There is no way you can sell what you have in your inventory (unless you have the finished product) before it gets processed or you acquire the materials needed to build it. That’s why the cost of goods sold is also called cost of sales. That includes direct costs of materials and labor for processing the inventory and make it translate into the finished product ready for sales. The cost of goods sold represents the cost incurred to turn the inventory in a finished product ready to be sold. There is another element to take into account for the sake of the inventory turnover ratio formula: the cost of goods sold. They are the most valuable items in the inventory as they might comprise finished goods, which can be valued at the net realizable value. In conclusion, they will have a higher value, although very subjectively determined. Therefore, in our example, the smartphone not fully assembled will be valued more in comparison to the raw materials, since the assumption is that the business will continue the operations long enough to sell the finished product eventually.įurthermore, the value of the work in progress stock will include things such as the labor costs incurred in the manufacturing process. How would you value them from the accounting perspective? Well, do you remember what does the going concern principle state?Īccording to this principle, accountants assume the business will continue the operations in the foreseeable future. Imagine your inventories are comprised of not fully assembled smartphones, either because the screen is missing or the CPU has not been completed yet. In the real world, these items may be considered worthless. In conclusion, according to FIFO the value of your inventory will be $800 or $8 x 100 while according to the weighted average will be $900 or ((50 x $8)+(50 x $10)) x 100). Therefore, the weighted average formula will be: ((50 x $8)+(50 x $10))/100 = $9 per unit. For example, the two batches comprise the same number of items or 50 items at $10 in the first batch and 50 items at $8 in the second batch. In the latter, the price of the goods will be averaged out. Practically the Inventory will be valued at the price of the latest goods received, in our example $8 per unit. Two methodologies can be used in this case: either the FIFO or the weighted average price. Therefore, your inventory comprises phone screens that range from one year ago up to three months ago.įurther, the batches acquired one year ago are valued at $10 per piece while the newly acquired are valued at $8 per piece. As technology progresses the price of some components decreases. Typically they include materials that have different values.Įxample: Imagine, your inventory comprises phone screens. In fact, that needs to be processed to become a final product. A raw material, for instance, if yet in a state that can’t be sold. We can classify the inventories based on how close they are to being sold. Inventories will be valued according to the “net realizable value” or the amount for which the goods can be sold for after subtracting the expenses incurred to make the sales.Īs we saw from the example above, if you own a company who manufactures smartphones, the inventories will be comprised of three kinds of goods that can be valued accordingly. Therefore, the inventories will be comprised of the finished product (smartphones), but also and mainly of components.Īs you can imagine the value of the inventories from the first to the second scenario will be slightly different. Therefore, your inventories will be mainly comprised of finished products. Imagine the scenario in which we have a company who sells smartphones the production gets outsourced. That is a broad definition as the inventory composition can vary based on the business and industry. The inventory is a list of goods a company has on hand to be sold. In the next paragraphs, we’ll look at the components you need to understand to calculate the inventory turnover ratio.
#Formula for inventory turnover ratio how to
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