How to Calculate and Increase Inventory Turnover Ratio
As a pro retailer, it’s not enough to know how to sell the right products.
You need to be an expert in inventory management as well— and you should have some idea of how sales and stock levels affect each other.
To know your inventory turnover ratio, which is instrumental for planning, purchasing, selling goods, and many more, this article, we will discuss:
- What is an inventory turnover ratio?
- How to calculate inventory turnover ratio
- What is a good inventory ratio?
- How to increase inventory turnover ratio
What Is Inventory Turnover Ratio?
Inventory turnover ratio is a way of measuring how many times you’ve sold through and replaced your inventory in a given period; how many times it has turned over, so to speak. Knowing this number will give an insight into the overall performance of your business.
Keeping inventory around for too long can be a problem. If you’re not selling your products, it’s going to be hard to make money because you won’t have enough revenue coming in from sales. Also, there will never be any new stock available if all of the old items are dusty and unsellable.
The inventory turnover ratio is a good way to keep tabs on your inventory. You can measure the overall health of your business, take into account any new selling strategies and adjust the pricing accordingly before you get blindsided by slow-moving stock.
Not all industries are the same. For example, some will have more inventory turns than others simply because of what is being sold. Commonly, clothing and perishable goods turn faster while automobiles take longer to sell.
How to Compute Inventory Turnover Ratio
It’s important to note that there are two ways of calculating the inventory turnover ratio. One way is by using sales, and the other is by using the cost of goods sold (COGS).
The inventory turnover ratio formula if you’re going to use sales is:
Inventory Turnover Ratio = Sales / Average Inventory
The more you sell, the less inventory that is on hand. The higher your sales are in relation to what you have left of stock, the better off financially it will be for your company.
Your inventory ratio can also be calculated by using the COGS. It is more accurate because it does not include the markup that could inflate the number and give you a higher one.
The best way to determine the cost of goods sold is by using an inventory number that includes all your products on hand. The formula for calculating inventory turnover ratio if you’re going to use COGS is:
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Simply, COGS is the cost to produce or purchase inventory items for sale, while Average Inventory is the average value of an item in stock. The “Inventory Turnover Ratio” calculates this by dividing COGS with Average Inventory and tells you how many times your inventory was sold during a certain period.
To calculate your average inventory, use this formula:
Average Inventory = (Beginning Inventory + Ending Inventory) / 2
The average inventory is the total amount of inventory in stock divided by two.
Inventory Turnover Examples
Let’s take an example to better understand turnover. Say we wanted to calculate how quickly our apparel store was turning over its shoe inventory.
The first thing we need to know is the cost of goods sold. For example, a company had $5000 worth of shoes that were purchased in a year. To find out how much inventory they need to purchase, we first have to know the cost of beginning and ending inventory.
Once you calculate those numbers together, divide them by 2. The total is $1300.
After gathering these numbers, we can now calculate the inventory turnover ratio.
5000 / 1300 = 3.8
Calculating days sales of inventory (DSI)
The day’s sales of inventory, or DSI for short, is a formula that will help you calculate the average length of time your cash sits in stock. This can be helpful because it puts turnover into daily context and helps measure how much money you’re losing from being tied up.
The DSI formula is:
DSI = (Inventory Value / COGS) x 365
The formula for determining the day’s sales in inventory is to divide your year-end inventory value by the cost of goods sold and then multiply that number by 365.
One important thing to note here is that regardless of how you choose to calculate inventory turnover, the key point is consistency.
What’s a Good Inventory Turnover Ratio?
A higher inventory turnover ratio typically means that you are selling more products than usual. A high number generally indicates that your company is moving products fast and often.
- You’ve set a budget and you know how much inventory to buy. You want enough on the shelves so that there is no chance of running out, but not too many items because then your store will be overstocked.
- You are selling your own products, but you need to motivate your employees with high pay and bonus structure.
- This will help them provide good service.
The problem with having a high inventory turnover ratio is that it can mean you’re not putting in big enough orders when restocking. If your customers are constantly running into empty shelves, they may be driven away from the store. Keeping an eye on how often this happens will help to keep them happy.
If you have a low inventory turnover ratio, it could be because of one or more problems with your business.
- You are buying too many units in your orders, and customers aren’t responding to the same demand.
- You’ve been stocking your shelves with products that are not what the customers want. You may have overstocked or understocked and they’re going to competitors for their needs instead.
Comparing inventory turnover by industry
Inventory turnover varies by industry. For example, fashion retailers average between 4 and 6 turns. Car dealerships, on the other hand, average between 2 and 3. Car components can have an inventory turnover ratio as high as 40.
Once you’ve calculated your ratio, compare it to the industry average as well as the competition.
How to Increase Inventory Turnover Ratio
If your inventory turnover ratio is below the industry average, you need to take action. Here are some helpful strategies on how to do this.
1. Adjust Purchasing Plans
Keep your inventory levels in check by forecasting accurately. Review the turnover ratio of various categories and compare it to their sales figures. When you see a decline in sales, order less of that product or category while also introducing new products
2. Review Pricing Strategies
When your sales are low, it is important to have a plan for how you will increase them. One way to do this is by changing the pricing structure of products and services.
- Bulk pricing is when customers get discounts for buying more than one item. The cost per unit decreases with the quantity, so you pay $3 if you buy 1 package of paper towels but only $2 if you buy 10 packages.
- If you have a seasonal business, start offering discounts earlier in the season. If your product is clothes, for example, make sure to offer smaller discounts about halfway through and gradually increase them as time goes on.
- Bundle pricing is when you offer a set of items together for an affordable price. You can also bundle with products that are in-stock, which may make it easier to sell certain things. It’s like upselling but with some work already done.
3. Try New Sales Tactics
Consider taking personal shopper appointments. You can do appointment shopping during regular or after store hours, online or in-person. It provides customers an intimate shopping experience and gives employees more opportunities for upsells.
Final Thoughts on Inventory Turnover Ratio
Keeping track of your inventory turnover ratio is an important metric to watch. If it starts dropping, you know that there are some adjustments and optimizations that need to be done for your business to succeed.