March 14, 2022 | Last Updated on: August 16, 2023
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Inventory turnover, also referred to as stock rate, is a key performance indicator (KPI) for managing and growing a business. As such, every inventory-carrying small business owner should be intimately familiar with how to calculate it, and how to improve it. A high inventory turnover rate means that your business demonstrates efficient inventory management. Plus, it tells you how fast your stock can be turned into cash, putting your small business in a better financial position. A low turnover rate may mean that you’re overstocking your shelves, or that customer demand isn’t as high as you forecasted.
In this article, we’ll look at how to calculate your inventory turnover rate and how to improve your inventory control in order to achieve optimal efficiency.
Inventory turnover is a ratio that shows the number of times a company has sold and replaced inventory during a given period. Ideally, your business is selling and replacing stock at an even rate, with little to no gaps in both the peak and off-seasons. Calculating inventory turnover can help your business make better pricing, manufacturing, and purchasing decisions.
Inventory turnover is a good measure for understanding how well your business is managing its stock. If you are overestimating the demand for your product and purchase too many goods, this will manifest as a low turnover ratio, and you will have too much ending inventory when you close your books at the end of the period. Conversely, if inventory turnover is too high, this could mean your business is leaving money on the table by missing sales opportunities that you could have taken advantage of if you had a larger beginning inventory.
You can calculate inventory turnover rate by dividing your costs of goods sold (COGS) in a period by the average inventory ((beginning inventory + ending inventory)/2) in the same period.
Tip: Average inventory is used to account for the fluctuating inventory levels or seasonality during the year. It is expected that certain businesses will sell more of their product during the summer or before the holidays and average inventory takes this into consideration.
The following inventory turnover formula demonstrates the relationship between these variables:
Inventory Turnover Ratio = COGS / Average Inventory
or
Inventory Turnover Ratio = COGS/((Beginning Inventory + Ending Inventory)/2)
For example, let’s say your Cost of Goods Sold was $100,000, your inventory at the beginning of the period was $20,000 and your inventory at the end of the period was $5,000.
The equation would look like this:
$100,000/(($25,000 + $10,000)/2 = $100,000/$17,500 = 5.71
This would mean that you had sold all of your average inventory almost six times during the period.
While this is a fairly straightforward calculation, there’s no need to calculate this manually. You can use this inventory turnover calculator.
Another useful measure that often accompanies the inventory turnover ratio is the Days Sales of Inventory (DSI). DSI measures how many days it takes for inventory to turn into sales. You can calculate DSI using the following formula:
DSI = (1/Average Inventory) x 365
Using our above example would result in:
DSI = (1/$17,500) x 365 = .021
A lower DSI translates to fewer days needed to turn inventory to cash. Note that DSI values can vary between industries. For example, grocery stores that sell produce will have lower DSI than car dealerships.
In order to assess how well your business is doing, compare the DSI of your business to the average for your industry.
The DSI is a more granular measure as it breaks down profitability into a daily context rather than quarterly or seasonally. You can use this measure to help you improve turnaround times and plan purchases.
Well-managed inventory levels show that your business’ sales are at the desired level and that costs are controlled. Inventory turnover demonstrates sales effectiveness and the management of operating costs. And the ideal inventory turnover rate would show that inventory matches sales.
To get an idea of how well your small business is performing, compare your inventory ratio to the industry benchmark, as it’s important to compare apples to apples.
Generally speaking, having a higher inventory turnover ratio is better than a low ratio. For example, a ratio of 12 over the course of a year means your inventory turns are happening once a month, but a ratio of 365 would mean you are selling out of your stock on a daily basis.
Of course, sometimes a high turnover ratio can be a struggle too. If you have high variable costs or running out of inventory is a problem, or if you’re facing supply chain issues, you may need to take action in order to produce more goods to meet demand.
Husband-wife duo Raza and David Bolos ran into this problem at their Czech bakery. They simply couldn’t keep up with the demand of the local neighborhood and used financing to purchase needed items that allowed them to operate throughout the week – a task that was not achievable in the past due to low inventory. The additional cash flow from their loan gave them the jumpstart they needed.
More typically, business owners face a low inventory turnover ratio. A ratio could indicate that sales are weak, that there is low demand for your product, or that you are selling big-ticket luxury items. Consider the following solutions to boost your inventory turnover ratio:
To optimize inventory turnover, you first need to be able to measure it accurately. A good inventory management platform that allows you to track your sales and stock levels in real-time can help with this. Such platforms will allow your business to manage inventory and report fluctuations with ease.
An inventory management system can assist with demand forecasting to show past performance and help you predict demand based on historical performance. Determining potential future trends while accounting for changing product demands will help your business make better purchasing decisions. It can also help identify low-performing stock or products that you are purchasing too frequently. Information gathered from these systems can be incredibly useful for creating purchasing plans that will turn the tides for your inventory ratio and decrease storage costs.
There are several inventory management software choices small businesses should consider, including Orderhive, inFlow, Lightspeed Retail, Upserve, Megaventory, and Zoho Inventory. Some inventory management systems specialize in serving particular industries, so be sure to find a platform that works for the products your company sells.
Being aware of your business’ inventory turnover ratio will be helpful for knowing how your business compares with others in your industry. For example, the average inventory turnover for the retail industry is 3.91. If your retail store has a stock turn rate of 4.0, this means you are in line with your industry’s average. This means that your business had to replenish its inventory about four times per period of time being measured.
Evaluate your sales, marketing, and inventory practices. Each of these teams needs to share information regarding what products are successful and those that are not generating enough interest. Communication among these teams will be key and each department in a retail business plays an integral role.
Sales can gauge how well a product performs with your customers. Marketing can work to increase foot traffic to events and websites and can recommend a pricing strategy for your target market. Management and purchasing will review inventory turnover to determine the most profitable items and those not worth ordering due to lack of customer interest.
Too much product or pricing that is too high can cause a low inventory turnover ratio. Spruce up sales and marketing efforts to sell more merchandise. There is no one size fits all strategy to move product. Instead, experiment with various strategies and tactics to see what works best for your small business, such as upselling, cross-selling, or readjusting prices. Obtaining advance orders can also help to eliminate unnecessary inventory.
Companies keep excess product to prepare for unseen demands. With better forecasting techniques and information on your stock, there is no need to invest in significant amounts of safety stock. You can further cut your losses by donating old inventory and focusing on faster-moving products.
Use this section as a guide to help you improve inventory management. Effectively managed inventory will improve your inventory turnover ratio, increase profitability, and enhance cash flow for your business.
An ABC analysis will help your business to understand what products are the most profitable and which are too costly. This process involves breaking down your inventory into three categories:
A: The most valuable products that cost the least to store long-term. These products are highly profitable.
B: These are mid-level products that are not big-ticket items in the A category but are nonetheless important sales to make.
C: Small-ticket items with a high turnover and a high volume that is critical to profitability.
Use this information to prioritize high-performing products and cut out those that lack sales interest for your customers.
Tracking product information such as the cost of items over time will alert you to factors like scarcity and seasonality. A solid inventory management system can track these metrics automatically, so you don’t have to. Knowledge is power; store as much useful information as your management system allows from barcode/SKU information, manufacturer origin, delivery schedules, etc. The more you know, the more you can plan for.
Whether you check your inventory once a year or once a month, make it a point to ensure that your product counts match up with your records. Inconsistencies can lead to uninformed decisions along the road. Ensure that everyone involved is aware of these counts and seek to reconcile any gaps immediately.
Unreliable suppliers can cause problems for your inventory. Make notes of suppliers that are habitually late on deliveries or short with orders. The first course of action would be to communicate with your supplier directly to solve these issues. Otherwise, be prepared to account for uncertain stock levels if you do not make a switch soon.
It’s a general rule that 80% of your profits come from 20% of your stock. If you are tracking product information and auditing inventory, it will not be hard to determine what part of your stock is that 20%. Prioritize this inventory management because these items make you the most money. Ensure that you have dependable suppliers for this stock so that you can deliver and replace it reliably.
A good inventory turnover rate will vary depending on the industry your small business operates in. It all comes down to how often you must replace your stock and how well your business manages inventory. Determine your business’ inventory turnover rate by taking a deep dive into your inventory performance. The good news is that if your inventory turnover rate is low, there are plenty of management techniques you can take advantage of, including technological integrations.
Look at how Navneet Kalra secured inventory financing to stock his perfume parlor within 24 hours – just in time for the holiday season.
