The cost of goods sold is reported on the income statement. Average inventory is usually calculated by adding the beginning and ending inventory and dividing by two. For instance, a company might purchase a large quantity of merchandise January 1 and sell that for the rest of the year.īy December almost the entire inventory is sold and the ending balance does not accurately reflect the company’s actual inventory during the year. The inventory turnover ratio formula is calculated by dividing the cost of goods sold for a period by the average inventory for that period.Īverage inventory is used instead of ending inventory because many companies’ merchandise fluctuates greatly throughout the year. That’s why the purchasing and sales departments must be in tune with each other. Sales have to match inventory purchases otherwise the inventory will not turn effectively. If the company can’t sell these greater amounts of inventory, it will incur storage costs and other holding costs. If larger amounts of inventory are purchased during the year, the company will have to sell greater amounts of inventory to improve its turnover. This ratio is important because total turnover depends on two main components of performance. A company with $1,000 of average inventory and sales of $10,000 effectively sold its 10 times over. In other words, it measures how many times a company sold its total average inventory dollar amount during the year. This measures how many times average inventory is “turned” or sold during a period.
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