Would you like to know if your organization’s inventory management system is running as efficiently as possible? You don’t have to go by gut feelings or opinions, but you can actually use hard data to track your performance over time. A good way to start is by measuring your annual inventory turnover ratio. Much like the Boy Scouts of America, your company’s inventory should do several good turns annually!
We will discuss what an inventory turnover ratio is, how to tell if your ratio is healthy or not, and how to improve it.
What Is an Inventory Turnover Ratio?
Total cost of goods sold in one year / Average total cost of inventory on hand in that year = Annual inventory turnover ratio
The reason you should calculate the inventory turnover ratio on an annual basis instead of just doing a single month or even a couple of months is because many companies experience seasonal changes in demand. Some products are more popular in the winter or summer, so it’s important to level the playing field by measuring the whole year and not just a quarter or month.
If you were to just use data from a half a year or less, you could end up with a skewed figure that is not reflective of the true figure. And this can wreak havoc with your plans, such as deciding how much inventory to carry. For example, if you come up with an inventory turnover ratio that is quite high, you might think you are not carrying enough products on hand to handle such a high volume of sales. But if that inventory turnover ratio comes from the busiest part of the year, you could be working off faulty data and you will wind up increasing your carrying costs and getting stuck with a lot of inventory that can’t be moved as quickly as you would like.
The opposite can also happen. If your inventory turnover ratio is taken from a few months where it appears to be extremely low, you might consider cutting your inventory levels drastically. However, this could just be the result of a low seasonal trend that only lasts a few months of the year. Thus, you would most likely experience severe shortages the rest of the year by making a decision based on data from such a limited date range.
In either case, you’re better off sampling as much data as possible, so it is best to take into account sales and inventory data from the whole year to balance the picture and make sure nothing is missed.
Fishbowl has an inventory control tool that will calculate this ratio for you. As you go about your business inputting orders into the system, it records everything and it can generate detailed reports showing you what your inventory turnover ratio is over a specified period of time. This can help you track your progress and make plans for the future.
What Is a Healthy Inventory Turnover Ratio?
An inventory turnover ratio of 1 means that you sold every item in your inventory once during the year. This would be considered quite low in virtually any industry. In most cases, the higher the inventory turnover ratio the better. However, you should try to find the balance between too low and too high of a ratio because both can lead to trouble.
Too low a ratio means that you might have too much inventory on hand and you’re risking product spoilage or obsolescence. Too high a ratio means you might be understocked and you risk product shortages and unhappy customers.
A healthy ratio is dependent upon your industry. Grocers and food producers want to turn their inventory over dozens of times a year to ensure they are selling products before they reach their expiration dates. Mattress producers and car sellers probably have a different idea of a healthy ratio because their products have a higher cost and markup. Makers of computers and other electronic devices face a unique challenge of attempting to meet demand while also avoiding the problem of having too many old models on hand when a new model debuts.
The reason it’s so difficult to pin down an exact number for the right inventory turnover ratio is because it depends on so many factors:
- The nature of your products, including their size and expiration date.
- Your relationships with your vendors.
- The needs and expectations of your customers.
- The capacity and number of your warehouses.
- And many others.
But don’t worry. There is hope because even if we can’t pin down an exact number that we are aiming for, the dirty little secret is that the inventory turnover ratio is simply the byproduct of a lot of smart ordering decisions that are all under your control. We will discuss how to optimize your inventory turnover ratio next.
How Do You Improve Your Inventory Turnover Ratio?
You should improve your inventory turnover ratio because doing so allows you to make the most of your warehouse space, keep carrying costs low, avoid shortages, and get good deals from your vendors. A good way to do this is to set up automatic reorder points on all of your inventory items. When a product’s quantity in stock gets too low, you will be alerted that it is time to order more of it. By doing this, you will avoid all of the pitfalls of overstocking or understocking, and your inventory turnover ratio will naturally climb or fall to its ideal level.
Use Fishbowl’s inventory control software to help you improve your inventory turnover ratio. Fishbowl offers a number of customizable reports and other tools to help small businesses successfully manage their inventory. Schedule a demo of Fishbowl today.
You might be surprised by what turns up when you run an annual inventory turnover ratio!
Robert Lockard is a copywriter with Fishbowl. He writes for several blogs about inventory management, manufacturing, QuickBooks, and small business. Fishbowl is the #1-requested manufacturing and warehouse management software for QuickBooks users. Robert enjoys running, reading, writing, spending time with his wife and children, and watching movies.