Inventory Turnover
What is inventory turnover?
Inventory turnover refers to the number of times that a company’s product inventory is sold and needs replacing, over a specific period. Another way to look at it is the number of days from when the inventory was manufactured or purchased to the date it was all sold or removed from circulation.
Whether you create a website to sell your goods online or you plan to sell primarily at a brick-and-mortar location—your inventory turnover is an important metric to understand.
The average turnover rate helps companies determine how frequently to update and manage their inventory in order to optimize profitability. It can also help them identify inefficiencies and other issues in the sales pipeline.
While a fast inventory turnover is ideal, it’s a subjective measurement and needs to be considered alongside factors like industry, time of year, current demand from the target market, as well as supply chain availability.
What is the inventory turnover ratio?
The inventory turnover ratio is the number of times a year a company’s inventory completely turns over. Knowing this will help assess the efficiency of inventory management as well as the sales cycle.
In order to calculate the inventory turnover ratio, you’ll need to know the following values. Make sure you take them from the same time frame (year, quarter, or month):
Cost of Goods Sold (COGS)
COGS refers to how much a company spends to produce or buy its inventory. You’ll find this value on your company’s income statement. You can also calculate it by using this formula:
Starting inventory + Purchases - Ending inventory
Average Inventory
This is the average (mean) monetary value of a company’s inventory. To get this value, you’ll need to know the starting and ending value of your inventory over the targeted time frame. Then, take the average of the two:
Starting value + Ending value ÷ 2
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How do you calculate inventory turnover?
Use this formula to calculate the inventory turnover ratio:
Inventory Turnover Ratio = COGS ÷ Average Inventory
Let’s go through an example:
Feather Light sells memory foam mattresses for $1500 apiece. At the start of the year, the company had 500 mattresses in stock and ended with 400. The total COGS for the year was $1.5M.
COGS = $1,500,000
Average Inventory = (500 × $1500) + (400 × $1500) ÷ 2 = $675,000
Inventory Turnover Ratio = $1,500,000 ÷ $675,000 = 2.22
With a ratio of 2.22, this means that Feather Light only turns over its mattress inventory two times a year.
You can also calculate the average number of days it takes to turn your inventory using the same metrics. It’s called Days Sales of Inventory (DSI) and the formula looks like this:
Days Sales of Inventory = Average Inventory ÷ COGS × 365
Feather Light’s DSI ends up being 164.25 days.
These ratios can’t be evaluated on their own. One thing to compare them to is the industry-wide ratio. Within the mattress industry, for example, Sleep Number’s inventory turnover ratio is 9.68 while Purple’s is 6.39.
Based on these findings, Feather Light company would be lagging quite a bit behind based on this data. At the very least, it should be turning its inventory around 6 times a year, or every 60 days or so, in order to keep pace with smaller mattress brands.
Why does inventory turnover matter?
Whether you are just starting a business or have an established company, it’s important to know your inventory turnover in order to optimize your operation and maximize your profits.
Here are some reasons why good management of your inventory matters:
Improve your forecasting
There’s a lot that goes into inventory management. If you know what your average turnover rate is—and, more importantly, what it should be—you can accurately forecast what you’ll need to stay replenished without overstocking.
Also, understanding how inventory demand changes is critical, too. There are many factors that can affect how slowly or quickly products move, like seasonal trends, industry-wide shortages, and supply chain issues. If you can predict when they’re coming and what kind of inventory levels are needed at that time, you’ll minimize any possible issues.
Make smarter money decisions
Your COGS and average inventory value are the two contributing factors to your inventory turnover ratio. If you know what sort of ratio to shoot for, you’ll be able to make smart money decisions when it comes to spending and pricing.
Specifically, you may find that you need to:
Get a different manufacturer
Invest in cheaper materials or supplies
Trim inefficiencies in your production process
Negotiate deals on supplier contracts
On the other hand, your pricing may need to be adjusted. Are you not selling enough because you’re charging too much? Or perhaps you’re experiencing weak sales because you’re devaluing your stock by charging too little? You’ll be able to fix these issues once you know what your ideal ratio is.
Reduce waste
Unsold inventory can lead to waste in a number of ways. For example:
Some of it may end up in bargain bins or be given away for free.
Products that get returned but that you’re unable to repackage or resell will get thrown out.
Time-sensitive and perishable items will also end up in the dumpster.
In addition, the longer you hold onto inventory—whether it ends up in the trash or not—the more it’s going to cost you to hold onto that stock.
Provide a better customer experience
When your inventory keeps pace with demand as well as all the external circumstances that affect it, your customers won’t have to deal with persistent out-of-stock notifications. They also won’t be distracted by a new sales event every time they visit your shop.
Alternatively, if you’re always selling products at a heavily discounted price, customers may be suspicious. Instead, a well-stocked store helps build trust among your customers.
Maintain your competitive edge
Poor inventory management can lead to a noticeable difference in what you’re selling compared to the competition. For instance, if your company is still pushing last season’s goods when everyone else has already made the switch, this can have a negative impact on customers and suppliers.
If you can manage your inventory turnover effectively, your business can maintain its competitive edge.
Tips to optimize your inventory turnover
Now that you know how to calculate your inventory turnover ratio and why it’s important, let’s go over how to get the most from it:
1. Know your industry’s average turnover rate
Inventory turnover rates differ depending on the type of business you run. Many tend to fall between 5 and 10, which means they sell and restock every month or so. However, that’s not a golden rule.
For example, grocery stores have very high inventory turnover due to the short shelf life of many of their products. Clothing retailers also have high inventory turnover due to seasonality and style trends.
Luxury goods sellers like high-end jewelry or custom vehicles, on the other hand, typically have lower inventory turnover thanks to longer production times and sales cycles.
When you gather your market research, make sure to check on both the industry average and what your competitor’s current rates are. That’ll give you a good range to shoot for instead of just one number to try and match.
2. Categorize your inventory
If you sell a diverse array of products, understand that not all of them will sell at the same rate.
Take Apple’s inventory, for example. The latest versions of the iPhone, Mac, and other top products are going to fly off the shelves before they even launch. Older models, however, won’t.
It’s not just the age of the product that can affect the speed at which it sells. There are going to be some categories and features that are more popular than others. By categorizing your stock, you’ll be able to adjust your inventory management and sales strategy for certain products based on how similar ones perform.
3. Be careful when using discounts
Customers may get excited when they see discounted products or big sales events. While that may help you get more product out the door, it’s a slippery slope.
Once you start relying on discounts or free giveaways to move your inventory, customers will take notice. There will be some that come to associate your brand with bargain hunting and will only buy from you when your stock is heavily discounted.
The answer instead may be a better pricing strategy if your inventory won’t move. That should reduce your losses. Then, if you have anything left over, don’t toss it out. Instead, donate it and write it off as a tax deduction. You might not get much, but it’s better than writing it off as a complete waste.
4. Keep a close eye on your inventory turnover
Your inventory turnover is one of those key performance indicators you have to keep tabs on regularly. The second you notice a change in it, you should begin researching possible causes so you can pivot your operation accordingly.
Did your competitors recently change their pricing strategy?
Is there a recession on the way?
Are longer-than-usual delivery times scaring off customers?
Have your suppliers grown too pricey?
Is your sales team struggling to close sales within the usual timeframe?
It’s a good idea to have a system in place that enables you to actively monitor and report on your inventory turnover ratio as well as changes both within and outside your company that are affecting it.
5. Automate your inventory and order management systems
Automation is a great way to add productivity and efficiency to nearly every aspect of business. And inventory management is no different.
When choosing business software, this is something to think about. Just make sure you’re focused on more than just the traditional inventory and order management platforms.
Your website builder, for instance, should be helping you manage your inventory. Look for a website and store builder that allows you to:
Add custom inventory limits to your products.
Alert customers when inventory is running low.
Send notifications to your inventory management team when products need to be replenished.
Give customers the option to request a notification when items are restocked.
Not only will these automations help you save money, but they’ll also help you keep the right amount of stock available at all times.