How to Calculate Inventory Turnover
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Originally Posted On: https://britecheck.com/blog/how-to-calculate-inventory-turnover.html
Definition, Formulas & Examples
Your inventory management practices have a significant impact on your business’s long-term success. The better you are at holding stock that can fulfill demand and sustain growth and still leave enough free working capital for daily operations and projects, the more likely your company will prosper.
However, keeping inventory levels at optimum is easier said than done. With unpredictabilities like market trends, raw material price fluctuations, and especially today’s pandemic-related shakeups, it is virtually impossible to maintain a 100% accurate inventory efficiency. Nevertheless, you can get satisfyingly close to this number if you fully understand stock management’s fundamental concepts. One of these fundamentals is inventory turnover.
In this article, we dive deep into inventory turnover, uncovering what it is, the role it plays in inventory management, and most importantly, what you can do to improve it.
What is inventory turnover?
Put simply, inventory turnover is the ratio between sales and current stock. Also known as inventory turn, this ratio is derived by dividing the cost of goods sold by the average inventory value. With this result, a business can calculate how many times it has sold and replaced inventory over a given period.
Inventory turnover’s primary purpose is to show you how well stock moves through your business. With that information, you can determine:
● Whether you stock less or excess inventory relative to what you use or sell.
● How often you restock and move inventory
● If you make correct purchasing choices based on customer demand
● The effectiveness of your marketing efforts.
Understanding inventory turnover can be a promising first step to achieving effective stock management. It gives you the answers to crucial questions regarding your stock and capital and makes you more confident when making critical business decisions.
Calculating inventory turnover
An inventory turn formula has two elements – current inventory and sales. So, the first step to calculating the ratio is determining your average inventory and the cost of goods you have sold over a particular period of interest, such as fiscal year, quarter, or month.
Average inventory is the average value of your company’s stock over a set period. If you use an inventory management tool like Britecheck, you can accurately determine this average by retrieving your opening and closing inventories from the app. With this data, you can easily calculate the average by adding your opening and closing inventory value and dividing the result by two.
Average inventory = (Opening inventory balance + Closing inventory balance)/2
For example, if your opening stock value is $100,000, and the closing value is $150,000, your average inventory is $125,000.
Cost of goods sold (COGS)
The cost of goods sold, also called the cost of sales, is a calculation of all the expenses that went into selling your products during the period in question. A simple determination is taking the inventory value at the period’s beginning, adding all the purchases you made, and subtracting the inventory value at the period’s end.
So, if your opening stock value was $100,000, the purchases made totaled $500,000, and your closing value was $150,000. Your COGS for that period was $450,000.
In addition to inventory turnover, COGS is also popularly used to calculate gross and net income. Gross income is gross revenue without COGS, while net income is gross revenue without COGS and expenses.
Now that you have both average inventory and the cost of sales, you can determine your inventory turnover ratio.
Inventory turnover ratio = Cost of goods sold / Average inventory.
Inventory Turnover Example
Say, in the dreadful 2020, your average inventory value was $100,000, calculated from the average of your opening and closing stock. Meanwhile, the cost of goods you sold was $150,000, including expenses like inventory purchases, warehouse costs, and direct labor expenses.
$150,000 / $100,000 is 1.5, which means in 2020, your inventory turn was a miserable 1.5. COVID-19 indeed took its toll.
Using the inventory turnover ratio for better stock management
An inventory turnover ratio that is too low or too high indicates ineffective inventorying. Low inventory turnover proves your stock is not moving as fast you would like, and your business is losing money because of having to hold inventory for longer than necessary. This lost revenue can be in the form of excess labor, storage facilities, or insurance charges. Moreover, you may have to discount or discard products that are nearing expiry.
On the other hand, high inventory turnover means your product is selling quickly, and your inventory is holding less working capital. If you deal with perishable products like foodstuff and flowers, a high turnover means you are losing little from stock expiries.
However, when your inventory turn is too high, it can signal that your business is struggling to keep up with demand and even losing out on potential sales. Even a slight disruption in your supply chain can lead to delayed or unfulfilled orders and cost you valuable clients. So, although business owners typically aspire to have a reasonably high turn, you may want to stock up a bit more to maintain a healthy inventory buffer for sustained growth.
What is the right inventory turnover?
The ideal inventory turn ratio entirely depends on your industry. Different sectors have varying products and sale seasons. For example, if you sell Christmas merchandise, you can shoulder a lower turn in October and November in readiness for the demand spike in December.
That said, inventory turn is generally considered favorable if it lies between five and six. A five indicates strong stock management that sustains both demand and a short stock shelf-life.
How to improve your inventory turnover
Calculating inventory turnover is of no use if you do not work to achieve the ideal ratio. Improving your turnover can make your stock management more efficient, reduce your storage costs, and boost profits.
Achieving the right inventory turn means being in constant control of both your inventory and cost of sales. It requires proper forecasting to determine when your demand peaks and drops, and effective marketing and smart pricing to keep your inventory moving. You must also adopt a restocking model that guides you to stock fewer quantities of fast-moving items that your supplier can deliver with a short lead time.
Additionally, keep a close eye on old stock and implement a firm first-in-first-out sale strategy. If you get stuck with some slow-moving stock, offer discounts and promotions to move it out quickly and get your inventory turnover back to normal.
Most effectively, ensure you have an inventory management system that supports your inventory turnover goal. With a mobile-based inventory app like Britecheck, you can monitor products as they move in and out of your store, right from the palm of your hand. These apps also give you real-time analysis, along with automated messages that tell you when your stock levels fall out of line. That way, you can take timely measures to adjust your inventory turnover.