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March 14, 2020

The Importance of Calculating Your Inventory Turnover Ratio

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Fora Financial

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  • Small Business Tips

There are many ways to improve your sales numbers, and thus your bottom line. One of the most effective methods to do this is to calculate inventory turnover.

What is Inventory Turnover?

Inventory turnover is a ratio that measures the number of times inventory is used or sold in a given period. The most commonly selected time chosen for inventory turnover ratios is a year. Knowing this inventory turnover ratio is crucial to many different industries. It assists in projecting the time it'll take to sell inventory. Also, it helps to determine when you are going to need additional inventory. This ratio can be calculated by dividing the days in your selected timeframe by the standard inventory turnover formula, covered below. The resulting number is an estimate of how many days it should take to sell your inventory.

The Importance of Inventory Turnover

If you're a retail owner, you know how crucial accurate inventory management is. Each stocked product, and every square foot of space (including storage costs), affect your business’ bottom line. When each month, quarter, and fiscal year ends, the profits or losses on your balance sheet reflect three things:
  • The products you offered to your customers.
  • Values of these items compared to their costs.
  • How quickly your business was able to push these products through your storefront and into your customers’ hands.
You should be aware that inventory management has a substantial impact on the long-term success of any retailer. However, you might be surprised that many businesses lack the systems to track their inventory balances correctly. This tracking is represented by the inventory turnover ratio. Below, we'll reveal everything you need to know about inventory turnover ratios. In the end, you'll be able to better manage your business's inventory turnover.

The Inventory Turnover Ratio Formula

The golden inventory turnover ratio is a measure of the number of times inventory is sold over a given period. There's a relatively simple calculation to determine how to find this number: Inventory turnover = Cost of goods sold / Average inventory To calculate an inventory turnover ratio accurately it’s crucial to calculate both average inventory and COGS. But what are these?

About Cost of Goods Sold

The cost of goods sold is a great place to start. These represent direct costs that are associated with the purchase or production of products that are sold to consumers. For manufacturers, cost of goods sold includes costs of labor and materials required. For retailers who don't make their products, it'll just be the product purchase price when it's obtained from manufacturers. There are a few examples of cost of goods calculation that can assist in preliminary inventory turnover ratios. After all, it’s essential to ensure that no stone is left unturned, as this can affect turnover and profits.
  • Retail Electronics
Typically, these stores don’t manufacture their products, and instead sell goods produced by others. With this type of retail store, the cost of goods sold is just the wholesale price of inventory sold over time.
  • Watch Designers
For these services, COGS includes prices of materials purchased. This includes bands, small gears, and other pieces involved in the development and manufacture of watches. In addition, the cost of goods sold will consist of the necessary labor associated with watchmaking. You’ll notice that these two types of businesses are vastly different from how they calculate their cost of goods sold. It's dependent on whether your company purchases products from others, or produces their goods on their own. However, for calculating the cost of goods sold, it doesn’t matter if your products are B2B or B2C. Remember, while businesses have many expenses, they aren’t all included in COGS. Rent for retail space, payroll, equipment, and tools; these expenses aren't parts of the cost of goods sold.

About Average Inventory

There’s some excellent news about the calculation of average inventory. When you’ve determined the COGS of your business, most of the work for average inventory is done already! Why is this? The only difference between these numbers is that the COGS will reflect the production or acquisition costs of purchased items. However, the cost of inventory is the same value for things that are currently on hand, or not yet sold. Calculating average inventory value uses similar calculations as found above. Meaning, the wholesale purchase price or the material and labor cost when making products on your own. Then, these are applied to inventory being held in-house at a specified point in time. However, it’s crucial to keep in mind that the amount of inventory on hand fluctuates in close to real-time. One strong example of this is the shipment receiving time. The day before and the day after receiving a massive inventory shipment shifts this value considerably. This is why the average inventory calculation exists. It provides a more definite idea of what consistent inventory levels are. The formula used to calculate average inventory over a given time is: Average inventory = (Value of inventory at the beginning of period + Value of inventory at the end of period ) / 2

Why Time Period Matters For ITR

Inventory measurements can be applied at different periods when calculating your turnover ratio. While one year is typically standard, there are times when you might want to calculate this value monthly or weekly. Retail stores that experience substantial seasonality are an excellent example of this. Inventory turnover during Christmas week will differ from the middle of April for greeting card stores. Turnover for swimming pool supply stores will be different in June than in December. Regardless of the range, you must apply the same date range to COGS that you do for average inventory calculations. If not, you’ll be comparing apples to oranges. You want your inventory turnover ratio to reflect what is going on inside your business accurately. Ensuring the same time period is being used for both calculations will help make sure your ITR is accurate.

When Is An Inventory Turnover Ratio Considered “Good”?

In broad terms, the standard rule of thumb for inventory turnover ratios is higher is better. However, there are limitations to this. If you have a severely low inventory turnover, this usually means your inventory spends excess time on shelves. This inventory isn't adding any value to your business’ bottom line. In the end, it translates into money spent on space where this inventory is just going to sit around. In addition, you have a higher risk of inventory damage and overall depreciation.

Having Too Much

For goods that are considered non-perishable (apparel, electronics, and more), you can have an inventory turnover ratio that's too high. For one thing, higher inventory turnover ratios can mean nothing more than higher volumes of sales. However, it may also reveal that you aren’t keeping inventory in stock to meet customer demand adequately. This draws back to the electronics store example above. If Apple products sell out the same day they enter the store, this is a sign to order larger product shipments. While this is technically a fantastic problem to have, you would be remiss not to keep an eye on things. It's detrimental for your customers to resort to your competition for their Apple fix if your inventory is inadequate.

Considering Product Types

In these cases, what can be regarded as a “normal” range for inventory turnover ratios? Sadly, this number changes drastically based on a variety of factors. Some common factors include products being sold, the nature of the business, consumer demographics, and seasonality. One strong example of this is stores selling perishable goods and food (bakeries, grocery stores, coffee shops, etc.). These establishments tend to have very high inventory turnover and for a good reason. Their products lose value and expire far faster than our electronics store example. Dairy products that aren't pasteurized will have a shelf life of just a few days. The same goes for produce. Meanwhile, that new iPhone can sit on shelves for a year and retain its value.

An Example Of Inventory Turnover

To truly understand calculating inventory turnover, an example is best. Let’s say an electronic store, reports in their income statement that their cost of goods sold is $4 million. They started the fiscal year with $500,000 in inventory and ended with $1.5 million in stock. To get their inventory turnover ratio, the first thing to do is to determine the average inventory. First, you'll add the beginning inventory value ($500,000) to the end inventory value ($1.5 million). Then, divide this sum ($2 million) in half to determine the business's median inventory at any given time. The result of this is $1 million in average inventories. Finally, divide the electronic store's cost of goods sold, which is $4 million, by your average inventory number. This results in an inventory turnover ratio value of four. So, this means they sold its full inventory stock four times through a fiscal year. Alternatively, it took them an average of close to 92 days to sell out inventory. Still, the question remains: What is a good inventory turnover ratio? Vend notes that for retail service providers, ideal ITR is typically between two and four. For this reason, the electronic company is at the high end of strong ITR.

Applying Inventory Turnover

Why is the application of inventory turnover ratio so crucial in your business? After all, it’s a relatively simple calculation, so it can’t be that crucial, right? Wrong. Below are some ways that inventory turnover can be applied to your business for essential decision making.
  • Turnover by Category or Product
Are there products your retail store sells out of faster than they can be stocked? Is there inventory that sits around taking up valuable space? These questions can be answered by calculating ITR for specific products or categories. Through the gathering of data on product popularity, you can develop smart decision making. This decision making covers sale items, markdown, and more reliable insight into future purchasing.
  • Total Inventory Turnover
The most critical number to calculate is the overall business inventory turnover. Start with the most prominent picture and then zoom into specific timeframes, products, and categories like the above. Luckily, many accounting software, such as Freshbooks and Wave, have sections on balance sheets for COGS and average inventory. This allows for a fast calculation of total inventory turnover.
  • Product Seasonality of Inventory Turnover
Sure, your business might not be a strictly seasonal affair. However, this doesn’t mean that seasonal patterns don't play into your inventories. By calculating seasonal inventory turnover, you can determine how much of particular products to stock based on seasons. This assists in matching manufacturing or ordering with seasonal customer preferences. It can also help you better manage your cash flow.
  • Seasonality of Overall Inventory
If you own a swim shop or a ski repair store, you understand that seasonality can affect your business's sales. For seasonal businesses, relying on an ITR that spans a full fiscal year can be detrimental. Adverse effects include excess inventory in the off-season and faster stock depletion in peak seasons. An easy way to prevent this is to utilize shorter time periods when calculating the inventory turnover rate.
  • ITR for Marketing Analysis/Product Placements
Seasonality and product segmentation might seem like obvious usages of inventory turnover ratio. However, there are additional applications of ITR as they relate to marketing efforts or product placement within a retail store. As an example, identify inventory that turns slower than desired. Now, move these products closer to the checkout. Wait a little bit, then recalculate turnover and see if this movement helped with sales.

Improving Inventory Turnover

Now, you know what your inventory turnover ratio is. You know how to calculate your business’ ITR, and what results to be on the lookout for. Also, you can apply the ITR to different facets of your business. Naturally, your next question should be, how do you go about improving your inventory turnover ratio? If you calculated your ratio and aren’t happy with your numbers, there are ways to move inventory more effectively:
  • Practice conservative ordering practices
Vendors have a way of pulling the wool over your eyes. They'll talk the world about their product and ensure you know their pricing will never be as low. However, manufacturing extensive products or ordering too much is one of the most common ways to affect ITR negatively. It's beneficial to ensure you order products conservatively. This goes double for products that are new to you and your business.
  • Don’t be afraid to move products around
You’d be shocked to learn how much location plays into consumer decision making. Think of the common example of positions of cereal boxes in grocery stores. Or impulse buy items in convenience stores. The same goes for eCommerce sites. Featuring specific products or calling out other images provide prominence and importance to those items.
  • Complementary products work wonders
In addition to product location, it’s essential to pay close attention to products that work well together. Gift wrap and greeting cards, lighter fluid and firewood bundles, the list goes on. One way to get a fresh set of eyes is to request the consultation of a third party. They are excellent at discovering things you’ve likely missed looking at the same products every day.
  • Put a focus on your marketing efforts
Marketing and advertising are another wonderful method to increasing inventory turnover ratios. Paying attention to products neglected on shelves, customer promotions outside your usual base can provide additional purchases. Otherwise, these products might remain on shelves as unsold inventory. Utilize social media and email marketing to highlight products to your customers. Or, you can include lower turnover products in online advertising and mailings.
  • Discounts can provide that extra boost
Offering discounts may not be any retailer’s initial choice when looking to move inventory. I’m sure you put a stronger weight into your profit margin over your inventory turnover ratio. However, when inventory sits in your store for a while, it takes up space. You’ve paid for these products, and aren’t getting any profit out of them. As a result, offering discounts to move these products opens up space and capital for other, better-selling products.

Our Final Thoughts on Inventory Turnover Ratio

There's a saying that the first and most important step is admitting there's a problem. This is where the inventory turnover ratio comes into play. It assists in identifying the problem area in your sales cycles. This way, you can take the necessary steps to improve inventory turnover processes when needed. Hopefully, these steps will assist in improved business inventories decision making. In turn, the goal is to push for higher volumes of sales in the long term. Are you looking for more tips and tricks to grow your small business? Subscribe to the Fora Financial newsletter for curated pointers and tactics. [cta-newsletter]