Inflation rate and inventory turnover ratios are two matters that business owners and managers have to deal with throughout the lifetime of a business. Companies normally aspire for a low inflation rate and a high inventory turnover ratio, since that would mean better use of resources. The lack of knowledge as to how both figures interact with each other can prevent you from optimizing operational efficiency and overall profitability.
The rate at which the general level of prices for goods and services is rising in an economy is commonly known as inflation. The term is not to be confused with an increase in prices within a single store or commodity, since the increase must affect the general price level of basic goods and services within an economy. Inflation causes monetary purchasing power to fall over a given time period and is usually measured using a country's consumer price index, or CPI.
Inventory in a business refers to the goods and services the business sells on a regular basis to generate profit. The rate or number of times a company's inventory is sold and replenished is referred to as inventory turnover ratio. This ratio tells you how well a business is turning its inventory into sales over a given time period. Dividing cost of goods sold for a year by average inventory during the same period yields this ratio.
The effect of inflation on inventory turnover ratio is influenced by the inventory accounting method used. First in, first out, last in, first out, and average cost are the most common inventory accounting methods applied by businesses. FIFO assumes that the first units purchased or manufactured will be the first units sold, while LIFO dictates that the last units purchased or manufactured will be the first units sold. The average cost method divides the total cost of goods available for sale by the total units available for sale to get the weighted-average unit cost.
When using FIFO during inflation, your cost of goods sold decreases, since its value will be based on prices during the time when such prices are least expensive. A lower cost of goods sold results in a lower inventory turnover ratio. For LIFO, your cost of goods sold increases, because items sold are based on the period when they are most expensive. A higher cost of goods sold results in a higher inventory turnover ratio. The average cost method results in a ratio that is somewhere in between the ratio produced by FIFO and LIFO.