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I am a little confused on the inventory turnover formula. According to the Motley Fool Investment Workbook, inventory turnover is computed by dividing sales by inventory. However, most financial books recommend dividing cost of sales by inventory. I am reposting a message from the Motley Fool Inv. Workbook board that addresses this very issue:

<<In chap 8, it's mentioned to divide inventory into the revenue, however, shouldn't it be divided
into the cost of sales??? It seems to me the latter would be a conservative position, since the
product(s) haven't been sold yet and the only cost tagged on it is the labor and material cost to
produce it. Once sold, though, it seems logical the product(s) cost would either escalate or
decrease the revenues.>>

Cost of Sales or Cost of Goods Sold divided by inventory is not used because in it is a fixed cost
along with the variable cost. For example, Coca-Cola pays a fixed cost for its plant that brews the
syrup whether the syrup is sold or not. Also included is a variable cost, which is all that wierd
stuff they put in it eye of newt, possum tails, etc (which I think the ingredients are secret). If Coke
sold no syrup in a year and sales were zero, you would have almost the same number if you
divided the cost of goods sold by inventory as you would if they sold a lot of product, since the
fixed cost is probably the greatest.

If Coke sold no product this year, you would have 0 dollars of sale for 1 dollar of inventory,
which would be very noticeable and important.


http://boards.fool.com/Message.asp?id=1360004000021001&sort=postdate

I have read the response but don't entirely understand it. Since "sales" can arbitrarily reflect any price that the company wants to charge for its products, wouldn't this variable cause too much variation in the formula? If anyone can shed any light on this, I would most appreciative! I have recently formed an investment club and we are using the TMF Investment Workbook as our first "text". I am putting together a spreadsheet to compute the various computations and formulas and want to ensure that the formulas I'm using are accurate. Thanks!

Karen :)
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Dear Karen,

I have seen both definitions :) As you said though, it seems like yours seems to appear more in accounting texts. I am inclined to agree with yours though. Doubling the price of goods does not affect how fast stuff sells, but does double TMFRunkle's definition of inventory turnover.

Furthermore, defined in your fashion, inventory turnover = 365/(days in inventory), with the latter quantity defined at

http://www.fool.com/portfolios/rulemaker/1999/rulemaker991102.htm

Also, I do not understand the "fixed cost, variable cost" argument that TMFRunkle presents.

I have seen TMFRunkle's definition appear, for example, when one compares "inventory turnover" to "asset turnover". The latter uses sales, and fits nicely into the return on equity "duPont decomposition":

return on equity = income/equity
= (income/sales)*(sales/assets)*(assets/equity)
= profit margin * asset turnover * leverage

IMHO just define exactly what you mean by "inventory turnover", and keep in mind that it is just one of many pieces of data for a company.

Best,

Lleweilun Smith
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Lleweilun,

Thank you for taking the time to answer my question. Thanks also for the link.

I've been lurking on this board for about a week now. I've come to appreciate very much your well-informed posts. I'm learning so much from reading this board! I'm starting at the beginning and working my way through all the posts, along with keeping up with the most current ones.

IMHO just define exactly what you mean by "inventory turnover", and keep in mind that it is just one of many pieces of data for a company.

That is certainly very Foolish advice and will help me to keep everything in proper perspective!

Thanks again!

Karen :)
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Karen,

The most accurate inventory turnover is based on COGS, not sales, which are stated at market prices. The inventory is carried at cost, which correlates with COGS. If sales are used, it overstates the calculated turnover. Additionally, the inventory should be averaged and not just use the one figure from the balance sheet.

I hope this helps.

Tom
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thalseth wrote:

The most accurate inventory turnover is based on COGS, not sales, which are stated at market prices. The
inventory is carried at cost, which correlates with COGS. If sales are used, it overstates the calculated turnover.
Additionally, the inventory should be averaged and not just use the one figure from the balance sheet.

I hope this helps.


Tom, yes it helps and thank you for your input. I am averaging inventory over two reporting periods since this was suggested in one of the financial books I'm reading. However, since it wasn't proposed by TMF, I wasn't sure of its "accuracy". You've validated it for me - thanks!

Karen :)
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