What Is Inventory Turnover Ratio and How Do You Calculate It?
Inventory turnover ratio is a valuable metric that tells you how quickly a company’s inventory is sold and replaced over a given period. The inventory turnover rate is another term used for this important financial metric.
Essentially, inventory turnover measures how long it takes to completely sell off the stock you purchased. The calculation involves dividing the company’s cost of goods sold (COGS) by the average value of the company’s inventory. The inventory turnover formula is: Inventory Turnover Ratio = Company’s Cost of Goods Sold / Average Inventory.
A high inventory ratio indicates you are selling stock fast, and vice versa.
In this post, we will dive deeper into the concept of inventory turnover, the ideal figure you should aim for, and tips to improve it.
What is Inventory Turnover?
Also known as stock turnover (or simply inventory turns), inventory turnover is a measure of how fast or slow items are flying off your warehouse shelf. Understanding inventory turnover is essential for managing inventory efficiently, as it helps you determine the right quantity of items to stock at any given time to improve cash flow.
Good inventory management involves aligning stock levels with consumer demand to avoid stockouts or overstocking. By monitoring inventory turnover, businesses can quickly respond to changes in consumer demand and maintain optimal inventory levels.
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How Does Inventory Ratio Work?
The inventory turnover ratio measures how efficiently a company manages its inventory, providing insight into stock management effectiveness. This ratio indicates how often a company sells and replaces its inventory over a specific period, usually a year, and directly impacts sales inventory levels. Monitoring the company’s inventory turnover ratio helps identify trends in sales inventory and operational performance. A higher inventory turnover indicates a more efficient operation, where goods are sold quickly and cash flow is better managed. Conversely, a lower turnover may signal overstocking or challenges in selling products.
How to Calculate Inventory Turnover
Calculating Inventory Turnover is a straightforward process.
To calculate inventory turnover ratio, divide the total cost of goods sold (COGS) for a given period by the average inventory value. The equation is as follows:
Inventory Turnover Ratio Formula = Cost of Goods Sold (COGS) / Average Inventory.
The cost of goods sold (COGS) represents the direct costs incurred in producing or purchasing the goods that you sell during a given period.
On the other hand, the average inventory is the median value of the beginning and ending stock over a given period.
For example, if you have 1,000 units of product at the start of Q1 and 10 by the time it ends, your average inventory would be:
1000+10/2 = 505.
If COGS is $5,000, the turnover ration comes out at:
5000/505 = 9.9
Goods Sold and Cost of Goods Sold (COGS)
The cost of goods sold (COGS) is a fundamental element in calculating your inventory turnover ratio. COGS represents all the direct costs involved in producing the goods your company sells, including raw materials, labor, and manufacturing overhead. To determine COGS, you start with your beginning inventory balance, add any inventory purchases made during the period, and then subtract your ending inventory balance. The formula looks like this: COGS = Beginning Inventory + Purchases – Ending Inventory
Understanding your COGS is crucial for accurate inventory turnover calculations. Since the inventory turnover ratio is calculated by dividing COGS by average inventory, any changes in your COGS will directly impact your turnover ratio. A lower COGS can lead to a higher inventory turnover ratio, which often signals efficient inventory management and a healthy sales cycle. By keeping a close eye on your COGS, you can better manage your inventory levels, optimize your turnover ratio, and ensure your business is running efficiently.
Inventory Turnover Calculation Examples
Example 1: Corel Fashion, an apparel retailer that deals in women’s wear has an average annual cost of goods sold worth $360,000. And on average, each inventory intake per cycle amounts to $10,000
Their inventory ratio is as follows:
Inventory turnover = $360000/$10000
This equals 36.
Example 2: Sly Collections, a high streetwear retailer, is unable to calculate its COGS, but knows its quarterly sales value, which is about $45,000 on average. And in the 3-month period, they process inventory worth $6000 on average.
Inventory turnover = $45000/$6000
This equals 7.5.
The two examples above are hypothetical, but they at least show you how to calculate your inventory turnover ratio without needing an inventory turnover calculator software.
You will want to aim for a higher inventory turnover ratio by stocking fast-moving products and eliminating hiccups along your supply chain.
Days Inventory Outstanding(DIO)
Days Inventory Outstanding (DIO) is a valuable financial metric that tells you the average number of days it takes for your company to sell its entire inventory. Closely linked to the inventory turnover ratio, DIO provides another perspective on your inventory management efficiency. The formula for DIO is: DIO = Average Inventory / (COGS / 365)
A lower DIO means your inventory is moving quickly, which helps reduce storage costs and minimizes the risk of holding obsolete inventory. However, if your DIO is too low, it could indicate insufficient inventory, putting you at risk of stockouts and lost sales opportunities. On the other hand, a high DIO suggests that inventory is sitting on the shelves for too long, tying up capital and potentially leading to excess or outdated stock. Striking the right balance between DIO and your inventory turnover ratio is key to maintaining efficient inventory management and meeting customer demand without overcommitting resources.
Six Reasons Why Tracking Your Inventory Turnover Ratio Is Important
Here are six reasons why monitoring your inventory turnover ratio consistently is important
1. Improves Inventory Management
A higher inventory turnover ratio is a sign of good inventory management, showing that you are efficiently managing your inventory by quickly selling products and restocking at a rapid pace. To maintain an optimal turnover ratio, businesses should proactively manage inventory by balancing stock levels to avoid both stockouts and overstocking. Conversely, a lower turnover ratio suggests that you may be carrying excess inventory, leading to increased storage costs and the risk of obsolescence. Regularly monitoring turnover ratios can help improve inventory management by identifying slow-moving stock and guiding strategies to optimize inventory levels.
2. Enhances Supply Chain Performance
Inventory turnover is closely related to supply chain efficiency. An optimal inventory turnover ratio signifies a streamlined supply chain, reducing holding costs and enabling you to respond more effectively to fluctuations in demand.
3. Improves Cash Flow Management
Effective inventory management positively impacts your cash flow. A higher inventory turnover ratio means that less capital is tied up in inventory, providing you with more liquidity to invest in other areas of the business or to address financial obligations.
4. Identifying Seasonal Trends
Analyzing inventory turnover over different periods can help identify seasonal demand patterns and plan inventory levels accordingly. This enables businesses to avoid stockouts during peak demand and minimize excess inventory during slower periods.
5. Performance Benchmarking
Comparing your inventory turnover ratio with industry averages and competitors helps you gauge your market competitiveness and identify areas for improvement in inventory management practices.
6. Enables You to Calculate Retail Prices Accurately
The key to staying profitable in business is calculating your product prices accurately. This is another area where tracking your inventory turnover ratio is beneficial.
What Does High or Low Inventory Turnover Ratio Mean?
Generally speaking, a high turnover means you are selling stock quickly, while a low turnover indicates the opposite.
High turnover ratios generally indicate strong sales and efficient inventory management, but they can also lead to stockouts if inventory is not replenished in time. A high inventory turnover is generally good because it reduces holding costs and increases profitability, but excessively high turnover can be problematic, causing lost sales due to insufficient stock.
However, there are some exceptions to this rule.
If you sell high-end goods, like designer bags or jewelry, your turnover ratio will most likely lean towards the low end. The reason is that products like this are slow-moving, and so won’t fly off the shelf quickly like the regular ones.
A lower inventory turnover ratio is often a sign of inefficiency. Low turnover ratios may indicate too much inventory or weak demand, which can result in excess stock that is not selling quickly. Too much inventory ties up capital and increases storage costs.
Furthermore, an extremely high ratio can be a bad omen for your business. For starters, it can be indicative of underlying understocking problems. It could also mean your prices are too cheap, and this might lead to heavy business losses.
Ideally, you will want to keep your turnover high, but not extremely high.
What is a High or a Low Inventory Ratio?
When can you say that your turnover ratio is high or low? To put it another way, what benchmark would you use to determine a high or low ratio?
The ideal inventory turnover ratio serves as a benchmark and varies by industry, product type, and business model. For example, in the apparel industry, the ideal inventory turnover ratio is between 5 and 10. This means anything south of 4 is low and north of 12 is pretty high.
Industry Benchmarks for Inventory Turnover
Inventory turnover ratios can vary widely across different industries, so it’s important to understand what’s typical for your sector. For example, retailers in fast-moving industries like fast fashion often have high inventory turnover ratios because they clear out stock quickly to keep up with trends and customer demand. In contrast, businesses dealing in specialized or luxury products, such as high-end automobiles or custom equipment, usually have lower turnover ratios due to longer sales cycles.
Comparing your company’s inventory turnover ratio to industry benchmarks is essential for evaluating your inventory management practices. If your turnover ratio is significantly lower than the industry average, it may signal issues with excess inventory or weak sales. Conversely, a much higher ratio could indicate strong sales but also the risk of running out of stock. Regularly benchmarking your turnover ratios helps you adjust your inventory management strategies, better meet customer demand, and stay competitive in your market.
What Can You Do to Remedy a Low Inventory Ratio Problem?
A low inventory turnover isn’t a death knell. Poor sales performance, often caused by weak demand, ineffective marketing, or pricing issues, can contribute to a low inventory turnover ratio. Unsold inventory ties up cash flow and can negatively impact profitability, especially if it becomes obsolete or dead stock.
Some things you can do to remedy a low turnover ratio include optimizing your pricing strategy, doubling down on marketing/promotions, strengthening your supply chain, and implementing strategies to improve inventory management.
Common Mistakes in Inventory Management
Effective inventory management is crucial for maintaining a good inventory turnover ratio, but many businesses fall into common traps. Overstocking is a frequent mistake, leading to excessive inventory, higher holding costs, and the risk of products becoming obsolete. On the flip side, understocking can result in inadequate inventory levels, causing lost sales opportunities and dissatisfied customers.
Another common pitfall is poor demand forecasting, which can cause both overstocking and understocking by failing to accurately predict customer demand. Inadequate inventory tracking is also problematic, as it can lead to discrepancies in inventory records and make it difficult to maintain optimal inventory levels.
To avoid these mistakes, businesses should adopt efficient inventory management practices such as implementing just-in-time inventory systems, conducting regular inventory audits, and using demand forecasting tools. By minimizing these errors, you can improve your inventory turnover ratios, reduce costs, and enhance customer satisfaction—ensuring your business remains competitive and responsive to market demand.
Tips to Improve Your Inventory Turnover Ratio
A low inventory turnover ratio breeds a lot of problems. One is that it causes dead stocks to fill up your inventory, leading to too many unsold inventories tying down your cash flow. Tracking inventory is essential for identifying slow-moving stock and taking timely action to address these issues. Refining your inventory management processes, such as implementing automation or software solutions, can help improve turnover and streamline operations. Ongoing efforts to improve inventory management are crucial for maintaining optimal stock levels and supporting business growth.
If you’ve been experiencing this, here are strategies you can try to turn your fortunes around for the better.
1. Regularly Monitor Stock Levels
Frequent monitoring of stock levels and efficient inventory control are both crucial for identifying slow-moving or obsolete items. Regularly assess inventory reports to determine which products are not contributing significantly to revenue and decide whether to reduce prices, run promotions, or discontinue them altogether. By promptly addressing slow-moving inventory, you can prevent it from dragging down your overall inventory turnover ratio.
2. Negotiate with Suppliers
Establish strong relationships with suppliers and negotiate favorable terms to reduce lead times and inventory costs. Seek discounts for bulk orders or early payments to improve cash flow and ensure a steady supply of goods. Efficient supplier management can lead to faster restocking and improved inventory turnover.
3. Optimize Order Quantities
Balancing order quantities is crucial to prevent excessive stock accumulation. Employ economic order quantity (EOQ) principles to determine the ideal order quantity that minimizes holding costs while meeting demand. Striking the right balance will help you maintain optimal inventory levels and enhance inventory turnover.
4. Leverage Inventory Management Software
Invest in reliable inventory management software to streamline your inventory processes and gain real-time insights into stock levels, sales patterns, and demand fluctuations. Modern inventory management systems can help automate tasks, reduce human errors, and provide data-driven suggestions for inventory optimization, ultimately leading to improved inventory turnover.
What Is a Good Inventory Turnover in Days?
Ideally, you should aim for an inventory turnover of 4 to 12 days for a healthy cash flow.
Move Your Business Forward With Uphance
Using the right inventory management software is crucial for achieving the optimum inventory turnover ratio. Doing so lets you track your inventory levels at all times, monitor stock as they move along your sales channels, and see stocks selling the fastest and slowest.
What better software to use than Uphance? Uphance comes with a load of features that make managing your inventory a breeze.
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FAQs
A company’s inventory turnover ratio is considered low when it’s 1 or less, although this figure largely varies by industry and niches.
A low inventory turnover rate means you aren’t selling goods as fast as you ought to. If allowed to fester, your business might run aground due to tight cashflow and obsolete inventory. If you’re unsure how much inventory you should order, gaining insights can help you avoid these pitfalls.
A high inventory turnover ratio implies you are selling out your merchandise fast. But you need to exercise caution because you might run into stockout problems if you don’t forecast and plan inventory purchases properly.
A good inventory ratio is anywhere between 5 and 10. Of course, this varies by industry and niches.
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