Inventory turnover ratio is an important metric to track for any retail business, whether you’re a traditional brick and mortar store or an online eCommerce brand. Today, we’re going to take a look at what inventory turnover is, how to calculate it, how to analyse your calculations, and how to improve.
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Inventory turnover ratio definition
Inventory turnover is calculated through a ratio that shows how many times inventory has been sold and replaced over a specific period of time.
Essentially, it’s a measurement of how fast a company sells their stock, with high inventory turnover generally pointing towards a thriving business, with low inventory turnover usually, but not always, indicating a struggling business.
The importance of inventory turnover ratio
The inventory turnover ratio is a vital calculation to evaluate business health and improve key processes in sales, inventory management, financial planning, and more.
With a good understanding of inventory turnover, you can make much better decisions around budgets, forecasting demand, and supply chain management.
It’s something your customers are bound to notice too, as understanding inventory turnover means you can better avoid stockouts and backorders, and create a better customer experience.
How to calculate inventory turnover ratio
To work out inventory turnover ratio, you’ll first need to calculate COGS (cost of goods sold) over the period you want to cover.
COGS is defined as the costs associated with sourcing and fulfilling your goods, including the cost of raw materials, shipping costs, storage costs, labour costs, and more.
Once you have identified the COGS, calculate your average inventory value using the following formula:
Beginning inventory + ending inventory / 2]
Formula for inventory turnover ratio
With COGS and average inventory value identified, you can use the numbers in the following formula:
Inventory turnover = COGS / Average inventory value
Let’s imagine that you’re an established business with a COGS calculated at £800,000, and your average inventory value was £400,000. With these figures, your inventory turnover ratio would be 2:
Inventory turnover = £800,000 / £400,000
Inventory turnover ratio = 2
Analysing your inventory turnover ratio
When looking at your inventory turnover ratio, the ideal number will depend on your industry. In some industries, an inventory turnover ratio between 2 and 4 is optimal, whereas in others an inventory ratio between 5 and 10 might be more ideal.
We’d recommend doing a bit of research into your industry to see whether you’re in the ideal range.
High inventory turnover rate
A high inventory turnover rate is generally seen as a good thing. After all, the higher your inventory turnover, the more sales you’re getting. That said, there are some disadvantages to a high inventory turnover rate if your inventory management isn’t optimized properly.
Let’s take a look at the advantages and disadvantages of a high inventory turnover:
Lower storage costs – By selling goods quickly, you’re lowering the storage costs associated with each inventory turn.
Increased cash flow – A steady stream of cash means that you’ll have more cash on hand for marketing, product development, and other essential business activities.
Less wastage – Products that move quickly have less chance to go out of date or become obsolete.
Ability to capitalize on trends – Fast sales mean you can better respond to customer demand and market trends.
Potential stockouts – If products are flying off the shelf, you may struggle to replenish inventory quick enough to meet demand.
Lower safety stock – Similar to the above, it can be difficult to have adequate buffer safety stock in place when sales are high.
Greater risk from supply chain issues – High inventory turnover puts more pressure on the efficiency of your supply chain.
Less flexibility on bundles and bulk orders – With a high inventory turnover, you will have less stock on hand to fulfil larger orders and bundle discounts.
Low inventory turnover rate
Lower chance of stockouts – With fewer products being shipped, you product availability should be much higher.
More flexibility with suppliers – With lower inventory turnover, you can use long lead times to your advantage, and negotiate better rates with suppliers.
Ample safety stock – It’s much easier to have lots of buffer stock in place when demand is low.
Higher storage costs – You’ll generally need to keep inventory in storage longer, leading to higher storage costs over time.
Capital tied up in inventory – Low turnover means less cash flow, resulting in less money available for other business activities.
More wastage and risk of obsolescence – Failing to sell products quickly can result in degradation or out of date goods which need to be wasted.
Less inventory data to analyse – Good inventory management is all about data, and the less sales you have, the less data you’ll be able to gain insight from.
How to improve a low inventory turnover rate
There are many ways to solve a low turnover rate, some of which involve considerate investment. However, low turnover can often be solved by addressing existing inventory issues, requiring time and thought, rather than cash.
Here are some common ways to improve a low turnover rate:
Experiment with new marketing channels
There are an enormous number of ways to market your business in the 21st century, both offline and online. While a low turnover rate doesn’t necessarily mean an absence of marketing, it could mean that your marketing efforts aren’t as effective as they could be.
Look at what your more successful competitors are doing on social media for inspiration. Experiment with new email campaigns, and consider whether your website is optimized for SEO. This can all be done with little to no investment, if you take time to learn best practices.
Marketing is often trial and error, and with some testing, you’ll soon find a channel and strategy that results in more sales, and increases your turnover rate.
Inventory analysis can be difficult if you have a large number of SKUs and low sales. However, one useful technique you can use is ABC analysis, which involves looking at historical data to determine which SKUs you should prioritize in your marketing and sales strategies.
Through ABC analysis, you can clearly identify fast and slow moving lines, and make a judgement on the SKUs you should prioritize, as well as on the ones you may be better off retiring.
If you aren’t selling as much as you’d like, it’s important to consider your value proposition. The best place to start is by looking at your competitors’ prices. If yours are vastly higher with no good reason, then you’re going to struggle to make the sales you want.
It’s not all about undercutting your competitors, though. While you can look to reduce pricing by optimising other areas of the supply chain and passing on the discount, you can also consider further ways to add value to your customers.
This might be through loyalty programs, free gifts, great customer service, competitions, and more. Give customers more reasons to want to shop with you.
Improve inventory management with James and James
At James and James, we can help you fix a low turnover rate by giving you back the time you need to do just that. We are an industry leader in the 3PL space, offering lightning-fast and 99.9% accurate fulfillment services.
We store, pick, pack, and ship your products anywhere in the world, and even take care of returns too. This frees up your in-house resources to focus on selling, optimising inventory, improving your supply chain, developing amazing marketing strategies, and much more!
Also included is our multi-award winning inventory management platform, ControlPort, which automatically highlights areas of inventory management closely related to inventory turnover, providing you with the insights you need to make improvements.