- A key indicator of how efficiently a business manages its inventory is the inventory turnover ratio.
- A high ratio indicates effective inventory management, whereas a low ratio signifies ineffective management or sluggish sales.
- Comparing the inventory turnover percentage to industry benchmarks or rivals can give context and point out areas for improvement.
- Demand forecasting, smart ordering, efficient marketing, and successful sales are just a few of the techniques needed to increase inventory turnover.
Inventory is very crucial for every organization, as it represents how many goods and raw materials are ready to sell. Also, inventory gives insights into managing assets effectively and helps you understand the time period for inventory to restock or reallocate resources.
Moreover, to manage your inventory, first, you need to understand the inventory turnover ratio. And that’s exactly what we will discuss in this blog. Here is the comprehensive analysis of the inventory turnover ratio—inventory turnover calculation and significance.
Table of Content
What is Inventory Turnover?
Inventory turnover is the rate at which inventory stock is sold, used, and replaced. The inventory turnover ratio is calculated by dividing the cost of goods by average inventory for the same period.
Being a business owner or operations manager, one of the first things you need to know is the inventory turnover ratio. The ratio number is an essential indicator of how efficiently your company sells its products and services. Additionally, it shows how often your company turns over its inventory.
The inventory turnover ratio measures how quickly your company uses and replaces its goods. This benchmark can change the way you run, optimize, and execute future operations by giving you an idea of how long it takes for goods to sell out.
Also, the number represents the days from inventory purchases, unsold inventory, and obsolete inventory.
How to Calculate Inventory Turnover Ratio?
The inventory turnover ratio is a simple but effective tool for measuring your business performance. It’s also an excellent indicator for determining whether you’re operating at peak efficiency.
If you’re looking for a way to measure the efficiency ratio of your inventory management processes and practices, calculating inventory turnover is a must.
The inventory turnover ratio shows how many times you turn over your inventory annually.
How? By dividing the cost of goods sold (COGS) within a given period by the average time list within that same period.
To calculate COGS, you need to add up all holding costs associated with producing and selling your product mix or services and divide that number by the number of units produced.
The inventory turnover ratio formula comes in handy in calculating the inventory turnover ratio.
Inventory Turnover = Cost Of Goods Sold / ((Inventory at the start of the period + Inventory at the end of the period) / 2).
Inventory Turnover = Cost Of Goods Sold / Average Inventory value in the period.
Let’s break down the formula for inventory turnover, and understand its components.
1. Cost of goods sold (COGS)
So, the cost of sales is the actual value of inventory converted into sales of inventory.
You derive the cost of goods sold simply by reducing the profit from the revenue generated. To put it simply, reducing gain from a company’s strong sales and the perfect inventory balance.
Profit here refers to gross profit. It is because net profit includes indirect expenses that cannot be attributed to inventory or direct costs.
- Cost of goods sold = Revenue from operations + Gross loss made
- Cost of goods sold = Revenue from operations – Gross profit made
Let’s understand this using an example:
Mobile phones worth $ 2,00,000 were sold for $ 2,20,0000.
- Here, $ 220,000 is the revenue generated from the operations of selling the phones.
- $ 200,000 is your cost of inventory or the cost of goods sold.
- You made a profit of $ 20,000
Cost of goods sold = Revenue from operations – Gross profit made
Cost of goods sold = $220,000 – $20,000
Cost of goods sold = $200,000
But what if we make a loss? Let’s understand it using an example as well.
Mobile phones worth $ 2,20,000 were sold for $ 2,00,0000.
- Here, $ 200,000 is the revenue generated from the operations of selling the phones.
- $ 220,000 is your cost of inventory or the cost of goods sold.
- You made a loss of $ 20,000
Cost of goods sold = Revenue from operations + Gross loss made
Cost of goods sold = $200,000 + $20,000
Cost of goods sold = $220,000
2. Average inventory
It is a crucial metric for businesses to track. It estimates the amount of additional inventory a company has over an extended period. It is calculated on the arrival of an average of stock at the beginning and end of the period.
- Average inventory value = (Inventory at the start of the period + Inventory at the end of the period) / 2.
Let’s understand it with an example.
The value of mobile phone inventory at the beginning of the year was $ 2,00,000, and it became $ 3,00,000 pricing at the end of the year.
Formula for average inventory turnover ratio:
Average inventory = (Inventory at the start of the period + Inventory at the end of the period) / 2
Average inventory = ($200,000 + $300,000) / 2
Average inventory = $250,000
3. Example of calculating inventory turnover ratio
Let’s calculate the inventory turnover ratio by considering an example now that we have a better understanding of the inventory turnover formula.
Inventory turnover calculator—assume the following metrics of your mobile phone business:
|Cost of mobiles sold||$500,000|
|Inventory at the beginning of the year||$250,000|
|Inventory at the end of the year||$275,000|
- Average inventory = (Inventory at the start of the period + Inventory at the end of the period) / 2
Average inventory = ($250,000 + $275,000) / 2
Average inventory = $262,500
We know the cost of mobiles sold = $500,000, as provided.
Using the inventory turnover ratio let’s calculate the turnover ratio.
- Inventory Turnover Ratio = Cost of goods sold / Average Inventory in the period
Inventory Turnover Ratio = 500,000 / 262,500
Inventory Turnover Ratio = 1.90
Therefore, 1.90 times the goods are converted into sales, i.e. the stock velocity is 1.90 times.
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How to Improve the Inventory Turnover Ratio?
Have you ever tried to go grocery shopping with only half a cart? It’s not fulfilling.
It’s the same thing with your inventory: you need to have everything you need, but not more than that.
You can’t just order fewer items more regularly, hold less stock in your warehouse (insufficient inventory management), or have excessive inventory and expect to see an improvement in inventory turnover. Retailers need a better way to manage and reduce dead stock.
Here are some ways you can optimize the inventory turnover ratio:
1. Use automation
Having good inventory management software is vital, so you can keep track of your stock inventory and calculate the stock turnover ratio for each SKU. A warehouse management system (WMS) or an enterprise resource planning (ERP) inventory module can do this for you.
You can identify which overstock products are not providing an adequate return on investment. How? By using a good system that calculates and monitors inventory turnover ratios down to the SKU level.
2. Get rid of old stock
The best way to reduce the amount of money and supply chain issues is the amount of inventory you need in the first place.
You can do this by adopting a lean inventory strategy, which means holding less product and turning it over more often. It will help reduce carrying costs and your risk of running out of popular items, but it also requires a tight supply chain and a quick turnaround time period.
3. Plan for seasonal trends.
Planning for seasonal trends will significantly help you improve your inventory turnover ratio.
How? The answer is simple: use capacity planning.
Capacity planning will enable you to manage your inventory levels to have the right supplies. It helps you predict when customer demand will be high and when you’ll need more employees. When it will be low, and therefore when you can reduce your workforce.
Capacity planning is not just about predicting how much product you can sell but also understanding how quickly you can make more products.
It combines forecasting for seasonal trends and production planning and comes in handy when optimizing inventory turnover ratios.
4. Improve market forecasting
One crucial factor is your forecasting algorithm, which you use to predict future customer demand for consumer goods and adjust inventory segmentation accordingly.
Forecasting algorithms can be truly simple or painfully complex, depending on what kind of data you have and what forecasting model you want to use for each inventory item in your store or warehouse.
But if you want to improve your stock turnover further, it pays to go beyond these basic calculations and use statistical demand models for forecasting principles to predict demand fluctuations.
Firstly, you need to factor into your forecasts an item’s demand type based on its position in the mix of products’ life cycles (new/old). You can then adjust your forecasting algorithms accordingly for the entire inventory.
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A good inventory turnover ratio has a good sales ratio of stocks. For most companies, the ideal turnover ratio should be between 5 and 10. It also means that the company will sell and restock again.
Inventory turnover ratios are different in every industry. Although, a high inventory turnover ratio often proves to be good because it indicates that the company is efficient at selling its product. However, a low inventory turnover ratio is a concern for the business as it will be considered weak sales.
Financial ratios tell you how quickly your company’s inventory is moving out of your warehouse. Keeping an eye on this ratio is essential because if your company’s inventory takes a long period of time to proceed, you are tying up too much money and inventory stock in unsold products.
With an automated solution, you can gather essential statistics about your business, find the economic order quantity for each product, and determine your business’s ideal inventory turnover ratio.
Market saturation, evolution from the growth phase to the maturity phase, changes in customer preferences, and adoption of new technologies are the factors that cause changes in higher and lower inventory turnover ratios.
The inventory ratio decreases because of slow-moving larger stocks and expensive items. Moreover, it might be low if you invest more working capital than required; eventually, it will increase the risk of excess inventory.
In today’s competitive marketplace, keeping track of your inventory is crucial. Not only you need to understand what products to sell in your store clearly, but also know where the products are.
Using the right software, you can track the amount of inventory you have and how much has been sold. Also, it is an excellent way to measure your time inventory turnover ratio. Moreover, if you want to increase delivery operations, get an Upper Route Planner.
Its efficient deliveries reduce the risks of stagnant inventory and returns. Therefore, it will contribute towards inventory control and result in a good inventory turnover ratio. Sign up for a 7-day FREE trial and explore the benefits of Upper.