Knowledge is power. After all, the more ways you have to gauge your company’s health, the better you can treat the underlying problems. Your inventory turnover ratio is one of the most revealing key performance indicators (KPIs) you can track. How efficiently can your business handle inventory?
What Is Inventory Turnover Ratio?
To start, let’s take a look at what an inventory turnover ratio is. The inventory turnover ratio represents a company’s ability to sell and replace its inventory over a specific period of time. This ratio represents your efficiency for your role in the supply chain. It is a vital measurement of a company’s health.
Why Is Inventory Turnover Important?
Understanding how long inventory sits before it is sold and how quickly it can be replenished has ramifications for a company’s operations. It can affect pricing structure, marketing efforts, manufacturing processes, and how often the business purchases goods or raw materials.
If your company has too much money tied up in inventory or can’t move inventory out fast enough to create space for new inventory, then you know your organization needs to address its operational efficiencies before they become a more serious problem.
Inventory Turnover Terms
To understand the inventory turnover ratio formula, you’ll need to be familiar with the following terms:
Average Stock
Also called “average inventory,” average stock is calculated by adding beginning stock levels to ending stock levels and dividing the total by two. The formula will look like this:
(Starting Stock + Closing Stock) ÷ 2 = Average Stock
This formula will give you the average amount of stock your company had over a set period of time. You may want to calculate average stock for different raw materials or products to determine usage or sales figures. This figure should be calculated with the dollar value of your inventory.
Cost of Goods Sold (COGS)
COGS measures the total cost of materials to create a product. It doesn’t factor in costs like employee salaries, electricity, other utilities, overhead, and other such expenses.
You’ll need to know the value of each inventory item and use the total value of your inventory at different stages to calculate your COGS.
Use the following formula:
Starting Inventory + Received Inventory – Final Inventory = COGS
Finding out your COGS helps your business to make wiser decisions about materials costs. After all, you might be able to source higher quality or less expensive parts once you see how much money is tied up in the items you produce and store.
Days Sales of Inventory (DSI)
DSI measures the average days it takes a business to convert inventory to sales. It’s calculated as follows:
(Average Stock ÷ COGS) x 365 days = DSI
The lower the number, the shorter the amount of time inventory will last. Lower numbers are positive since they indicate a company is able to make and sell items quickly without having them linger in warehouses for extended times.
How to Calculate Inventory Turnover Ratio
Now that you have some necessary terms, let’s go over how to calculate the inventory turnover ratio and walk through a step-by-step example.
Inventory Turnover Formula
You’ll need to calculate your COGS and average inventory first. Once you do, the formula is calculated as follows:
COGS ÷ Average Stock = Inventory Turnover Ratio
Example Calculation
Let’s say you have 500 electric guitars that represent your starting inventory. Over a year, you receive 1,000 more, which would represent your received inventory. At the end of that year, you have 100 electric guitars. 200 guitars would be your ending inventory. Each guitar is worth $500.
Now, let’s calculate our COGS:
$250,000 + $500,000 – $50,000 = $700,000
Next, let’s calculate our average stock:
($250,000 – $50,000) ÷ 2 = $100,000
Now that we have our COGS and our average inventory, we’ll calculate our inventory turnover ratio
$700,000 ÷ $100,000 = 7
Now you know your inventory turnover rate is 7, which means that over the inventory period measured, you sold your stock 7 times.
What Is a Good Inventory Turnover Ratio?
The answer to this question is dependent on the industry. There are different metrics each industry uses to determine its success and there’s no one number that can define every business.
You might hear that businesses should strive for a number between 5 and 10. This isn’t true! Your particular industry might find that 5 is an excellent number or that 10 is terrible. Take a look at these industries and their inventory turnover ratios:
- Lumber: 13
- Oil/Gas Extraction: 4
- Computers and Parts: 25
- Bars/Restaurants: 3
- Clothing: 24
None of those industries have inventory turnover ratios between 5 and 10, yet they still turn profits and sustain themselves in the marketplace.
You’ll need to benchmark your ratio against other businesses in your field to see how you stack up against the competition.
How to Maximize Your Inventory Turnover
If you want to achieve high numbers for your industry, there are some essential KPIs you should optimize. Here are some of the steps to take:
Automate Inventory Management
Use inventory management software to remove human error and increase speed. Inventory management alone will help many processes in your company because you’ll know how many materials and goods you have on hand from one moment to the next.
Eliminate Underperforming Products
Products that don’t sell take up valuable space. Stop selling those products and stock products that do sell!
Analyze Your Prices
Are you asking too much or too little for your products? Can you handle vendors who want a minimum order quantity (MOQ)? Go over your strategy to make sure your prices aren’t digging you into a hole where your profits won’t follow.
Optimize Your Marketing
Advertising requires finesse. If you don’t know your product’s core demographic and how to appeal to these customers, it’s time to overhaul your marketing efforts.
Calculate Your Sell-Through Rate
Think of your sell-through rate like inventory turnover measured over shorter periods of time. You can use this figure to determine which items take up valuable inventory space and which are selling like hotcakes.
For High Inventory Turnover
A high rate means that you are able to take raw materials, transform them into finished products, sell them, and do it quickly. This minimizes your inventory carrying cost. You’re able to turn products into cash and you have your finger on the pulse of the market.
For Low Inventory Turnover
A low rate means you do a poor job of transforming raw materials into finished products or perhaps you don’t have a solid sales strategy. You will need to analyze where the weak link is and address the problem.
Inventory Turnover vs. Days Sales of Inventory
While similar, these two figures focus on different measurements. Inventory turnover is concerned with the number of times stock has sold over a set time period, while days sales of inventory is concerned with how long stock sat around unsold.
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