What is Inventory Turnover and How to Calculate it?
Inventory Turnover Ratio (ITR) or simply put Inventory Turnover is a figure that shows how long it takes for a business to sell through its inventory. The inventory turnover can also be used to represent how strong sales are at a certain business and those that are having a higher IT are stronger in sales than the ones that have a lower IT.
The definition of inventory turnover
Inventory turnover is a financial ratio that shows the number of times a company has sold successfully and replaced its inventory throughout a given time period. The inventory turnover formula helps to divide this period into days and show how many days it takes for a company to sell through the inventory it has on hand.
How to calculate inventory turnover?
Calculating the inventory turnover and closely monitoring it can help businesses to better manage their inventory and make more informed decisions on pricing, marketing, and the purchase of new inventory. The formula for calculating inventory turnover is as follows, Inventory Turnover rate = Cost of Goods Sold/Average Inventory. In order to better understand the calculation, the variables need to be defined:
- Timeframe: usually one year but can be any period you choose to look at;
- Average inventory: it is the average of the dollar value of the inventory you began the period with and the dollar value of the inventory you have finished the period with;
- Cost of Goods Sold (COGS): it is the cost of your sold goods that is also represented in your annual income statement.
So, the Inventory Turnover rate can also be calculated as IT = Cost of Goods Sold / [(beginning inventory + closing inventory)/2].
Things that inventory turnover can tell you
As the Inventory Turnover shows you how fast a business is selling its products on hand, it can imply multiple things for an observer. When a business has a low Inventory Turnover rate it can signal the following:
- excess or overstock inventory is being held;
- the goods offered for sale are not meeting the expectations of the targeted niche;
- the goods the business is offering are priced higher than what the consumers are willing to pay for them;
- there are not enough or not successful marketing efforts to get the consumers interested in the products and generate sales.
But sometimes low inventory turnover can also be a good thing. By having a high inventory turnover rate you can potentially miss out on business if the product or product variant is not readily available for your customers when they need them. Also, when a certain product’s price is expected to rise in the foreseeable future, it is a good idea to purchase an excess stock prior to the price change so you can keep a higher margin without raising the prices you are offering to your end customer.
However, in general, you would want to keep your inventory turnover at a high level for the following reasons:
- retailers that move out inventory faster tend to be better performing;
- the longer a product is hold, the higher the handling and storage cost will be which will negatively impact your profitability. Or in the case of goods that are perishable, it can even mean that you will end up having to throw them away;
- if a business keeps trying to sell goods that are not desirable for consumers and not offering newness to them, it will give fewer reasons for the consumers to return;
- there is also an opportunity cost associated with low inventory turnover as a product that is not selling efficiently can cause cash flow issues for the business and prevent the purchase of products that might sell faster.
A great example of companies that keep their inventory turnover rate high are those in the fast fashion business such as Zara and H&M. They keep their inventory low of each product they place an order for and are quick to sell through and replace their product offering on a regular basis. This way they have a minimal holding cost and also keep their customers interested in newness and give them a reason to return to the stores more often.
What is dead stock and what to do with it?
Dead stock is also referred to as obsolete inventory and used for inventory that is unsold and it is close to the end of its lifecycle. Also, it is inventory that has not been sold or used for a considerably long time and is not expected to be sold in the foreseeable future. Unfortunately, this type of inventory can cause large losses for a company and needs to be written off or written down. In our highly competitive world today where consumers are better informed and have a higher expectation of the products they are offered, the product life cycle tends to be shorter and inventory tends to become obsolete much faster than before.
How to better manage inventory?
Inventory management is key for every business to make sure that the stock they have on hand is going to generate income and hence profit. Businesses can apply an open-to-buy system in order to manage the replenishment of their inventory better. The open-to-buy system is a budgeting system to budget and manage the purchase of new merchandise. This can be used to monitor and improve the management of inventory and can be integrated into the business’ financing and investment protocol. However, keep in mind that this open-to-buy system is not suitable for any type of merchandise. It can work well with fashion apparel and accessories but will not be applicable for fast-selling consumer goods or other basic items.
In order to best manage your inventory, it is advised to invest in inventory management software that syncs in real-time and ensures that your stock levels are updated correctly. Inventory management can vary from business to business, so it is vital that you choose the software that is the best fit for your store. Make sure you are comparing several software before you make a decision and invest in one.
Days Sales of Inventory
Taking a step further, you would also want to concentrate on the Days Sales of Inventory (DSI) as this will also be an important measure for your inventory management. Days Sales of Inventory is basically the inverse of Inventory Turnover and shows how many days it requires for your business to sell inventory while Inventory Turnover will show you how many times you will need to restock during a year. Days Sales of Inventory is calculated as (Inventory / Cost of Goods Sold)*365. This number will represent the number of days that are needed for you to turn your inventory into sales.
What is a good inventory turnover rate?
It is hard to say what is a good inventory turnover rate for a business as it is highly dependent on the market it operates in and the type of products it is selling. For example, an automobile manufacturer will have a lower inventory turnover rate than a company that is selling fast-moving consumer goods. This is because consumers tend to purchase low-ticket items much faster than more expensive items where they need time to make a purchasing decision.
For this reason, Inventory Turnover rates can only be assessed when industry average and competition are taken into consideration as well. Companies are aiming to have their inventory turnover rate as high as possible as this way they do not have their assets tied up in goods which allows them more liquidity and financial stability. Also, keeping the inventory turnover high helps to avoid ending up with unsellable inventory for a reason. This reason can not only be spoilage but also damage during storage, technological obsolesce, theft, and many others. But at the same time, it is important to make sure that you have enough merchandise available on your hand and you are not missing out on business due to not being able to offer products to your potential customers.
To sum up, it is important for every business to closely monitor and assess their Inventory Turnover rate on a regular basis and compare it to those who are best-in-class examples from the same industry. There are several tactics that can help to manipulate the Inventory Turnover such as discounting and promotions. But it is also important to keep in mind that these will negatively affect the profit margin on the goods and hence have an impact on the Return On Investment (ROI). Consequently, it is better to plan carefully and only purchase the amount of inventory you are confident you can sell-through.