Inventory management can be a difficult task. Business owners must keep track of which products are most in demand, which products require a discount due to underselling and how to strike a balance between demand and recovery. It’s crucial to know the pace at which the inventory is sold, as well as the conditions of the store, in order to make the right decisions for your company. Finding the right inventory ratio is key.
What is the inventory turnover?
The inventory turnover ratio (ITR), in a nutshell, measures the speed at which inventory is sold. This ratio measures how often inventory is sold and replaced over a given period.
Business owners can use a mathematical formula to determine how long it will take to sell their stock. This is important for managing pricing, manufacturing, purchasing, marketing, warehouse and other strategies. ITR can also be used to compare past years with each other in order to identify trends and to compare competitors within the same market.
How to calculate the inventory turnover
The average value of the inventory for the same time period is divided by the COGS to calculate the turnover. This is how the formula appears mathematically:
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory Value
Cost of Goods Sold is a direct cost for producing goods. It includes all goods a business has, whether they are finished or raw, and that it intends to sell.
To calculate the average inventory value, divide the sum of beginning and ending inventories of a period by 2. It looks like this mathematically:
(Beginning Inventory + Ending Inventory) / 2= Average Inventory
You can also see our Example of a Good Way to Start
We’ll use an example so you can see the results. Let’s say a small-business owner sells laptop covers that can be customized. The formula for calculating the average cost of goods sold would be as follows:
$60,000 / $10,000= 6
This means that, on average, the company selling customizable laptop covers turned its inventory six times over a period of a year. This turnover ratio represents how often an organization turns its inventory into profits.
Why is a high inventory turnover rate important?
What is an acceptable inventory ratio? In most industries, an inventory turnover rate of 5 to 10 is acceptable. This means that the company will restock every 1 to 2 weeks. The goal is to have the right amount on hand to meet sales demand without having to reorder too early.
A high turnover ratio is a sign that an organization is doing well, as they are selling their products at a fast rate. Low turnover usually indicates that sales have decreased or demand for the product has dropped.
There are exceptions to this rule. It can also be an indication that the business has insufficient stock. This is also known as “stock out costs.” If a high turnover ratio is present, it may indicate that more inventory should be purchased to keep up with sales and avoid running out of goods or services. Your potential revenue may be limited if your ITR is double-digits.
Consider the Business Type
You should also consider what type of business and goods you sell. Each month, not everyone faces the same costs. For example, a farmer may only need to buy certain equipment every so often, not even once a month for items such as a tractor. This means that the cost of their inventory can vary greatly from one year to another.
Companies that sell perishable products will require a higher ratio of inventory turnover because they need to sell their goods regularly to prevent losses due to spoilage. A large tech company selling expensive software will have a higher profit margin and therefore a lower inventory turnover rate. It’s not outrageous, because the companies make more money from a single purchase and don’t have to “restock”.
What to do if you have low inventory turnover
Here are some factors to consider if you want to increase your inventory turnover rate.
- Competitor analysis. What are your competitors doing? Do they offer lower prices for similar products? Has their marketing strategy improved? You may need to adjust your business financing and pricing if the market is competitive.
- In house analysis Does your sales force have an impact on how well and often you sell your product? You may need to improve your sales by implementing some strategies or undergoing training.
- Product Analysis. It’s likely that your ITR has been consistently low. This could mean the demand for your products is declining and it is time to update your stock.
Stock management strategies to maximize your inventory turnover
Idealistically, the markets with high volumes and low margins have the highest ratios of inventory turnover. This is not always possible in certain industries. Use these strategies to maximize your ITR.
- Understand your industry. Understand the trends, market and competition in your field. If you are selling a product that has a high profit margin and you don’t replace your inventory as often, then you should plan accordingly. If you are in charge of a market with a large volume, your focus should be on selling inventory quickly.
- Supply Chain Management. The cheapest supplier may not always be the best choice, especially if the lower price means that your orders don’t come in fast enough to meet your needs. Make sure that you are working with the right supplier and retailer for your company.
- Offer special discounts and promotions. You can quickly move items off the shelf by offering discounts or promotions. It’s better to lose some profit than nothing or have perishable products go to waste.
- Use forecasting to your advantage. By preparing yourself with data and industry trends you can create a more effective marketing strategy. One of the best strategies to maximize your inventory is by leveraging seasonality.
