. Average inventory is taken with both the beginning and end of the time period.
Assume your company had a cost of goods sold of $100,000 last quarter, which is also a 13-week period. You had $30,000 in inventory at the start of the quarter, and $10,000 in inventory at the end of the quarter so average inventory is $20,000. Divide the cost of goods sold by the average value of inventory on hand for inventory turnover. The equation is:
$100,000 / $20,000 = five turns per quarter
This means inventory turned five times over the quarter.
To calculate the number of weeks inventory is on hand, divide the total quarter amount by 91 days (13 weeks). The equation is:
91 / 5 days = 18.2 days
This means inventory is on hand for approximately 18 days, or two weeks, six days.
Using the wrong time period can lead management to bad data, and bad data leads to poor decision-making. If you use a cost-of-goods-sold amount over a shorter inventory time period, you may overestimate inventory turnover and vice versa. It is also important to compare the number of weeks inventory is on hand against competitors as a benchmark. Three weeks may seem good, but if your competitor's average inventory weeks is 1.5 weeks, it may be an opportunity for improvement.