Itâs not a stretch to say that, for most companies, the movement of inventory through the supply chain is your business. How good your operation is at that is the strongest indicator of future success.Â
So, how does a company gauge the health of that movement? One way is inventory turnover ratio (see what is inventory).
Inventory turnover ratio shows how efficiently a company handles its incoming inventory from suppliers and its outgoing inventory from warehousing to the rest of the supply chain. Whether you run a B2B business (see what is a B2B company) or direct to consumer (DTC), turnover is vital.
Inventory turnover ratio is a measure that shows how many times a business has sold then replaced their inventory over a set time period.
Looking at the inventory turnover definition, itâs clear that itâs an important metric. It sheds light on how good your business is at selling inventory. And on how many inventory days youve got left.
Inventory Turnover Ratio | Explained with Example
What to include in an inventory turnover formula
When calculating your own inventory turnover ratio, it is important to use accurate data based on business sales and what you have in inventory. An inventory includes more than just finished products. It will typically also include any raw materials used to create products and any goods that are in progress. For example, a business that manufactures and sells clothing would likely include the fabric used to make the clothing pieces in its inventory.
What is inventory turnover rate or ratio?
Inventory turnover rate shows the number of times a business has sold and replaced its inventory of products during a particular period of time. The inventory turnover definition is the time it takes to sell all the products within the inventory and replenish them. When calculating your inventory turnover ratio, you can use the information to determine your business annual inventory turns, or how long it takes to sell all the inventory you have.
Using this information can also help your business make decisions on how to price goods, when to purchase additional goods, how much to invest in marketing and how to handle manufacturing. A well-managed inventory also keeps costs under control and indicates that your company is selling products at a consistent rate.
Inventory turnover example
To get a better idea of what inventory looks like in practice, review this example:
Jasons Apparel Co. is a regional apparel manufacturer that sells its products to customers all over the world. During the fiscal year 2019, the company reported its annual cost of goods sold at $1,000,000 and a year-end inventory of $4,000,000. Using the formula, the inventory turnover rate for the fiscal year 2019 was 0.25.
(1,000,000 / 4,000,000 = 0.25)
Inventory turnover formula
If you are wondering how to find the inventory turnover ratio, you can start by looking at the formula and inserting your own business data. The formula is:
Cost of goods sold / average inventory or sales / inventory
The cost of goods sold includes the price of each product, as well as the expenses and costs associated with producing the goods. It doesnt include any indirect costs, such as sales, marketing or overhead costs required to produce it.
The average inventory is important to include in the ratio because it accounts for any seasonal fluctuations, such as holiday purchase surges or seasonal slow-downs. Many companies sell higher numbers of products during certain times of the year, so calculating the average will provide a better overall idea of the inventory turnover.
A high inventory turnover ratio is better as it indicates that a business is selling its goods quickly and achieving consistent demand for the products. A company can use this number to determine whether its purchasing and sales departments are aligned, as the inventory turnover rate should match with the purchasing schedule and plan. When a business has too much inventory, it can result in financial strain. Moving inventory consistently indicates strong sales and better operating cost management.
What is day sales of inventory?
Day sales of inventory refer to the number of days it takes to sell a companys entire inventory. You can also take the inverse of the number produced with the inventory turnover formula and multiply it by 365 to get the day sales of inventory, also known as DSI or days inventory. This inventory formula is:
(Average inventory / cost of goods sold) x 365
A lower day sales of inventory number is ideal, although it can vary based on the industry. For example, a store that sells groceries would have lower day sales of inventory than a luxury watch manufacturer. The grocery stores products are perishable and must be sold within a shorter period of time, and the products are priced lower and essential to a wider group of consumers. Luxury watches and other similar products have a higher price point and a smaller group of consumers, so this type of company would have a higher day sales of inventory.
In the previous example, to calculate the day inventory of Jasons Apparel Company, you would apply this formula:
(1 / 0.25) x 365 = 1,462
Based on these calculations, it would take 1,462 days, or four years, for Jasons Apparel Co. to sell its entire inventory.
How to improve inventory turnover
Now that you understand how to calculate your business inventory turnover ratio, you may be wondering what to do with the information. Use these steps to improve your ratio and turn your inventory into more sales.
1. Compare the number to your industry benchmark
A number might seem high in one industry and low in another based on the target audience and business margins. Grocery stores have an average inventory turnover rate of 14, while automotive parts companies can be as high as 40. Before you can determine the success of your ratio, you probably need an industry benchmark.
2. Forecast your business needs
Another way to improve your inventory turnover rate is to forecast the needs of the business and plan for surges and slowdowns. Fashion trends, seasonal needs and holidays can all impact consumers buying habits. Look at your previous sales data and industry trends to make forecasts based on typical fluctuations.
3. Work on your marketing:
Effective marketing can impact whether buyers are purchasing items from your inventory. Use marketing strategies to reach new markets, appeal to members of your target audience and identify what sets your business and products apart from your competitors. Use a range of marketing techniques, including SEO, social media, content marketing, email campaigns and paid advertising to expand your reach.
4. Automate the inventory
Inventory automation is important for effective inventory management, particularly for businesses that offer e-commerce and in-person sales. The right automation tool can provide alerts when inventory numbers run low and provide real-time stock and inventory updates as sales happen.
5. Restock more efficiently
When a product sells quickly, it is tempting to keep a large stock of it in inventory. However, it often makes more sense to restock smaller quantities more frequently because it reduces excess inventory and overstock. Making more frequent orders may also benefit the business financially if vendors offer discounts for regular customers.
6. Move older inventory
Older items in your inventory can impact your companys turnover ratio, so look for ways to move those items and replace them with newer items that have a higher demand. Consider offering discounted pricing or giving the items away as a gift with purchase to move outdated stock.
7. Negotiate rates
Be sure to negotiate the rates you receive from your suppliers and distributors regularly to get the best prices and keep costs under control. Regular customers often get better rates, so if you can show a consistent pattern of ordering or purchasing from a particular supplier, you may qualify for a discount.
8. Evaluate pricing often
If you are having trouble moving inventory, the pricing could be one of the reasons. Use pricing psychology tools and strategies to determine the proper price point for your goods, and compare your prices to the prices of competing products. Continue to check in on pricing and evaluate it regularly to maintain high sales levels.
How is inventory turnover rate calculated?
- The inventory turnover ratio can be calculated by dividing the cost of goods sold by the average inventory for a particular period.
- Inventory Turnover = Cost Of Goods Sold / ((Beginning Inventory + Ending Inventory) / 2)
- A low ratio could be an indication either of poor sales or overstocked inventory.
Is 1.5 A good inventory turnover ratio?
Is 2 a good inventory turnover ratio?
What does an inventory turnover of 2.0 mean?