There is a delicate balance between having too much or too little inventory on hand. Too much inventory leads to high holding costs, while too little inventory means possible lost sales. One of the key metrics that can help you find that balance is the inventory turnover ratio.
Knowing how to calculate inventory turnover is critical as it helps you understand how effective your company carries out inventory management. This article will discuss how to find the ideal turnover ratio and share practical tactics for reaching that goal.
Understanding Inventory Turnover Ratio
Inventory turnover is the amount of inventory or stock sold in a certain period. Knowing a company's inventory turnover offers many useful insights into what products are selling best as well as how the company manages its overall costs.
So, what does the inventory turnover ratio mean for your business? It refers to the number of times your company spends and replaces its inventory through sales during the accounting period. In simple terms, the inventory turnover ratio reflects how fast a company sells an item and is used to measure sales and inventory efficiency.
Generally, a low inventory turnover ratio means something is not right with the business. In most cases, it happens due to slow product restocking or overstocking products that don’t sell well. A high inventory turnover ratio, on the other hand, means good cash flow, as demand for your company’s products is high. However, this is not always the case (we will further explain this below).
How to calculate the turnover ratio
Calculating the inventory turnover ratio is quite simple, provided you have accurate data. First, you simply need to know your company's cost of goods sold (COGS) and average inventory.
COGS consists of direct materials and labor and overhead costs incurred in manufacturing the products your company sells. It does not include other costs such as distribution, marketing, and sales, or administrative fees.
Average Inventory is used because companies have different inventory levels during other times of the year – for example, a high inventory level just before holiday shopping and a low inventory level at the beginning of the year.
To get the inventory turnover ratio for a particular accounting period, divide the COGS with the average inventory.
Inventory Turnover Ratio Formula: Cost Of Goods Sold/Average Inventory
For example, a retail company sold $500,000 in products this year and had an average inventory of $250,000; therefore, their inventory turnover is 2. That means they have to replenish their entire stock twice over the past year. This number shows that products are selling at a profitable rate.
What is a good inventory turnover rate?
There is no one magic number for a healthy inventory turnover ratio. A “good” inventory turnover ratio varies by industry and business type. High inventory turnover can be good in some cases and harmful in others. That's why you should compare your inventory turnover with businesses in your industry and optimize your inventory from there.
For instance, an annual inventory turnover ratio between 4 to 6 is generally considered healthy for eCommerce businesses. But jewelers, who sell small items with high-profit margins, typically see low inventory turnover in the 1 to 2 range. They can sustain inventory turnover ratios lower than the 4 to 6 range because their profit margins and markups on individual items are typically much higher than that of eCommerce businesses.
How to Optimize Your Inventory Turnover Ratio
Simply knowing how to calculate inventory turnover isn’t enough. You need to arm yourself with tactics to improve your inventory turnover ratio. Here are seven ways to move it in the right direction.
1. Get yourself a solid inventory management system
You can't optimize your inventory turnover without measuring it first. That's why it's important to arm your business with a good inventory management platform that lets you track your sales and stock levels in real-time.
Automation is essential for proper inventory management, especially if you sell your products on multiple channels at the same time. ScaleOcean, for example, notifies you instantly when a sale is made, with stock being updated in real-time. It also provides you with automated messages you can send to your distributors as well for restocking.
2. Forecast your inventory needs properly
Not all products have the same level of popularity. For example, seasonal items or fashion trends significantly affect inventory. That's why it's so essential to forecast annual and quarterly orders.
With a robust inventory management system, you can collect and analyze data about your inventory – what is selling and what is not. This data will enable you to better predict and understand customer trends, develop better procurement strategies, identify obsolete stock, and eventually improve inventory turnover.
3. Improve your replenishment strategy
Your order cycle could be the culprit. Of course, having a solid stock of your most popular items is a great way to keep your sales cycle going on all cylinders, but efficient restocking, in particular, is essential. Fortunately, if you have accurate historical data, this is a simple problem to fix.
Using a sound purchasing management system can greatly help you control your inventory purchases. You can create reorder points by setting your minimum inventory levels, automatically create purchase orders, and make orders from your suppliers from the system.
4. Consider using the just-in-time inventory method
Just-in-time (JIT) is an inventory management method in which goods are ordered, stored, assembled, and/or produced to fulfill orders at the last minute. The goal is to get orders to customers quickly while minimizing product holding costs.
The JIT method is inherently riskier than using safety stock because it increases the likelihood of running out of stock or late deliveries, and larger inventory inflows/outflows can make inventory control more difficult. However, much of this risk can be reduced by regular supply chain monitoring and proactive customer communication.
Many successful retailers who sell products with short shelf lives use the JIT method to minimize excess stock and reduce the number of products they end up throwing away due to expiration when stored in their warehouses or store shelves. Pharmacies, for example, can use JIT inventory management to ensure prompt delivery of drugs to their customers while minimizing the number of pills that expire before they are purchased.
This method might as well work for your business. So, if you find that an item is easy to sell, don't buy it in bulk and stockpile yourself. Instead, it is better to keep it in small quantities but do it more often. This will not only help you reduce overstock, but also give you the chance to get better prices from suppliers, which can also positively affect your turnover.
5. Use better pricing strategies
The wrong pricing strategy can be the reason behind slow inventory turnover. A single pricing strategy may not work for all of your items all the time. Simply reducing the price may not lead to an increase in sales volume. In fact, it may even teach your consumers to only buy from you during the sale.
Instead, analyze your prices, market situation, your target group – and tailor your business accordingly. You can explore several pricing strategies: premium, bargain, seasonal, rush delivery, providing different pricing levels for different types of customers, cost-plus pricing, including bonuses or added value with purchases, and games that are always popular with cents (like 99 cents versus 50 cents).
6. Enhance your customer experience to boost sales
Customer experience is one of the key brand differentiators in today’s market. Research has shown that brands with excellent customer experience bring in 5.7 times more revenue than competitors that lag in customer experience. Good customer experience also means your customers will spend more. In fact, 86% of buyers are willing to pay more for a great customer experience.
Customer experience covers everything from your website design to social media interactions, so chances are, if you dig deep enough, you will find at least one area of your customer experience that could use some improvement. Fortunately, at ScaleOcean, we have helped companies improve their customer experience by offering delivery transparency. With our real-time shipment tracking tool, you can set up automatic delivery notifications with live tracking to go out to every customer when their order is on its way.
7. Reduce your risk of products being returned
Product returns can hurt your sales and inventory. And while returns and exchanges will never go away completely for the product business, that doesn't mean you're powerless to minimize their frequency.
Here are e few things you can do to minimize the risk of your product being returned:
Describe your products in detail
Be honest in your product descriptions. Few things disappoint consumers faster than getting a product that doesn't look, feel, or function as it looks online. Make sure your product photos are well lit and provide an accurate representation of your items.
Make sure your products are safe during transit
The best way to avoid damage during last-mile shipping is to use your own in-house shipping team who are fully trained on how to handle your goods. But if this isn't possible, make sure your product is properly wrapped, insulated, and cushioned so that it can withstand a bumpy ride.
Track your shipments
Some products end up returning to the warehouse because the buyer is not home to receive the package. To tackle this issue, you can take advantage of our real-time shipment tracking tool in our Inventory Management module to get the latest information about the delivery of your package. This kind of transparency and communication helps ensure your customers actually get their shipments (and won't return to your facility).
The inventory turnover ratio is an important KPI that can be used to assess the performance of your entire business. It is a good indicator of how well your company is serving its market and how well the sales and procurement departments are in sync.
If you're off the mark, consider including the inventory and customer-facing solutions we recommend for your business. You won't reach your ideal ratio overnight. However, with reliable processes and a long-term inventory management strategy, you'll be able to achieve that balance sooner than you might think.