What is Inventory Turnover?
It is the rate at which a company orders and replaces its stock depleted by sales. It includes all the items in a company’s stock that will be sold. It is calculated to help a business make informed decisions regarding pricing, marketing, manufacturing, and purchasing. It also allows you to have a rough idea of how your company is performing and in which sector.
When inventory turnover is calculated and managed correctly, you can ensure that your company never runs out of supply. It also means that company sales are optimum and the costs are managed correctly.
What is Stock Turnover Ratio?
The inventory turnover ratio is also known as the the stock turnover ratio. It is used to calculate the rate at which inventory is managed over a certain period. The inventory turnover ratio formula can be used to calculate the number of days it takes to sell the inventory in stock.
How to Calculate Inventory Turnover?
The turnover ratio formula is derived by dividing the average inventory by the cost of the items over the same period. If the inventory turnover ratio is high, it means that the business is doing good sales.
The inventory turnover ratio formula:
Inventory Turnover Ratio=Cost of Goods Sold/Average Inventory
Cost of goods sold is the total cost incurred in manufacturing or sourcing and marketing a product and sold by the company over a certain period. The cost of goods is found on the company’s income statement.
Average inventory is the mean amount of inventory during the same period. Some companies use an average amount while others use end-of-period values.
Maintaining inventory turnover is important as it gives you an idea of how the company is performing.
Why is Inventory Turnover Important?
Inventory is the number of items a company has in stock. This includes raw materials, materials undergoing manufacturing, and finished products that can be sold. For retail stores, inventory is the sum of finished goods. For example, shirts in clothing stores or cereal boxes at a supermarket.
Inventory turnover is the number of times a company replaces its stock that has depleted due to sales during a certain period. Thus, inventory turnover helps the business owner analyse costs for sales.
There are some key points you must remember while generating inventory turnover ratio:
- Higher inventory turnover ratio means better sales: A higher inventory turnover ratio means that the goods in your company are being sold and replaced at a higher rate. Hence, there is a greater demand for your products, and your business is doing well.
- Low inventory turnover ratio means lesser sales: On the other hand, if your company generates a low inventory turnover ratio, the products you manufacture or source are not being sold actively. Hence, it indicates a decline in sales for your company.
- Inventory turnover ratio shows inventory management: The inventory turnover ratio shows how a company does its inventory management. In some cases, a company may manufacture or source too many goods that remain unsold for a long time. On the other hand, a company may not manufacture or source certain goods enough, so they are always in short supply. Both these cases affect the business adversely and need to be managed efficiently for optimum business output. The inventory turnover ratio helps accurately calculate the inventory turnover rate, thus letting you stock items appropriately.
- Inventory turnover ratio shows syncing within various departments: Inventory should match the number of items sold. It can be unprofitable for a company to have items in its inventory that don’t sell. A company’s sales and purchase departments must work in sync with each other for maximum profit. If the sales department hasn’t sold an item, the purchasing department should not order more of the same item and vice versa.
Inventory Turnover Ratio Explained
As mentioned above, inventory turnover is the amount of inventory sold and replaced over a certain period. To calculate the inventory turnover ratio, the cost of goods sold (COGS) is divided by the inventory of the same period. While some companies take an average of the inventory during the period, others prefer to take the last quantity at the end of the period. You can use the end quantity if your business is uniform throughout the entire period.
To calculate the average inventory, you have to use the following formula:
Average Inventory=Inventory at the beginning+Inventory at the end2
You can also use this formula for calculating average inventory:
Average Inventory=Sum of all the inventory in a given period number of months in the same period
How Does Inventory Turnover Work?
Most companies prefer using average inventory quantities because the average evens out sudden peaks and valleys from the changes during a certain period. For example, a certain day might have a sudden peak value in an otherwise normal month. Hence, average inventory gives a more balanced measure of the inventory.
For instance, during festivals like Diwali, there is a massive surge in the purchase of fabrics and apparel. However, the months preceding and following the festival show depleted numbers of sales.
However, some companies use the ending inventory values for the same period as the COGS is calculated.
The inventory turnover ratio formula can be used to calculate the time it will take for the entire inventory at present to be sold. This time is calculated in terms of days and is called Days Sales of Inventory (DSI).
Days Sales of Inventory
Days sales of inventory (DSI) is the number of days it will take for the current inventory to sell out completely. As with the inventory turnover formula, DSI is also calculated using a simple formula. It is the inverse of the inventory turnover ratio multiplied by 365.
DSI=Average Inventory/COGS x 365
As it is the inverse of the inventory turnover ratio formula, the rules for DSI are different too. The lower the DSI is, the better because it means that the inventory will be sold out in a short time. However, DSI values can be different for different companies. For example, a company that sells groceries will have a lower DSI than a company selling fabrics. Hence, it is important to compare the DSIs of companies of a similar type.
Example of Inventory Turnover Ratio
ABC Textiles is a textile manufacturer specialising in menswear. In the fourth quarter, Q4, which is its busiest quarter, the COGS of the business was INR 50,000, and the average inventory was INR 5,000. Using the inventory turnover formula, we have to divide INR 50,000 by INR 5,000. The inventory turnover is 10.
Now, we will calculate the DSI of the company, that is, the time it will take for the company to sell its current inventory. Using the inverse of the inventory turnover ratio formula, we have
Why Does Inventory Turnover Matter?
Inventory turnover is very important to indicate the performance of the company. If the demand for a certain item decreases, you might be still holding on to the item in your inventory without the hope of a sale. In such cases, you might find it profitable to unload the item by offering discounts or incentives to the customers. These techniques help you sell the item and hence reduce the inventory in stock.
As a business owner, you need to maintain a high inventory turnover. A high inventory turnover ratio means that sales are earning profits and your business is flourishing. You can make quick and informed decisions that result in profitable deals for both you and your customers. The inventory turnover ratio also helps you maintain customer relationships by stocking their favourite items according to their demand.
You must remember that a sudden high inventory turnover ratio might mean that your company is not keeping up with demand. There may be delays in the supply chain, or the market might see a sudden spike in demand for a particular item. Maintaining an inventory turnover ratio regularly will help you decide whether you need to raise prices, order more supplies, add more suppliers to the list, or do something else to balance the supply-demand cycle.
Factors to Consider While Calculating Inventory Turnover
Here are some things you need to keep in mind while managing inventory:
Usually, a manufacturer sets the maximum and minimum price for an item. However, you can decide if you want the item in your inventory and whether it will balance your inventory. If you think an item may cause your inventory turnover to go down, you can reconsider.
- Capital investment
If you wish to match supply to market demand, you might consider doing business with companies which supply small amounts of items over a long period as per your demand. This might cause your capital to be tied up with a limited number of suppliers, but you will not have to worry about supply chain issues.
- Total costs
While calculating the COGS of your inventory, you must also add other related costs to the actual item cost. For example, you need to factor in warehouse rent, interest, transportation, insurance, etc., while calculating the value of an item.
Best Inventory Turnover Ratio for a Business
Typically, it is considered that if the inventory turnover ratio is high, it is better for the company. A low inventory turnover ratio means that the sales of the company are down or there is a decreasing demand for the goods.
However, there are certain exceptions to this. For example, the automobile industry has low inventory turnover rates because nobody buys a car a month after getting a new one. Other industries are exceptions to the rule.
If the inventory turnover ratio of your business is too high, it does not mean that your business is doing good sales. It means that your company cannot keep up with the market demands. In such cases, the purchasing department needs to meet the sales department, know about the demand, and modify purchasing plans accordingly.
High-volume, low-margin industries such as food industries and clothing industries usually have a high turnover ratio. Low-volume, high-margin industries such as automobile industries and jewellery industries have a low turnover ratio.
You have to consider various factors, including customer preferences, seasons, sales patterns, etc., to determine the ways to manage your inventory and maintain a healthy inventory turnover ratio. In some cases, business owners use the cost-to-retail method of inventory management that measures the ending inventory value by calculating the ratio of the inventory cost to the retail price.
What Can I Do If My Inventory Turnover Ratio is Low?
If your company’s inventory turnover ratio is low, you need to analyse your and your competitors’ inventory. Do your competitors have some other more popular products? Are they offering a lesser price for the same product? Are they sourcing products from a cheaper supplier?
Once you get the answers to these questions, you have to modify your sales strategy. If there is a new, more popular product in the market, you can give away the product that you already have with the new product for free. This way, you can deplete the inventory. You can also offer discounts and offers on the product for more movement. You can also stop ordering the product in earlier quantities.
You also need to consider the performance of your employees. Is the sales team doing its best to sell the product? What strategies can be adopted to make the product more attractive to the customer? It might be time for you to come up with new ideas.
What is the Ideal Inventory Turnover Ratio?
The ideal inventory turnover ratio for most industries is around 5 to 10. For industries with low-volume, high-margin such as a car company, the ideal inventory turnover ratio will be much more than this. For industries with high-volume, low-margin such as grocers, the ideal inventory turnover is much lesser than five as they need to sell their products quickly to maintain a fresh supply.
Other Uses for Inventory Turnover Ratio
Besides estimating the company’s performance, the inventory turnover ratio can be used to improve various other aspects of business:
- Trend analysis
An inventory turnover ratio helps you analyse upcoming trends depending on market demand and the unsold inventory in stock. You can make decisions regarding purchasing patterns and order more or less of an item so that you have more control over your inventory.
- SKU metrics
A company measures its inventory turnover ratio generally at the SKU (stock-keeping unit) level or the segment level to have more control over individual stock levels. Segmentation is the process of creating SKU segments according to your company’s preferences.
- Pareto principle
The Pareto principle or the 80/20 rule applies to most businesses. In this case, it means that 80% of your sales revenue will be generated by 20% of the SKUs in your inventory.
Practical Uses of Inventory Turnover Ratio
One of the main ways to use inventory turnover ratio practically is by optimising inventory management methods. Here are some ways in which you can optimise the process:
- Streamlining the supply chain
The cheapest suppliers may not always be the best choice for your business. In some cases, you need a faster delivery or more quantity in place of costs. You should know how to maintain a balance between costs and reliability. Streamlining the supply chain process can benefit your business.
- Managing your pricing
You can realise greater margins on items that are in huge demand to cover the costs trapped by unsold and immovable inventory (also known as obsolete or dead inventory). If you are sure the inventory is not going to get sold, you can offload it in a way that helps you cut your losses like donating it to charity and claiming tax exemption.
Inventory reports and inventory turnover ratios give you data that lets you analyse and predict upcoming trends in customer behaviour. You can make plans to include the relevant products along with the slow-moving items in the inventory to realise a greater margin.
- Improving your ranking
You need to periodically compare your inventory turnover ratio with your peers in the industry. By studying these ratios, you can create new strategies to improve your inventory turnover ratio, thus, improving your ranking among your peers in the industry.
- Automating orders
When you automate your order processes, you can increase the efficiency of your business. Automation is also time- and cost-saving. However, when you use software that manages inventory while completing orders, you ensure that you always have the relevant inventory in stock in enough amounts. This gives you better control over your inventory and less scope for errors.
The inventory turnover ratio formula gives us a fair idea of how the company is performing in maintaining inventory and turning it into sales. The ratio also helps us with inventory cost management and proper inventory management.
In addition to this, the inventory turnover ratio helps a business owner understand how well the items in the company are being sold. If the inventory turnover ratio is less, it means that the sales are down or that the market is not performing well. It is always better to have a higher inventory turnover as it indicates that the inventory in the company is sold at a good rate.
However, a high inventory turnover ratio could mean that the company is losing sales. This happens when the inventory is lesser than the demand. In such cases, it is better to compare the inventory turnover ratio with the companies in similar fields that are managing their inventory efficiently.