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Retail and E-Commerce

Inventory Turnover Ratio Explained: Calculation, Methods and Value

Discover the inventory turnover ratio: its definition, calculation, and importance in effective business management for optimal efficiency.


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.

You first need to 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.

TABLE OF CONTENTS:

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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.

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.

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

disposing-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.

market-predictions

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.

Opt for Enhancement to Boost Your Business Efficiency

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It boosts productivity by eliminating manual tasks like making phone calls for updates, reducing delivery delays, and providing estimated arrival times. With this automated system, you won't need to constantly monitor drivers or attend to clients.

If a driver is unavailable, you can quickly reassign or swap routes to another driver using Upper. Plus, you can generate weekly or monthly reports for analysis. These detailed reports help you assess team performance and review previous deliveries easily.

FAQ on Inventory Turnover Ratio

What constitutes a good inventory turnover ratio?

A good inventory turnover ratio suggests a healthy sales rate of stocks. Typically, the ideal turnover ratio for most companies falls between 5 and 10. This range indicates that the company is consistently selling and restocking its inventory.

Is a higher inventory turnover ratio advantageous or disadvantageous?

Inventory turnover ratios vary across industries. Generally, a high turnover ratio is favorable because it signifies efficient product sales. Conversely, a low inventory turnover ratio raises concerns about sluggish sales for the business.

What insights does inventory turnover offer?

Inventory turnover reveals how swiftly a company's inventory moves out of its warehouse. Monitoring this ratio is crucial; if inventory remains stagnant for too long, it means tying up excessive funds and stock in unsold goods.

How can you achieve an ideal turnover ratio?

Implementing an automated solution enables you to gather crucial business statistics, determine the economic order quantity for each product, and identify the optimal inventory turnover ratio for your business.

What factors influence the inventory turnover ratio?

Market saturation, transitioning from growth to maturity phases, shifts in consumer preferences, and technological advancements all impact variations in inventory turnover ratios.

Why does inventory turnover decrease?

Conclusion

In today's competitive market, keeping track of your inventory is essential. 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.

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