Find out how long your products stay in stock and create a fitting strategy
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Inventory turnover is a concept used in management and accounting to measure how often a company buys and sells its products or goods over a given period. This allows for determining the speed at which stored items are used, sold, or replaced. It is a crucial evaluation of a company's performance in inventory and supply chain management.
A high turnover ratio indicates that stocks are replenished quickly, indicating good collaboration with suppliers and an effective response to customer demand. Conversely, a low ratio can lead to issues of expiration or overstocking.
Through inventory turnover, you gauge the efficiency of your inventory management by assessing how often products are sold or used. It is, therefore, a vital indicator for maintaining a balance between supply and demand while minimizing storage-related costs.
By calculating your inventory turnover ratio, you can improve three important aspects for your business:
Products that linger in your warehouse generate no profit. To minimize storage duration, it is crucial to measure the average time products stay in your warehouse before they are shipped to customers. By identifying high-turnover products, you can orient your purchasing policy and adjust production and supply strategies.
This is particularly important for distributors and wholesale companies selling perishable goods, such as food items. Failing to calculate your inventory turnover ratio may leave you with cash frozen in unsold products.
When the inventory turnover ratio is associated with an inventory and sales management software, it becomes a valuable tool to identify your best-selling items with unprecedented precision.
Inventory turnover plays a key role in calculating Working Capital Requirement (WCR) as it helps estimate the company's ability to manage its supply cycles, thereby maintaining a healthy cash flow. Moreover, a high inventory turnover spreads fixed costs over a greater number of goods, which can enhance profitability.
You can also use the inventory turnover ratio to understand your company's performance relative to your industry.
Inventory turnover is calculated in the form of a ratio, and there are two methods to do so.
This method is currently the most widely used.
Formula: Inventory Turnover Ratio = Total Revenue / Average Stock at Selling Price
Example
Your distribution company generated $200,000 in revenue during the year.
Beginning inventory was $60,000, and ending inventory was $40,000. For this method, both inventory figures are valued at selling prices.
Average inventory is therefore:
($60,000 + $40,000) / 2 = $50,000
The inventory turnover ratio is:
$200,000 / $50,000 = 4
Using this revenue-based method, inventory turned over 4 times during the year.
Formula: Inventory Turnover Ratio = Cost of Goods Sold (COGS) or Purchase Cost of Goods Sold / Average Stock Value
The average stock corresponds to the average value of a company's stocks over a given period (a month, a quarter, a semester, a year, etc.). If you use an inventory management software, you can easily have it calculated.
There are two main ways to calculate the average stock value:
At first glance, one might think that both methods yield the same result: your annual sales do not change when calculated on a monthly basis. However, every business experiences monthly fluctuations in sales and stocks. The monthly average ensures that these fluctuations are considered in your calculation and is, therefore, more accurate.
For instance, if you sell more items in summer than in winter, the monthly stock calculation will more faithfully reflect the final result. Think of it as a high-resolution image of your company's finances.
An inventory turnover ratio considered optimal generally ranges from 2 to 4 for most e-commerce businesses. However, there is no single ideal inventory turnover ratio for every business. It depends on factors such as your industry, seasonality, supplier lead times, and product lifecycle. A low ratio (1 or below) may indicate overstocking or insufficient sales, but it needs to be interpreted in the context of your business. Compare your result with similar periods and, where data is available, with comparable businesses.
You should compare your inventory turnover ratio to the industry average to determine if it's faster (higher) or slower (lower) than your competitors.
The longer a product stays in stock, the more overhead you end up spending on it. Storage costs tend to remain relatively stable from year to year, but your stock levels change – and unfortunately, you can't increase the selling price of an old product to cover the cost of storing it for five years.
Therefore, most entrepreneurs aim for a high inventory turnover and implement measures to reduce the risk of stockouts and logistical expenses.
To enhance your inventory turnover, there are various solutions depending on your situation.
For a higher inventory turnover, it is necessary to reduce orders and/or increase sales.
For a slower inventory turnover, you either need to order more goods to stock in your warehouse or decrease sales (a less likely alternative).
Recommended reading:
Inventory management: issues, optimization, and methods
Christmas 2020 inventory management: How to deal with unsold stock
The 5 inventory management mistakes small businesses often make
The inventory turnover ratio is an excellent way to determine whether you should increase or decrease your stock, as well as to make decisions regarding your inventory management. Like any metric, it needs to be continuously assessed. Therefore, you must ensure that you can react accordingly. The inventory turnover ratio provides an ongoing insight into your stock performance and can help you adjust your strategy accordingly.
A specialized inventory management software like Erplain helps you achieve a balanced inventory turnover and adapts to your wholesale, distribution, or import-export business, providing accurate data for your sales and stocks. Erplain combines a set of features with an intuitive interface that facilitates the calculation of the inventory turnover ratio.
Divide the number of days in the period by the inventory turnover ratio calculated for that same period. For example, with an inventory turnover ratio of 5 over a 365-day year, average inventory holding time is 365 ÷ 5, or 73 days.
An overall calculation provides an initial overview of your business. Analyzing turnover by product or product category then helps identify slow-moving items and those that require closer attention when planning replenishment.
Yes. For an individual product, divide the number of units sold during the period by the average number of units held in stock. Make sure you use the same unit of measurement throughout. When combining products with different values, use a value-based calculation instead.
Monthly monitoring is a practical starting point. Adjust the frequency to suit your business and compare equivalent periods, particularly if sales are seasonal. To help prevent stockouts, also monitor available quantities and supplier lead times.
Inventory management software centralizes useful information for your analysis, including sales, stock movements, and inventory valuation. This data helps you compare products and adjust purchasing decisions. With Erplain, you can monitor stock levels and access sales and inventory valuation reports to support this analysis
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