To figure out how your business has been performing, it’s crucial to keep an eye on your stock levels. This practice, known simply as inventory management, helps business owners and managers make important decisions timely with optimal results.
But there are certain performance metrics you need to be aware of if you want to stay informed of your company’s health, growth, and profitability. One such metric is inventory turnover, a critical indicator that helps determine how efficiently you’re utilizing your limited resources.
In this article, we’re going to talk about inventory turnover and its role in inventory management, covering everything you need to know about its calculation and significance. We’ll also discuss five actionable tips that you can implement to optimize your inventory turnover rate.
Let’s get started!
What is the inventory turnover rate?
Inventory turnover is a metric that tells you how quickly your business is converting its inventory into successfully sold finished goods and replacing the used-up inventory with new stock.
To put it more simply, inventory turnover tells you how many times your inventory is sold and replaced in a given period, such as a month or a year.
A high inventory turnover means that you’re selling your inventory quickly, which is usually a good thing because it means you’re generating revenue and not tying up too much money in unsold inventory. On the other hand, a low inventory turnover may indicate that you’re not selling your inventory as quickly as you’d like, which could lead to cash flow problems, excess inventory taking up valuable space, and a bunch of other financial and operational issues.
The inventory turnover formula
The formula for calculating inventory turnover is as follows:
Inventory turnover ratio = Cost of goods sold (COGS) ÷ Average inventory
What each item in the turnover formula means
Let’s go over each item in this formula and see what it means.
Cost of goods sold
The cost of goods sold (COGS) is the cost of all the products a company has sold over a specific period. To calculate the cost of goods sold, you need to add up the cost of raw materials and the costs of labor, storage, maintenance, insurance, packaging, shipping, and any other expenses directly incurred from the purchase or production of the stock that you have sold.
A high COGS could be both good and bad. It could simply mean that you are selling a good quantity of stock in a given accounting period, i.e., your sales figures are impressive. It could also mean that your manufacturing costs are too high, hinting at low profitability. Similarly, a low COGS could also indicate both good and bad things, such as great cost-efficiency or slow-moving stock. Thus, its individual impact is difficult to determine on its own; it can paint a better picture when combined with other metrics, such as the second component of the inventory turnover ratio.
Average inventory
This one seems to be a bit more straightforward than COGS. Average inventory refers to the average amount of stock at hand for a business over a particular duration. It’s the mean of the quantities of inventory you have at hand at the beginning and end of an accounting period or cycle, which is often a year. This is how it’s calculated:
Average inventory = (Beginning inventory + Ending inventory) ÷ 2
A high average inventory signifies that you are holding onto too much unsold inventory, which means your capital (cash) is tied up and can’t be invested into anything else at the moment. It also means you aren’t making the ideal amount in sales fast enough. But at the same time, it shows that you are well-stocked and won’t be facing a shortage any time soon. Similarly, low average inventory can be good or bad both. For example, it could indicate savings in terms of stock holding expenses. But you could also be at risk of a stockout.
Let’s see how these two elements work and what they signify when considered side by side, or rather, one atop the other.
The significance of having a good inventory turnover rate
There’s no clearly defined number that you can label as a “good” inventory turnover rate. However, the number being high or low does hold some significance.
What a high inventory turnover ratio means
A high inventory turnover rate indicates that you’re converting your inventory into sold products quite quickly, which is usually a good thing because it means you’re generating revenue from a high enough demand, with prices that most definitely satisfy your customers.
It also points towards you having a stable cash flow and not tying up too much money in unsold inventory. This means that your cash can be redirected towards other more important or urgent financial matters, and you’re doing a good job managing inventory.
What a low inventory turnover ratio means
A low inventory turnover rate means that you’re not selling your inventory fast enough, which means your already limited capital has gotten tied up in unsold stock and isn’t getting converted into revenue and, consequently, profit. It points to potential cash flow problems, if not immediately, then definitely in the near future, and also reflects inefficiencies in managing inventory.
Furthermore, a low stock turnover ratio could mean that you are not able to generate a high enough demand for your products, perhaps because of ineffective pricing strategies or some other underlying issues.
5 ways to improve your inventory turnover ratio
There are many quick hacks for a business to optimize its inventory turnover ratio, but here are five actionable tips with long-term impacts that you can implement at your organization.
1. Start using inventory management software
Inventory management software can be of incredible help in a lot of ways for businesses of all types and sizes.
Firstly, modern inventory management systems enable real-time tracking, which means you are fully aware of the quantity, and even the location, of stock on hand at any given time. This can help avoid stocking issues such as overstocking or overordering. You can thus avoid tying up your capital in excess inventory and subsequently avoid losses due to stored items spoiling or becoming obsolete.
Employing digital solutions for stock management also helps streamline the inventory ordering process by optimizing reorder levels based on careful data analysis and placing orders automatically once those reorder levels are reached. This not only saves time but also ensures that you’re never out of stock, leading to happy, loyal customers.
By keeping your stock levels optimal, you’ll be able to strike a balance between having enough inventory to meet demand and not running out, all while keeping carrying costs at a minimum.
When choosing a digital solution, it’s important to compare inventory management software on the market. Look for features such as real-time inventory tracking, order management, analytics, and user-friendly reporting tools to help you make informed decisions about what to stock, when to reorder, and in what quantity.
2. Adopt lean principles
The second tip for improving your stock turnover ratio involves the implementation of lean principles for inventory management.
Just-in-time (JIT) and first-in-first-out (FIFO) are two popular lean inventory management strategies that can help streamline operations.
Under the JIT method, you order only what you need as and when the need arises for it. It helps avoid overstocking and thus significantly reduces carrying costs. Kanban is one popular type of JIT system. It involves using cards or other hard-to-miss visual signals to indicate when an inventory item is running low and needs to be reordered. This demand-based system effectively boosts team efficiency, communication, productivity, and deliverability.
On the other hand, we have FIFO, which ensures that items that were bought the earliest are also the first ones to be used up, reducing the risk of loss due to dead stock, spoilage, and wastage from items sitting in inventory for too long.
Adopting lean principles can also help you optimize your safety stock quantity by reducing lead times and using data analytics to predict customer demand more accurately. By doing so, you will be able to reduce the amount of safety stock you usually keep on hand and instead order only when needed.
Other lean principles that might be relevant to get a good inventory turnover rate include continuous improvement, total productive maintenance (TPM), value stream mapping, and 5S, all of which ultimately improve inventory turnover.
3. Record and study your sales data
Regularly collecting and analyzing your sales data is a critical process for identifying trends and patterns in customer demand and adjusting your inventory levels accordingly. It helps prevent excess inventory and also minimizes the risk of stockouts.
Perhaps the most significant benefit of studying your sales data is that it helps you better understand what your customers want. By exploring customer purchase history and feedback in depth, you can tailor your inventory offerings to better meet their needs and preferences. This can help you improve customer satisfaction and drive repeat business, too, further speeding up sales and driving up the cost of goods sold.
Consequently, sales data analysis allows you to identify slow-moving stock. This includes items that take a while to sell. It ties up valuable capital, can ruin your cash flow, and is a major contributing factor towards a low turnover rate. By identifying slow-moving stock and taking the necessary steps to prevent or get rid of it, such as offering discounts or reselling or quickly repurposing it, you can improve your inventory turnover rate.
To make the most of your sales data, it’s a good idea to use specialized tools such as proper demand forecasting software, customer surveys, POS systems, and BI and analytics tools. These tools can help you study your data more easily and predict future demand more accurately, so you can adjust your raw material and finished product inventory levels accordingly.
4. Find ways to boost sales and reduce returns
Predicting demand accurately is only one aspect of managing inventory levels–what about the part where you focus on generating more demand? To maximize your revenue, you need to work on two aspects of the sales process. The first is the actual sale itself. The second aim should be to minimize returns. The following tips will help you achieve this goal.
a. Consider investing in any relevant marketing activities required to increase the visibility of your products. In addition to a well-optimized website or mobile app, social media platforms, email, and paid ads are also some great ways for e-commerce businesses to effectively reach their target audience.
b. Make sure that the quality of your products is top-notch. This will help increase customer satisfaction and loyalty, which will, in turn, result in improved customer retention and repeat sales.
c. Ask your customers for feedback and use it to improve your products and services. Take appropriate steps to make them feel seen and heard. Take meaningful action based on their feedback. Provide excellent after-sales service and support to further ensure that your customers feel valued and appreciated.
d. Work on a pricing strategy that will favor not just you but also your customers. Implementing smart pricing techniques such as competitive pricing, bulk discounts, product bundling, and free shipping can help attract more customers, gain their loyalty, and increase sales manifold.
e. Invest in a reliable third-party logistics (3PL) provider who you can trust enough for order fulfillment. A smooth and timely delivery, with the added guarantee that every product will reach your customer in tip top shape, can greatly improve customer satisfaction and reduce the likelihood of returns.
5. Negotiate better prices from suppliers
Convincing your suppliers to give you lower prices can contribute significantly towards a good inventory turnover rate. By reducing the actual cost of goods sold and minimizing holding costs, you get a chance at more competitive pricing, improved cash flow, increased profitability, and, in conclusion, a better turnover ratio.
Building long-term relationships with your suppliers can be a great way to get some financial favors. When you have strong relationships with your suppliers, you can work towards mutually beneficial contract terms. Also, it’s important to stay on good terms with every supplier you do business with so that you can turn to any of them in times of need. Having backup options is essential if you want to avoid crises such as stockouts.
To negotiate better prices, you can also consider buying in bulk, which can get you some great volume discounts. However, there needs to be a balance between your stock costs and your stock levels. You don’t want to fall into the trap of purchasing more than you need just to get lower prices. It could quickly lead to overstocking and end up hurting your inventory turnover rate instead.
Wrapping up
Given the major significance of a business’s inventory turnover ratio, it’s important to ensure that this figure lies within desirable ranges for your business. The two main components of turnover calculation are cost of goods sold and average inventory. These, on their own, might not mean much to a business. But coupled together, they could give you some valuable insights into your business’s sales, cost-efficiency, profitability, and overall performance and success.
Thus, it’s important to optimize your turnover ratio, for which we suggest adopting five effective tips. Our recommendations include investing in an inventory management system, adopting lean manufacturing practices, not ignoring sales data, choosing appropriate marketing channels, and building strong bonds with your suppliers.
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