Do you know how many times you sold or replaced your inventory last year? Or how many days certain products have been lying in your stockroom? If you’re in the business of selling products, having this knowledge can make or break your success. Put simply, a business that is selling more of its inventory is meeting customer expectations, and it needs to keep its stock levels high to avoid missing out on sales. Conversely, a business that isn’t selling much may be carrying obsolete inventory that is not in demand. And so it might need to overhaul its entire product lineup. How do you know where you stand? By understanding the concept of inventory turnover, and how it applies to your business.
What Is Inventory Turnover?
Inventory turnover (also known as stock turnover or inventory turn) is a measure of how frequently a business sells its products during a certain period. The period is usually a year, but it may vary depending on your business needs and age. The inventory turnover ratio indicates whether a company is selling its products slowly or quickly while reflecting the peaks and valleys caused by the holidays, back-to-school, and other similar periods. That information, in turn, helps the business strategize and make informed decisions about its future direction.
Any inventory-based business can calculate the turnover ratio to make key decisions, including whether:
- Order volumes need adjusting
- Supplier relationships need revisiting
- Product prices require a change
- Promotions can help sell off excess inventory
Knowing the inventory turnover rate is especially important for businesses operating in fast-changing niche markets like fashion and apparel. Stocking too many sweater vests could mean deadstock that results in a financial loss. If you want to achieve steady and balanced growth, you must keep up with market changes and practice inventory control according to your turnover ratio.
How to Calculate Your Inventory Turnover Ratio
You can determine your inventory turnover ratio or rate using this formula:
Cost of Goods Sold / Average Inventory = Inventory Turnover Rate
Cost of Goods Sold (COGS) is the cost you pay for sourcing the items that you sell. Cost of Goods Sold can consist of product material costs, packaging costs, and labor costs. Your supplier will quote you a price that covers each of these costs while earning them a profit. Therefore, your COGS would simply be the total purchase price for all the inventory you sell in a given period. You can figure out your COGS total by looking at your profit and loss statement. If you’re a manufacturer of your own products, just add up the cost of materials plus the labor it takes to make an item to determine your COGS. But make sure to exclude indirect expenses like marketing and rent from your calculation, as Cost of Goods Sold only accounts for direct costs.
Average inventory is the average of the initial inventory and ending inventory for a specified period. You can find this average by adding your ending and beginning inventory balances and dividing the total by two. For example, if your ending inventory balance is $50,000, and your beginning inventory balance is $20,000, your average inventory is $50,000+20,000/2 = $35,000. It’s best to use average inventory for your turnover calculation and not the “inventory on hand” because the latter’s value can fluctuate considerably if a large order arrives. And you don’t want your turnover ratio to be affected by a sudden rise in inventory value.
Inventory turnover example
An apparel company wants to calculate its inventory turnover for 2019. At the start of the year, it had an inventory of $25,000. The inventory at the end of the year was $45,000. The total cost of goods sold was $70,000. If we apply the inventory turnover ratio formula, the turnover rate would be:
$70,000 / $35,000 = 2
($35,000 is the average inventory after adding the year-end inventory ($45,000) and initial inventory ($25,000) values and dividing it by 2.)
You can use an inventory turnover calculator to determine your turnover rate. Just add your COGS and average inventory data to the fields and let the tool handle the rest. It’s a quick and easy way to see how you’re faring in terms of sales. Xero offers one that simplifies the turnover ratio calculation for businesses.
Ideal inventory turnover ratio
What is a good inventory turnover ratio? Well, that depends on your business, merchandise, and industry. However, a ratio between 2 and 4 indicates that you’re selling the inventory you buy efficiently and you’re replenishing quickly enough to prevent stockouts. In contrast, a rate of 1 or below often implies that the business has excess inventory. The reason might be that your inventory is obsolete, or you’re buying stock faster than you can sell it. It’s crucial to maintain inventory levels by analyzing your sales performance so that you can prevent dead stock that eats away at your profits.
How to Calculate Days in Inventory
Days in Inventory indicates the average number of days in a year that a business holds its inventory before selling it in the market. You can calculate it by using this formula:
Days in Inventory = Days in accounting period / Inventory turnover
Assuming that you want to calculate Days in Inventory over a year (i.e. 365 days) and your inventory turnover ratio is 5, the result would be:
365/5 = 73 days
This implies that your business is holding inventory for 73 days on average before converting it into sales.
Days in Inventory results vary from industry to industry, but companies should always try to lower the number of days they hold onto their stock. More Days in Inventory could be a red flag that there are problems with your marketing or product quality. As a result, you might decide to order new stock, introduce discounts or use other promotions to encourage people to buy more frequently. Identifying ways to shorten your Days in Inventory is crucial as it helps free up cash that you can invest in other areas of your business.
Is A Low Inventory Turnover Always Bad?
Having a low inventory turnover can be financially damaging to a company. However, there are certain industries where businesses can stay profitable despite holding slow-moving inventory. For example, a business that sells specialized machinery in the printing industry may sell only a few units per year. However, it is likely to be profitable as such items often allow companies to keep a high margin. That said, keeping inventory for too long means you have money tied up in your stock. If you took a business loan to purchase your initial inventory, you’d need to pay interest as well as maintenance costs. Plus, there’s always the risk that a natural disaster might wreak havoc on your storage space and inventory.
Should I Ever Be Concerned About A High Turnover Rate?
Most inventory-based businesses desire a high turnover rate, but it’s important to be careful. If the turnover gets too high, and you are not replenishing stock as quickly as you’re selling it, it could result in stockouts. Stockouts are not only damaging for your sales, but they can also harm your online visibility as customers turn to other websites for their purchase. The good news is that it’s easy to avoid the negative effect of higher-than-average turnover rate. You simply need to purchase more inventory of your best-selling items so that you have enough backstock in place to meet customer demand.
How to Improve Your Inventory Turnover Rate
If your inventory turnover ratio is lower than the industry average, you should look for ways to improve your inventory turns. Here are some strategies that can help:
1. Invest in marketing
Marketing can give a huge boost to your inventory turnover rate. However, it needs to be well-designed and cost appropriate. Fortunately, the advancements in digital tools mean businesses no longer have to allocate a huge budget to promote their offerings. You can spread the good word about your company and its products by using platforms like Instagram and Facebook. You can even partner with influencers to get your items in front of a relevant audience. Make sure to measure and monitor your campaigns to ensure you’re getting a successful return on your investment.
2. Negotiate with suppliers
Do you always buy inventory from the same suppliers? If yes, then you could try negotiating a better product price the next time you place an order. Take advantage of any options that could get you a lower price, such as prepaid FOB freight, advance payment discounts, and extended credit. Distributors and wholesalers often give cheaper rates to their regular customers, so if you purchase regularly, you may be able to slash your overall inventory costs. Pro tip: Identify the key person in the supplier’s company to negotiate with. Talking to someone who has the authority to make pricing-related decisions is much more effective than trying to squeeze a better deal out of a junior team member.
3. Purchase inventory more frequently
If you’re unsure of the sales potential of a particular item, don’t buy it in bulk and overstock yourself. Over-ordering items is a common culprit of a low inventory turnover. A better strategy is to purchase smaller quantities of the item, but more frequently so that you always have enough stock to meet customer demand. Frequent purchases are an effective way to cut down on excess inventory. That said, you might need to place larger orders before the beginning of key shopping periods like the back to school season or Christmas holidays.
4. Incentivize customers to pre-order
If you can get people to register their orders in advance, i.e. before you order the inventory, you can plan your purchases according to their demand. This can help you keep your stock levels lean, improving your inventory turnover in the process. To encourage customers to pre-order your items, consider offering some incentive like an early-bird discount. You can also consider leveraging the tactic of scarcity to increase your pre-orders – for example, the first 100 pre-orders will get a limited-edition gift that won’t be available with the regular orders. Using this strategy enables you to invoke FOMO (Fear of Missing Out), which is a powerful way to get people to take action.
5. Forecast consumer demand
Should you order inventory for product X before Black Friday, or after? Does your stock move faster in winters or summers? The ability to forecast your demand allows you to improve inventory turns. For example, if you’re a fashion retailer selling faux fur coats, and your forecasts show no demand for this item after Christmas, what would you do? The smart thing is to order the item in a lesser quantity and shift your focus on other desirable merchandise that sells all year round. The research that goes into forecasting consumer demand can be complex, but analyzing your historical sales data and market trends can help you source the right products in the right quantities from suppliers.
6. Get smart about pricing
Pricing can be a complex science. And for most businesses, simply lowering prices isn’t necessarily going to boost their inventory turnover rate. In fact, it may encourage customers to only shop when there’s a discount. What you need to do is practice smart pricing. Think about how premium products seasonal trends, free shipping, and VIP customers can be a part of your strategy, then set a price that doesn’t undervalue your merchandise while enabling you to stay competitive in the industry.
It’s critical for an inventory-based business to stay on top of its inventory turnover rate. It helps you see whether your company is holding excess inventory or has healthy stock balances. Consider measuring your inventory turnover against the industry average to see where you stand. If your turnover rate is lower than the industry average, your inventory runs the risk of becoming obsolete. Fortunately, tactics like marketing, purchase price negotiations, pre-orders, demand forecasting, and smart pricing can make your business more efficient at selling inventory.