One hallmark of a successful business is a regularly cycling inventory. But what does a good rate of change actually look like? How do you calculate inventory turnover, and how do you act on your results? In this blog, we’ve got answers to all these questions and more. Read on to learn how understanding your inventory turnover ratio can:
- Help you track and anticipate sales patterns
- Free up warehouse space
- Free up capital
- Improve your operational efficiency
What Is Inventory Turnover?
Inventory Turnover Ratio is a metric that measures how fast your products sell after they’ve been stocked. To calculate inventory turnover, you’ll need to understand two additional metrics:
Cost of Goods Sold (COGS): The total cost of your products sold during a set period, including raw materials, manufacturing, and transportation of materials. To calculate COGS, take the value of all the goods in your inventory for a given period (X), then subtract the value of the goods that remained in your inventory at the end of that period (Y).
X – Y = COGS
Average Inventory/Average Stock: The average monetary value of your inventory/stock during a set period. To calculate your average inventory, take the starting value of your goods in inventory for a given period (Z), then add the value of the goods that remained in your inventory at the end of that period (Y). Finally, divide the resulting sum by two.
(Z + Y) / 2 = Average Inventory
Why Inventory Turnover Matters
A high inventory turnover ratio tends to equate to a more profitable, efficient business. It indicates you’re not over-ordering on stock and tying up your capital (and warehouse space) unnecessarily. It also means your supply chain is sufficiently stable, permitting you to consistently refresh your inventory. Finally, it shows that customers have a sustained interest in your products.
On the other hand, a low inventory turnover rate can be a sign of inaccurate market forecasting and over-ordering. If your rate turns out to be lower than what’s considered optimal, it’s time to look for ways to either reduce the amount of inventory you’re acquiring or increase your rate of sales.
The Formula for Calculating Inventory Turnover
The formula for how to calculate inventory turnover is relatively straightforward. We already touched on the two key variables above: COGS and Average Inventory. Once you’ve calculated those two metrics, use them in this formula to get your inventory turnover:
Cost of Goods Sold (COGS) / Average Inventory = Inventory Turnover
Note that this metric is distinct from your Inventory Sales (I/S) ratio. While both metrics are used to assess the efficiency of your inventory strategy, they’re calculated in different ways. An I/S ratio is the quotient of the average value of your inventory divided by your total sales during a given period.
Step-by-Step Guide to Calculate Inventory Turnover
The first step in calculating inventory turnover is to determine your COGS and your Average Inventory amounts. Most businesses can use their financial statements or inventory records to calculate these values.
The second step is to run the formula we laid out above: COGS / Average Inventory.
Finally, you have the option of extrapolating your results to estimate your inventory turnover for a longer period of time, such as a full fiscal year. Calculating your turnover during a shorter time period, say a month or a quarter, is typically easier than trying to calculate for the full year. However, when you extrapolate, you assume you’ll have the same COGS and average inventory numbers throughout the year. If your business experiences substantial seasonal fluctuations, this type of extrapolation is more likely to be inaccurate.
Next, let’s look at an example. Say your business starts the first quarter with $10,000 worth of office supplies in inventory and does not restock during the quarter. At the end of the quarter, you’re left with $1,000 worth of unsold inventory. Here’s how you would calculate your annual inventory:
COGS: $10,000 – $1,000 = $9,000
Average Inventory: ($10,000 + $1000) / 2 = $5,500
Quarterly Inventory Turnover: $9,000 / $5,500 = 1.6
Annual Inventory Turnover: 1.6 x 4 = 6.4
An annual inventory turnover rate of 6.4 means that you’re completely replacing your inventory around 6 times a year, or roughly every two months.
Interpreting Your Inventory Turnover Ratio
Once you have your inventory turnover ratio, the next step is figuring out what it means for your business. Generally, higher is better, but too high may mean you’re frequently out of stock and failing to meet customer demand. To find the right sweet spot, start by looking at what’s typical for successful businesses in your sector.
For example, a good inventory turnover ratio for a fashion e-commerce business is between 4 and 6, while a thriving brick-and-mortar grocery business can expect a much higher ratio of between 10 and 15.
This variation between industries is driven by a number of factors, including:
- Amount of inventory
- Perishable vs. non-perishable goods
- Number of SKUs
Strategies to Improve Inventory Turnover
If your inventory turnover ratio comes in lower or higher than is optimal for your industry, don’t fret. There are steps you can take to improve your inventory strategies and, ultimately, your business’s overall efficiency.
First, you should adjust your inventory acquisition rates to better meet customer demand. That means reducing acquisition if your inventory turnover ratio is too low and increasing it if your ratio is too high. If customer demand is historically variable for your business, you can leverage demand forecasting tools to get a better idea of how to fine-tune your inventory management.
Another method for raising your inventory turnover ratio is to reduce lead times through supply chain optimization. In other words, work to reduce the time it takes for products to reach your inventory so that you can replenish your wares faster. Finally, you may need to adjust your pricing. Generally, lowering prices will increase your ratio, while raising prices will reduce it.
Common Challenges and How to Overcome Them
To finish, let’s look at some of the common challenges businesses face when managing their inventory turnover ratio and strategies for overcoming them.
First up: seasonal fluctuations in inventory turnover. The most common example is holiday sales, where a business’s Q4 sales spike significantly higher than any other quarter. If you experience substantial seasonal fluctuations, consider estimating your ratio on a quarter-by-quarter basis instead of extrapolating out to an annual rate. This increased granularity will help you maintain a more optimal inventory throughout the year.
Next: obsolete or slow-moving inventory. Bundling this kind of inventory with in-demand items is often a good strategy for getting things moving. You can also pursue liquidation options with surplus resellers if you want to guarantee it all gets taken care of quickly.
Finally: balancing turnover rates with product availability. You may find that striking the right ratio, where you’re avoiding both stock-outs and locked-up capital, seems borderline impossible.
In this case, data is your friend. Look for resources that can help you analyze factors like forecasted demand, industry trends, seasonal fluctuations, and the like. This additional information can help you understand why your balance has been off historically and how you can fix it.
Improve Your Inventory Management with AMS
Tracking your inventory turnover ratio accurately will help you operate more efficiently, better meet customer demand, and prevent you from sinking excess capital into stock. But that kind of tracking requires reliable data to work.
Luckily, with AMS as your fulfillment partner, you can always count on precise, accurate inventory management, ensuring you have exactly what you need to make sound inventory decisions all year long. Partner with AMS Fulfillment for expert inventory management solutions.
