How to Calculate Inventory Turnover and Improve Your Business’s Cash Flow
Find out how long your products stay in stock and create a fitting strategy
How often does your wholesale business replace its stock
This question is more complicated than it seems at first glance. Hopefully, you’re selling a good volume of inventory on a regular basis – but you’re also replacing that inventory to prevent stockouts.
How do you know how fast you run out of stock, and why is that information valuable? This performance metric is called inventory turnover, or stock turn. Learning how to calculate inventory turnover will help you do three ultra-important things for your business:
- Make Smarter Purchasing Decisions. It should come as no surprise that products sitting on shelves produce no profit. To minimize the amount of time individual products remain in stock, you need to measure the average amount of time products remain on shelves before customers purchase them.
- Keep Merchandise Moving. This is especially important for wholesale distributors who deal with goods that expire – like food products. If you don’t calculate your inventory turnover ratio, you will end up cash frozen in products that aren’t selling.
- Sell More of What Your Customers Want. When combined with inventory management software and sales data, you can use inventory turnover to determine your top sellers. Importantly, you can do this with unprecedented accuracy and precision.
Depending on your industry, you can also use inventory turnover to find out how well your wholesale business is doing compared to industry standards, which are often publicly available.
But first, we need to go over what exactly inventory turnover is and how you can calculate it.
How to Calculate Inventory Turnover
Inventory turnover is a ratio that compares the value of your total inventory with the number of times you sell that value.
The formula is simple:
By dividing your gross sales revenue by the cost of inventory over a one-year period, you can find out how many times you’ve gone through your inventory during that time.
Here’s an example:
If your distribution business bought $50,000 in goods last year and sold $200,000 worth of goods over the same period, your inventory ratio is a simple 4.0.
That tells you that you sold four times the value of your inventory over the course of the year. In this situation, you should plan on purchasing at least four times your inventory throughout the next year.
Calculating Average Inventory
One of the things that business owners, accountants, and inventory management specialists often disagree on is how to calculate inventory. Your choice of inventory management software may do this automatically. If it does, you should understand the equation it uses so you know how accurate your inventory control figure is.
- The simplest way is to add inventory from the beginning of the year to inventory at the end of the year and divide by two.
- The more precise way is to add the beginning of each month’s inventory and the ending inventory of the most recent month and divide by 13.
At first, it may seem like the two methods achieve the same thing – your annual sales haven’t changed just because you calculated on a monthly basis. However, every business encounters monthly fluctuations in sales and inventory. The monthly average ensures you catch those fluctuations in your calculation.
For instance, if you sell more items during summer than in winter, calculating monthly inventory will reflect that in the final result more accurately. Think of it as a higher-resolution image of your business finances.
How to Interpret Inventory Turnover and Improve Performance
Once you know how often you sell through the value of your inventory every year, you can start putting that knowledge to work. First, you should compare your inventory turnover to your industry average to determine whether it’s faster (larger) or slower (smaller) than your competitors’.
- A faster inventory turnover reduces the costs of storing merchandise. It means you need less warehouse space and fewer hangars and fixtures, and it reduces the risk of carrying obsolete or expired products. However, it increases the risk of stock-outs and can increase shipping costs if you don’t optimize a logistics strategy to fit.
- A slower inventory turnover requires more infrastructure to accommodate but protects your business against stock-outs during peak season. It saves on shipping costs, but only for products that don’t expire or become obsolete over time.
The longer a product stays in stock, the more overhead you end up spending on it. Carrying costs tend not to change from year to year, yet your inventory does – and you can’t raise the price of an old product to cover the cost of keeping it on a shelf for five years.
As a result, most small businesses tend towards keeping their inventory turnover fast and making arrangements to ensure they are protected from stock-outs and logistics expenses.
One of the ways your business can do this is by using monthly sales and inventory data to prepare for high-volume sales periods ahead of time. You can predict how much of your inventory value you’re likely to sell during a busy period and order accordingly.
Inventory and order management software allows you to compensate for these fluctuations once you calculate inventory turnover. With the right digital infrastructure in place, you can automatically update inventory levels in real-time and use that data to purchase new products right before they sell out.
Small business tends toward a Just-in-Time (JIT) strategy. This technic achieves exactly what your name suggests. It allows you to order the products only when you are about to ship them so that you don’t have to spend too much holding onto unsold inventory.
Manage Inventory Efficiently With a State-of-the-Art Toolset
Professional inventory control software lets you optimize your stock more efficiently and have a faster inventory turnover that accommodates your wholesale business. It combines a state-of-the-art feature set with an intuitive interface that help with the calculation of your inventory turnover.
You can use erplain to track inventory valuation by day for individual products. This improves the inventory turnover formula by calculating by days instead of months (and dividing by 366 instead of 13). Get the best-in-business intelligence and integration in one place using this next-generation application