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
Let’s say your distribution company purchased $150,000 worth of products last year and sold them for $200,000 during the same period.
The beginning-of-year stock is $60,000, and it is $40,000 at the end of the year.
The average stock shall be ($60,000 + $40,000) / 2 = $50,000.
Inventory Turnover Ratio:
$150,000 / $50,000 = 3
According to this method based on the cost of goods sold, the inventory turnover ratio is 3. This means that stocks are reordered 3 times during the fiscal 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.
The optimal inventory turnover ratio typically ranges from 2 to 4 for most e-commerce businesses. However, it can vary based on the industry, the seasonality of the business, cost structure, strategic priorities, operating cycle duration, and product lifecycle. A ratio lower than or equal to 1 indicates an excess of stock.
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.
