Explained: Inventory Turnover Ratio, Its Calculations & Significance 

Inventory is the lifeblood of any organization. It keeps the gears turning and represents the value of your business at any given time.

It gives us insight into how effectively we’re managing our assets, which means you’ll know if it’s time to restock or reallocate resources. 

Understanding the inventory turnover ratio is a significant part of managing your inventory. And that’s exactly what we will learn in this blog.

Here is the comprehensive analysis of the inventory turnover ratio—inventory turnover calculation and significance.

What Is Inventory Turnover? 

Being a business owner or operations manager, one of the first things you need to know about is the inventory turnover ratio. This number is an essential indicator of how efficiently your company sells its products and services. In essence, 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.

More specifically, it’s a number representing the days from when your company purchases goods (beginning inventory) to when they are sold again (ending inventory or list). The journey from inventory purchases to sales (or beginning inventory to ending inventory) is considered one complete “inventory turnover.”

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 effectiveness of your inventory management 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 list within that same period.

To calculate COGS, you need to add up all costs associated with producing and selling your products 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).

Or

Inventory Turnover = Cost Of Goods Sold / Average Inventory value in the period.

Let’s break down the formula and understand its components.

1. Cost of goods sold (COGS)

So, the cost of sales is the actual value of inventory converted into sales.

You derive the cost of goods sold simply by reducing the profit from the revenue generated. To put it simply, reducing gain from company’s sales.

Profit here refers to gross profit. It is because net profit includes indirect expenses that cannot be attributed to an inventory.

  • Cost of goods sold = Revenue from operations + Gross loss made
  • Cost of goods sold = Revenue from operations – Gross profit made

Let’s understand 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 inventory a company has over an extended period. It is calculated by arriving at 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 $ 200,000, and it became $ 300,000 at the end of the year.

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.

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), or have too much inventory and expect to see an improvement in inventory turnover. You need a better way to manage your 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 levels and calculate the inventory turnover rate 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 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 you spend on inventory is to reduce 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 frequently. It will help reduce carrying costs and your risk of running out of popular items, but it also requires a tight supply chain and quick turnaround times.

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 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 ratio.

4. Improve market forecasting

One crucial factor is your forecasting algorithm, which you use to predict future customer demands for specific items and adjust inventory 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 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 forecasting principles. 

Firstly, you need to factor into your forecasts an item’s demand type based on its position in the product life cycle (new/old). You can then adjust your forecasting algorithms accordingly.

Choose Upper For Increasing Business Efficiency 

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With Upper Route Planner, you can reduce the cost per delivery and achieve the desired number of same-day delivery. This is a key component of an efficient supply chain. 

Upper Route Planner’s fully automated process helps you deal with delivery challenges with fewer resources and save time while boosting productivity and profits. In addition, Upper Route Planner removes manual dependencies (incessant back and forth, draining phone calls and paperwork), lack of real-time visibility, and delivery delays.  

Efficient deliveries reduce risks of stagnant inventory and returns and thus contribute toward inventory control and a good inventory turnover ratio.

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Get the benefit of Upper and perform timely deliveries with the best routes. Switch to a fully automated process and achieve your desired organizational goals by improving the inventory turnover ratio.

FAQs

The inventory turnover ratio (ITR) is a helpful way to measure your inventory management efficiency. It tells you how often you sell and restock your inventory, which can help you determine whether or not your inventory levels are where they should be.

However, while knowing the industry average ITR is essential, it’s not necessarily a good number for you to target. You want to use your unique situation as a guide when evaluating your ITR.

If your industry has an average of 10, but yours is lower than 5, don’t panic! That means your competitors are selling faster than you are. A lower inventory turnover ratio (or low turnover) isn’t bad. It means there’s room for improvement in getting rid of old stock and replenishing shelves with new products.

Inventory turnover ratios are a crucial indicator of how efficiently a company manages its inventory. It’s measured by the number of times a company sells and replaces its stock of goods in a period. But note that inventory turns are different for different industries.

Although, high inventory turnover ratio often proves to be good. Why? Bcause higher inventory turnover ratio = company is more efficient at selling its products = the better for your business.

Low inventory turnover ratio is a cause for concern, as it would indicate that demand for your products has declined. It could be caused by poor management or overstocking certain items, resulting in excess inventory costs.

As a business owner, you may be familiar with inventory turnover rate. This ratio can 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 time to proceed, you are tying up too much money and inventory stock in unsold products.

You could use that cash flow for other purposes for your business or even invest it in something else.

By looking at the inventory turnover ratio, you may also be able to tell how effectively your company manages its existing inventory. A low inventory turnover indicates that your inventory is sitting around too long, and perhaps there are ways to improve this process!

If you’re looking to streamline your supply chain and improve your inventory management, there’s no better way to do it than with an automated solution.

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.

It will help you to maintain optimum stock levels, analyze which products are selling best and most minor, keep the best possible balance between sales and inventory levels, and even automate your stock management.

Takeaways References 

In today’s competitive marketplace, keeping track of your inventory is crucial. 

Not only do you need to understand what products sell in your store clearly, but you also need to know where they are at all times.

Using the right technology, you can track how much inventory you have and how much has sold. An excellent way to measure this is by calculating your inventory turnover ratio. 

It will help you understand how quickly or slowly your business sells its products so that you can make financial decisions that benefit both current and future operations!

Author Bio
Rakesh Patel
Rakesh Patel

Rakesh Patel is the founder and CEO of Upper Route Planner. A subject matter expert in building simple solutions for day-to-day problems, Rakesh has been involved in technology for 30+ years. Looking to help delivery businesses eliminate on-field delivery challenges, Rakesh started Upper Route Planner with the ultimate goal of simplistic operations in mind.

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