It is imperative to the system of operations that businesses take note of what stock is selling and how quickly. This helps businesses assess the efficiency of their inventory management, demand forecasting, and marketing strategies, allowing them to make any necessary adjustment to improve their sales. The way in which this is usually calculated is by using the inventory turnover ratio. This article will be exploring the uses of the inventory turnover ratio, by looking at the factors that affect it and how to implement the ratio calculation.
What is Inventory Turnover?
The inventory turnover ratio, or a business’ inventory turnover, refers specifically to the amount of times a business has sold and replaced its stock within a given period. This financial ratio allows a company to calculate how long it may take, on average, to sell its inventory.
Previously mentioned, the main benefit of knowing your company’s inventory turnover ratio allows for more effective inventory management strategies to be implemented, as the ratio will assist in highlighting weak points within the current inventory management system. Knowing your inventory turnover ratio additionally allows for a better understanding of cash-flow management, through inventory optimization, and decisions dealing with pricing and purchasing.
Consider a retail outlet stocking a wide array of trendy, fast-fashion items. Because of the constant, high demand for these clothing items, coupled with effective marketing strategies and the implementation of strong inventory management software, the company sees a high inventory turnover ratio. Selling and replacing inventory several times a year will result in the company generating more revenue and profits.
How to Calculate Inventory Turnover
The inventory turnover calculation is a simple ratio that divides the cost of goods sold by the average value of inventory. Cost of goods (COGS) refers to the cost of goods sold, as this represents the direct costs associated with the production or acquisition of the goods sold during a specific period. Cost of goods is used instead of physical sales as the sales amount will include the mark-up, whereas the inventory turnover ratio is more interested in the total cost to the company. Here is the inventory turnover formula:
Inventory Turnover = COGS/Average Value of Inventory
Interpretation of Inventory Turnover Ratio
Earlier in the article, the concept of a high inventory turnover rate was introduced. But what is it? The description of a high or lower stock turnover explains how inventory turnover ratios are interpreted once calculated. A low stock turnover rate indicates weak sales, and that cash may be tied up in excess, unsold products that are taking up too much space within storage. This can point to issues in various sectors, be it marketing or inventory management. A high inventory turnover ratio, on the other hand, usually implies that stock is selling well and that more stock should be purchased.
Retail giant, Amazon, is famous in the supply-chain industry for its high turnover ratio. As one of the leading, global companies, Amazon experiences a high turnover ratio due to the company’s recognition and awareness, large volume of sales and high product demand. Overall, Amazon’s high inventory turnover ratio is a clear indication of its operational efficiency and ability to meet customer demand.
A well-known company with a low inventory turnover is none other than jewellery company, Tiffany & Co. Their low turnover rate can be attributed to the high cost and slow-moving nature of their luxury products. However, Tiffany & Co. has maintained a strong financial performance, despite its low inventory turnover ratio, due to its high profit margins and loyal customer base. Tiffany & Co. does not only serve as an excellent breakfast location, it also serves as an interesting example as to how a low turnover company can maintain profitability through strategic planning and marketing.
Factors Affecting Inventory Turnover
Unlike Tiffany & Co. many other companies with a low inventory ratio, however, can usually attribute this result to poor sales. But how does this occur? Here is a list containing a few factors affecting inventory turnover:
- Industry: As in the Tiffany & Co. example, the industry that a company operates within can often dictate its turns ratio.
- Demand: When demand is high, a company may sell its inventory quicker, resulting in a higher inventory turnover ratio. In contrast, when demand is low, a company may struggle to sell its inventory. This can also be worsened by external factors such as seasonality and current affairs.
- Pricing Policies: Pricing products correctly will help mitigate issues of high-priced stock not selling, or low-priced stock selling too fast without any back-up inventory. Both cases can result in a company not generating enough revenue to cover costs.
- Inventory Management: Companies with poor implementation of inventory management can find themselves in situations of overstock or understock.
- Competition: A company within a competitive industry might need to adjust their pricing strategies and marketing efforts to maintain a competitive advantage and achieve a higher turnover ratio.
How Many Turns of Inventory do you do?
Average Inventory Turnover Period
Also known as Days’ Sales of Inventory (DSI), the average inventory turnover period is the average number of days it takes for a company to sell its entire inventory. Differing from the inventory turnover ratio that looks at the amount of times a business has sold and replaced its stock, this calculation represents the average length of time that inventory is held before it is sold. However, the inventory turnover ratio is necessary for the average inventory turnover period formula:
Average Inventory Turnover Period = Number of Days in Period/Inventory Turnover Ratio
A working example: if a company has an inventory turnover of 5 and the period in question is one year, or 365 days, the average inventory period would be calculated as such:
365 days/5 = 73 days. Meaning, on average, it takes the company 73 days to sell its entire inventory. The average inventory turnover period can provide insight into a company’s inventory management practices and efficiency, where a shorter period indicates that a company is efficiently managing its inventory and quickly turning over its stock and a longer period points to excess inventory or slow-moving products. Calculating this metric can also be useful for benchmarking your company against your own historical performance, as well as industry peers.
What is a Good Inventory Turn?
The ideal values for the inventory turnover ratio point to a higher ratio indicating that a company is selling and replenishing its inventory frequently. This is, however, subject to the industry of the company as well as any other specific circumstances outside the realm of inventory management efficiency and pricing strategy. Improving one’s turnover ratio can bring benefits from optimized inventory levels to reduced holding costs, from increased cash flow to improved profitability. These factors are synonymous with customer satisfaction, as a high inventory turnover ratio implies that there is good product availability, and that the company can and has responded effectively to market demands. By monitoring and improving their inventory turnover ratio, businesses can enhance their operational efficiency, financial performance, and competitiveness in the market.
How to Improve Your Inventory Turnover
With the boom of e-commerce, globalization and general increase in international trade, a modern business must tackle the complexities of handling multiple distribution centers, points of sale and sales channels rendering Inventory Management a real challenge.
Inventory management software systems have now become a must have for any modern business. Intuendi.com has proved itself a leader in the Inventory Management cloud base software market, and with it’s best in class demand forecasting tool, can provide powerful insights into improving your inventory turnover.
