Inventory Turnover Ratio: How to Calculate It + Get More Value

Inventory is important for every business because it shows how many goods and raw materials are ready to sell. It also helps you manage assets better and figure out when to restock or shift resources.

Namely, some products sell fast, while others are hard to sell even with big discounts. Most items fall somewhere in between, so businesses need to track how quickly they sell. This helps with pricing, promotions, supplier decisions, and product planning.

To do so, you must understand the inventory turnover ratio to keep your inventory in check. That’s what this blog is all about. We’ll break down the inventory turnover ratio, how to calculate it, and why it’s important.

What is Inventory Turnover?

Inventory turnover is how fast your stock is sold, used, and replaced. You calculate the inventory turnover ratio by dividing the cost of goods by the average inventory for a specific period.

As a business owner or operations manager, knowing your inventory turnover ratio is crucial. This number shows how efficiently your company sells its products and services and how often you turn over your inventory.

The inventory turnover ratio tells you how quickly your company uses and replaces its goods. It helps you understand how long it takes for products to sell out, which can influence how you run, optimize, and plan future operations.

This ratio also indicates the time from purchasing inventory to having unsold or obsolete stock.

How is The Inventory Turnover Ratio Used?

Companies use inventory turnover ratios to improve inventory management, pricing, supply chains, and sales strategies. Here are three common ways businesses use them:

• Spotting Trends
  Inventory turnover helps businesses see which products are selling fast and which are moving slowly. This makes it easier to decide when to stock up on popular items or cut back on products that aren’t selling well.
  
  
• Managing Stock Levels
  Turnover is often tracked at the SKU (stock-keeping unit) level to better control inventory. Businesses group similar products to compare their performance. Some retailers also look at turnover based on store locations to see where certain items sell best.
  
  
• Knowing When to Restock
  Inventory turnover helps businesses decide the best time to reorder products. The goal is to restock before running out but not too soon, which could lead to overstocking.
  
  
• The 80/20 Rule in Inventory
  The Pareto principle applies to inventory too—about 80% of a company’s sales often come from just 20% of its products. Some items, called loss leaders, are priced low to attract customers who might buy other, more profitable products. Knowing which products matter most helps businesses keep the right inventory levels.

Calculating the Inventory Turnover Ratio

The inventory turnover ratio is a simple yet powerful tool for measuring your business performance. It's a great way to see if you're running at peak efficiency.

If you want to measure how well your inventory management processes are working, calculating inventory turnovers is essential.

The inventory turnover ratio tells you how many times you sell and replace your inventory each year.

How? You divide the cost of goods sold (COGS) by the average inventory during the same period.

To figure out COGS, add up all the costs associated with making and selling your products or services. Next, divide the overall amount by the number of units manufactured.

Here's a helpful formula to understand the inventory turnover ratio:

Inventory Turnover = Cost Of Goods Sold / ((Beginning Inventory + Ending Inventory) / 2).

Or

Inventory Turnover = Cost Of Goods Sold / Average Inventory value in the period.

Let's simplify the formula for inventory turnover and look at its parts.

1. Cost of goods sold (COGS)

So, the cost of sales is the actual value of inventory that's been sold.

You get the cost of goods sold by subtracting the profit from the revenue. In simple terms, it's what you take away from a company's good sales and ideal inventory balance.

Here, profit means gross profit because net profit includes other expenses not directly related to inventory or direct costs.

Cost of goods sold = Revenue from operations + Gross loss incurred Cost of goods sold = Revenue from operations - Gross profit earned

Let's understand this with an example:

If you sold mobile phones worth $200,000 for $220,000, the revenue generated from selling the phones is $220,000. The cost of inventory, or the cost of goods sold, would be $200,000. You made a profit of $20,000.

So, using the formula:

Cost of goods sold = Revenue from operations - Gross profit made

COGS = $220,000 - $20,000

COGS = $200,000

Certainly! Let's break it down with an example where a loss is incurred:

If you sold mobile phones worth $220,000 for $200,000, the revenue generated from selling the phones is $200,000. The cost of inventory, or the cost of goods sold, would still be $220,000. You incurred a loss of $20,000.

So, using the formula:

Cost of goods sold = Revenue from operations + Gross loss incurred

COGS = $200,000 + $20,000

COGS = $220,000

2. Average inventory

It's an essential measure for businesses to track. It gives an idea of the extra inventory a company holds over a period. It's calculated by averaging inventory balances, typically at the start and end of the period.

The average inventory value is calculated by adding the inventory at the start of the period to the inventory at the end of the period, then dividing the sum by 2.

Let's illustrate this with an example:

At the beginning of the year, the value of mobile phone inventory was $200,000, and by the end of the year, it rose to $300,000.

Using the formula for average inventory turnover ratio:

Average inventory = (Inventory at the start of the period + Inventory at the end of the period) / 2

Average inventory = ($200,000 + $300,000) / 2

Average inventory = $250,000

3. Calculating Inventory Turnover Ratio: An Example

Now that we have a clearer grasp of the inventory turnover formula, let's calculate the inventory turnover ratio using an example.

Inventory turnover calculator—consider the following metrics for your mobile phone business:

Cost of mobile phones sold: $500,000

Inventory at the start of the year: $250,000

Inventory at the end of the year: $275,000

Average inventory is determined by adding the inventory at the start of the period to the inventory at the end of the period, then dividing the sum by 2

Average inventory is calculated by adding the inventory at the beginning and end of the period, then dividing by 2:

Average inventory=Inventory at the start+Inventory at the end2Average inventory=2Inventory at the start+Inventory at the end​

In this case:

Average inventory=$250,000+$275,0002Average inventory=2$250,000+$275,000​

Average inventory=$262,500

Given the cost of mobiles sold is $500,000, we can use the inventory turnover ratio formula to find the turnover ratio:

Inventory Turnover Ratio=Cost of goods sold/Average Inventory

Inventory Turnover Ratio=Average InventoryCost of goods sold​

Inventory Turnover Ratio=$500,000$262,500Inventory Turnover Ratio=$262,500$500,000​

Inventory Turnover Ratio=1.90Inventory Turnover Ratio=1.90

This means goods are converted into sales 1.90 times, indicating a stock velocity of 1.90 times.

What Your Inventory Turnover Ratio Says About Sales

If a business has a low inventory turnover ratio, it could mean products aren’t selling well or there’s too much stock. One of the reasons could be poor marketing or a bad product selection. In simple terms, a low turnover means items are sitting on the shelves for too long.

A high inventory turnover ratio usually means strong sales. Most businesses want a high inventory turnover because it means they aren’t keeping too much money tied up in unsold products. It also helps boost profits by making better use of fixed costs like rent and employee wages. But it could also mean the business isn’t keeping enough stock. Nevertheless, running out of products is still a better problem to have than struggling to sell them.

How quickly a business sells its inventory is an important sign of success. Companies that sell products faster often do better than their competitors. Fast fashion brands like H&M and Zara are good examples. They make small batches of clothing and restock quickly with new styles. If products don’t sell fast, it costs businesses more money to store them. Plus, slow sales mean less space for new items that might sell better.

If inventory turnover starts to drop, it could mean demand is going down, and businesses should consider starting to produce less.

Improving the Inventory Turnover Ratio: Strategies to Boost Efficiency

Ever tried grocery shopping with just half a cart? It's hardly satisfying.

Inventory management works similarly: you need what's necessary, but not an excess.

Simply replenishing inventory regularly, minimizing stock in the warehouse, or holding excessive inventory or dead stock won't necessarily improve inventory turnover. These practices signal poor inventory management. Hence, retailers need more effective methods to enhance inventory management.

Below are some methods to optimize the inventory turnover ratio:

1. Implement Automation

Using effective inventory management software is essential. It helps you track your stock levels and calculate turnover ratios for each product. Whether it's through a warehouse management system (WMS) or an inventory module in enterprise resource planning (ERP) software, having the right tools is crucial.

With a good system in place, you can pinpoint which products are overstocked and not delivering a satisfactory return on investment. This is achieved by tracking inventory turnover ratios right down to the individual product level.

2. Dispose of Outdated Inventory

The most effective way to save money and avoid supply chain problems is by minimizing the amount of inventory you initially need.

You can achieve this by embracing a lean inventory approach, which involves keeping fewer products and selling them more frequently. This strategy lowers carrying costs and the chance of running out of popular items. However, it demands a well-managed supply chain and swift turnaround times.

3. Anticipate Seasonal Patterns

Planning for seasonal trends is key to enhancing your inventory turnover ratio.

How? The solution lies in capacity planning.

Capacity planning aids in managing inventory levels to ensure you have the right supplies. It enables you to anticipate periods of high consumer demand and adjust your workforce accordingly. Likewise, during low-demand periods, you can reduce your staff.

Capacity planning isn't solely about predicting sales volume; it's also about determining how quickly you can replenish your inventory. By integrating seasonal trend forecasting and production planning, capacity planning proves invaluable in optimizing inventory turnover ratios.

4. Enhance Market Prediction

An essential aspect is your prediction method, which helps anticipate future customer demand for consumer goods. You adjust inventory segmentation based on these forecasts.

Forecasting algorithms can range from really simple to quite complex, depending on your data and the forecasting model you choose for each item in your store or warehouse.

To boost your stock turnover even more, it's worth going beyond basic calculations and using statistical demand models to predict demand changes.

Start by considering an item's demand type based on where it is in its product life cycle (new or old). Then, tweak your forecasting algorithms for your entire inventory accordingly.

Other Important Inventory Calculations

Tracking inventory turnover isn’t the only way to measure business performance. Other key calculations, like asset turnover ratio and inventory holding period, help you understand how efficiently your company uses its resources. These numbers can guide better decisions on sales, stocking, and overall operations.

Asset Turnover Ratio

This ratio shows how well your business uses its assets to make sales. A higher number means your company is using its assets more efficiently. You can find this ratio with the formula:

Total annual sales ÷ average assets = asset turnover

To get your average assets, add the value of your assets at the beginning and end of the year, then divide by two:

(Beginning assets + ending assets) ÷ 2 = average assets

Inventory Holding Period

This tells you how many days, on average, your company holds onto inventory before selling it. A lower number is better because it means products are selling faster. Use this formula to calculate it:

(Inventory ÷ cost of sales) × 365 = holding period

When Inventory Turnover Ratios Fall Short

The inventory turnover ratio is useful, but it has some limits. Different industries, seasonal demand, and changing costs can all affect the numbers. Businesses need to look at the full picture to make smart inventory decisions.

• Industry differences: Some industries sell products faster than others. Comparing turnover across different industries can be misleading. For example, in 2022, U.S. auto dealers took about 63 days to sell a car, while food stores sold products in just 32 days.
  
  
• Seasonal changes: Some businesses sell more during certain times of the year. A high turnover in busy months might make the yearly average seem higher than it really is.
  
  
• Changing costs: The cost of making or buying products can change due to material prices or currency shifts. This can affect the accuracy of the turnover ratio.
  
  
• Hidden costs: Keeping inventory low is good, but it can lead to extra costs. Businesses might have to pay more for rush orders, deal with stock shortages, or lose sales.
  
  
• Restocking time: The ratio doesn’t show how long it takes to restock products. A high turnover is great, but if a business can’t restock fast enough, it might run out of items and lose customers.

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FAQ on Inventory Turnover Ratio

Conclusion

All in all, when you know how quickly your inventory sells, it helps you make better decisions on pricing, restocking, and promotions.You need a clear idea of what products to sell in your store and where everything is located.

With the right software, you can monitor how much inventory you have and how much has been sold. It's also a great way to check how quickly your products are selling. If you want to boost your delivery operations, try eLogii. Its efficient deliveries help reduce the risk of stagnant inventory and returns. This improves inventory control and results in a better inventory turnover ratio.