If you run a business that sells physical products, accurate and up-to-date inventory management is crucial for your success. Inventory turnover ratio is a business performance metric that can help you understand how well your company translates inventory into profit. But what is a good inventory turnover ratio? In this blog post, we’ll guide you through everything you need to know about inventory turnover and reveal the ways to achieve a high inventory turnover.
What Is an Inventory Turnover Rate and Why Is It Important?
Inventory turnover is a ratio (ITR) that helps businesses see how many times they sold and replaced products/inventory within a given period of time. It is an efficiency rate that shows how effectively companies manage the inventory. As the name of the ratio implies, by calculating the inventory turnover you will understand how your inventory “turns over” or sells during a fixed time period.
Following simple numerical logic based on units, if a company had 1000 units in stock on average and sold 1000 units in the year, then the ITR is 1. So the company turned over the inventory only once. But if the business sold 5000 units, while having 1000 units in stock on average, then the ITR is 5. So this number shows that the company purchased a lot of inventory during the year. You get a good indication of what the ratio is between the sales made and the inventory held on hand.
The turnover rate is an extremely important efficiency metric to determine how much a business sells as a percentage of its total inventory. You will get insightful measures not only into your company’s financial efficiency but also into inventory holding expenses. So you will be armed to better manage expenses such as rent, utilities, insurance, labor, and other inventory management costs.
In general, the ITR plays a crucial role in business success for two main reasons:
- Stock purchasing – a company can purchase too much inventory over a fixed time period. And it will have to take actions to sell it all in order to boost the inventory turnover rate. However, companies that acquire too much inventory often face challenges in selling that excess inventory. This results in additional expenses such as storage and inventory holding costs or extra labor issues.
- Sales issues – sales and purchasing departments must always work collaboratively. Sales must always match the inventory purchases. Otherwise, the inventory turnover will be out of balance. In order to tune the sales and purchase between each other, you can use an inventory turnover ratio calculation.
Inventory turnover management is very important for any company’s success. And the above mentioned two components must be accurate, in order to achieve accurate measurements.
Efficient ITR helps companies avoid overstocking and understocking the inventory levels and improve the efficiency of operations between departments (e.g. development, sales, marketing, purchasing, etc.). The ITR metric can guide business’s decision-making to make more data-driven decisions regarding inventory purchasing and holding.
Inventory Turnover Ratio Formula and How to Use It?
The inventory turnover is calculated by dividing the cost of goods sold by the average inventory for a specific time period. There are two important components you need to know to calculate the inventory turnover ratio:
Cost of goods sold (COGS)
COGS can be identified from the annual income statement. If you need to use the COSG data from a specific week or month, then you can retrieve the number from the weekly or monthly income statement. You can also calculate the COGS from the balance sheet using the following formula:
│COGS = Beginning Inventory + Inventory Purchases During The Period – Ending Inventory
- Average inventory (AI)
Average inventory is the average of the beginning and ending inventory for the designated time period. We use average inventory instead of ending inventory because many companies’ merchandise fluctuates throughout the year. Here’s the formula to calculate the AI.
│AI = (Beginning Inventory + Ending Inventory) ÷ 2
When you know the values of COGS and AI you can calculate the inventory turnover ratio using the following formula:
│Inventory Turnover Ratio = Cost Of Goods Sold ÷ Average Inventory
The ITR is a very useful metric for the following reasons:
- It can be used as a comparison metric to industry averages and help identify your company’s performance in the market.
- It will give you insights and visibility into how well your company’s internal operations are coordinated, especially between sales and purchases.
- You will get an idea of how efficiently your company controls the merchandise
- It shows how liquid your company’s inventory is. Inventory is the biggest asset of the company. So it’s especially important for the investors to see how well the company transforms inventory into cash.
So what is a good inventory turnover ratio? There is no one universal answer to this question because it always depends on the company and industry it operates in. However, a business should always aim to have a high inventory turnover ratio. A low inventory turnover might indicate that the company has poor inventory management and fails to turn the inventory into cash. A high inventory turnover measurement means the company’s sales, inventory, and costs are well-coordinated and its inventory is liquid.
Case Study: Calculate the ITR
Let’s apply the formula to a real-life example to better understand how the ITR works. We need to calculate the inventory turnover for ABC Inc. Here’s what we know:
COGS = $50,000 + $490,000 – $60,000 = $480,000
AI = ($50,000 + $60,000) ÷ 2 = $55,000
ITR = $480,000 ÷ $55,000 = 8.73
Days inventory outstanding = 365 ÷ 8.73 = 41.8
The number indicates that ABC Inc. sells its entire inventory within a 42 day period. Given that ABC Inc. is a huge corporation, we can conclude that the number is quite impressive. The company manages to sell its inventory very well and turn it into cash flow. However, it’s important to keep the ITR balanced. When the turnover rate is too high, this might indicate lost deals since there’s not enough inventory to cover the demand. That’s why it’s always best to compare your ITR to the industry benchmark.
Ways to Achieve a High Inventory Turnover
A low inventory turnover rate brings up a lot of disadvantages. The most common ones are obsolete inventory accumulation and extra inventory storage costs. There are several ways how you can improve your ITR if you have a low inventory turnover. We already know that a low turnover means that a certain amount of your inventory isn’t selling well. Below are some methods you can use to fix the low inventory turnover problem.
Forecast the Demand in Advance
Consumer demand is the most unstable thing in the business. Given the seasonality and trends, we can explicitly state that not all items are constantly wanted and desired by customers. If you want to manage your inventory and make sure that it sells well, you need to be able to forecast and plan the demand in advance. So you need to become a demand-driven business that manages all the inventory.
You can forecast the demand manually or use a demand planning software. In either case, you need to have some data to rely on. You previous historical data can help you come up with specific trends. By analyzing these trends, you will get insights into how and why specific products sell well or poor. Eventually, by forecasting the demand and ordering the amount of stock that will correspond to the demanded number, you will improve your ITR.
Increase the Demand via Promotions
If you find yourself carrying too much inventory, then you need to find a way to get rid of it ASAP. There are many techniques you can use to sell the excess inventory, and promotions are one of them. Discounts and promotions are the best way to boost sales by increasing the demand for the slow-selling products. When you have too much inventory on hand, this means that it’s high time to enhance your marketing efforts.
Consider using steep discounts that are available for a limited time only. The limitation of time creates a sense of urgency. You can also use promotional methods like bundling the products. You can bundle the slow-moving products with fast-selling ones and offer an attractive discount for the bundled product. Or you might also consider a gift option for purchased over a specific amount of money. Remember that it’s always more efficient to sell the product for cheap or gifting it, rather than keeping the excess stock.
Evaluate How Effective Your Pricing Strategy Is
Sometimes, if products are not selling well, the problem lies not in the lack of interest but in how you price the item. While all businesses want to ensure a high ROI and maintain stable margins, by putting a way too high price on the products can leave you with no sales at all. But that doesn’t mean that you need to simply lower the prices to make them appealing to all.
Creating an effective pricing strategy means that you consider all the factors that influence the value. These include all the raw materials, staff, processing costs, expenses, and competitors’ rates. By simply lowering the prices you might achieve a high turnover but still have a low revenue. So you need to take smart actions when building your pricing strategy.
What Is Your Ideal Inventory Turnover Ratio?
So what is a good inventory turnover ratio for your business? The answer to the question is not so straightforward. To say that the ITR should be high is a very vague statement because the “high” is very different for every industry and company. So as discussed, it’s very much dependent on the size of your manufacturing company and the industry in which you operate. When comparing your ITR to the industry benchmark, don’t compare yourself to larger competitors if you run a small business.
One mistake that small businesses often make is that they misleadingly believe that a successful ITR for a large company will work for them too. However, small manufacturing operations don’t scale up to large manufacturing. So there’s no one-size-fits-all approach within the whole industry. Always consider the size of your company. Likewise, relying on the size only would be wrong too. Consider a company that manufactures mainstream products and an expensive jewelry company. Both of the companies are small, but their ITR is very different.
So to answer “what is a good inventory turnover ratio” question, you need to take into consideration numerous factors. Once you do that, you can always improve your inventory turnover rate and improve your bottom line. Strive to make your inventory work for you and not against you. And aim for a high inventory turnover to make it work.