Inventory management is no easy feat: business owners have to keep track of what products are in high demand, what products need to be discounted due to underselling, and how to find a happy medium between demand and recovery. To make the best decisions for a company, it’s important to understand the rate at which inventory is being sold, the circumstances the store is in, and other relevant factors. This is where finding the right inventory turnover ratio comes into play.
What is inventory turnover?
Simply put, the inventory turnover ratio (ITR) measures how quickly inventory is sold. This financial ratio determines how many times inventory was sold and replaced in a specific period.
By using a mathematical formula, business owners can figure out how long it takes to sell their inventory, which is key to managing inventory pricing, purchasing, manufacturing, marketing, warehouse management, and other business strategies. The ITR is also used to compare previous years to each other to identify trends, and even compare to competitors in the same market.
How to calculate inventory turnover
Inventory turnover is figured by taking the cost of goods sold (COGS) and dividing it by the average inventory value for the same period of time. The formula looks like this mathematically:
Cost of Goods Sold (COGS) / Average Inventory Value = Inventory Turnover Ratio (ITR)
The cost of goods sold is the direct cost of producing goods, which includes all the goods a company has, raw or finished, that are intended to be sold.
To calculate the average inventory value, take the sum of the beginning inventory and ending inventory of a certain period of time and divide it by 2. Mathematically, it looks like this:
(Beginning Inventory + Ending Inventory) / 2= Average Inventory
Let’s use an example to see what results can look like. Say a small business owner sells customizable laptop covers. If the cost of goods sold is approximately $60,000/year and the average inventory was worth $10,000/year, the formula would look like this:
$60,000 / $10,000= 6
This result means that the customizable laptop cover company typically turned over its inventory 6 times in a year’s worth of time. That turnover ratio is essentially how often a company turns inventory into profit.
Why does a good inventory turnover ratio matter?
So, what is a good inventory ratio? For most industries, a 5 to 10 inventory turnover ratio is an acceptable rate, meaning the company restocks approximately every 1 to 2 months. This is intended to balance having the right amount of inventory on hand to meet the demand of sales without reordering too early or unnecessarily.
In general, a high turnover ratio indicates that a business is doing well because they’re selling their goods at a high rate. A low turnover is usually a sign of decreased sales or the demand for your product is lowering.
However, this isn’t always the case: there are some exceptions. A high turnover ratio can also indicate that there is insufficient inventory stock, also called “stock out costs.” A high turnover may be a suggest that a business should purchase more inventory to account for the rate of sales to avoid running out and prolonging available services or goods. If your ITR is in the double digits, you may be limiting your potential revenue.
Consider the Business Type
It’s also important to consider the type of business you have and the type of goods you are selling. Not everyone has the same recurring costs each month. A farmer, for example, only needs to purchase certain equipment once in a while—not even once a year for items like a tractor. That means that their inventory cost may largely vary from year to year.
For companies that sell perishable goods, they will need a higher inventory turnover ratio because their goods need to be sold regularly to avoid losses from spoilage. However, a large tech company that sells expensive software programs is going to have a naturally higher profit margin, which results in a lower turnover rate. This isn’t outrageous because these companies get more money on a single sale and don’t need to “restock” as often.
What to do when you have a low inventory turnover
If you have a low inventory turnover ratio and you need to raise it, here are some things you should consider to find the root of the problem.
- Competitive analysis. How are your competitors performing? Are they offering lower prices for a similar enough product? Have they improved their marketing strategies? You may have to adjust your pricing and business funding depending on the competitive market.
- In-house analysis. Do you have a salesforce that affects how well and how often your product is sold? There may be some strategies or training to help improve sales efforts.
- Product analysis. If your ITR is consistently low, it’s possible that the demand for your product is fading and it’s time to freshen up the variety of stock you carry.
Tactics to optimize your inventory turnover
Ideally, high volume and low margin markets have the highest inventory turnover ratios. However, that isn’t always possible for certain industries. Try these strategies to optimize your ITR.
- Know your industry. First and foremost, understand the trends, the market, and the competition in your industry. If you sell a luxury product with a higher profit margin, you likely aren’t replenishing your inventory often and should budget accordingly. If you manage a high-volume market, your efforts should go towards selling a lot of inventory quickly.
- Supply chain management. Sometimes the cheapest supplier isn’t the best option, especially if those lower prices mean your orders aren’t fast enough to keep up with your turnover demands. Make sure you have the right retailer and supplier for your business.
- Promotions and discounts. If you need a quick turnaround, get what isn’t selling off the shelves by offering special promotions or discounts. You may lose some of the profit, but it’s better than not making anything or perishable goods going to total waste.
- Take advantage of forecasting. By being prepared with hard data and typical industry trends, you can have a better marketing strategy by offering bundles or other perks during certain times of the year. Capitalizing on seasonality is one of the best ways to optimize your inventory.
Need Funds to Optimize Your Inventory Turnover?
If you need to optimize your inventory turnover ratio but can’t afford it, explore working capital loans from QuickBridge. You can free up the funds you need to focus on inventory strategy and improvement without losing any momentum in your day-to-day operations. Learn more about your loan options today by speaking to one of our loan specialists (888.233.9085) or apply now.