To effectively manage a company’s pricing strategy, supplier relationships, promotions, and product lifecycle, it’s important to have a good understanding of what products are selling well and how quickly they’re selling. The inventory turnover ratio holds crucial information that can guide a company’s inventory management, forecasting, sales, and marketing efforts.
The term “inventory turnover” refers to the length of time between when company purchases and sells an item. If the company sells all the purchased stock, excluding items lost to damage or shrinkage, it has completed one turnover of inventory.
The number of inventory turnovers per year can vary depending on the industry and product category of a company. Consumer packaged goods, for example, tend to have high turnovers, while luxury goods have a low turnover, due to long production times and low unit sales.
What is Inventory Turnover Ratio?
The inventory turnover ratio measures the number of times a company has sold and replaced its inventory within a specific timeframe. To get the inventory turnover ratio, the cost of goods sold (COGS) is divided by the average inventory:
Cost of Goods Sold / Average Inventory = Inventory Turnover Ratio
Before calculating the inventory turnover ratio, though, you must first calculate the average inventory in a given period. You can get this value by dividing the sum of your beginning and ending inventory by two.
(Beginning Inventory + Ending Inventory) / 2 = Average Inventory
The formula for inventory turnover ratio can also be used to determine how many days it will take to sell the current inventory. A low inventory turnover ratio can indicate weak sales or overstocking. It may suggest issues with a company’s merchandise strategy or insufficient marketing efforts.
If a company has a high inventory turnover ratio, it indicates that they have good sales. However, it could also indicate that the company does not have enough inventory. It’s better to have the problem of making sure there’s enough inventory to support sales than reducing inventory because of poor business.
If a low inventory turnover ratio is due to an increase in inventory before a supplier price hike or increased demand, it can be beneficial during inflation or supply chain disruptions. During the COVID-19 pandemic, the retail industry experienced a sharp decline in inventories, which made it challenging to meet demand during the subsequent recovery phase.
Why is the Inventory Turnover Ratio Important?
By calculating and tracking inventory turnover, businesses can make better decisions in areas such as pricing, manufacturing, marketing, purchasing, and warehouse management.
Ultimately, the inventory turnover ratio measures the effectiveness of a company in generating sales from its stock. It’s a critical measure of a business’s performance, as companies that can turn inventory into sales faster can outperform competitors. This means that customers will likely return — as opposed to a store that holds stock in its inventory for extended periods.
If you have a low ratio, consider analyzing your inventory to find out the reason. Is your competitor’s price lower? If so, review your pricing strategy. Is the demand for these products decreasing in the market? Then you may need to adjust your stock mix.
Additionally, if inventory is piling up and your purchasing strategy is no longer working, you might want to alter it to avoid having too much capital tied up in your inventory. A low ratio may also indicate underperforming salespeople, which means that you might need to invest in training or hire additional manpower.
How Do You Improve Your Inventory Turnover Ratio?
Finding and maintaining a healthy inventory turnover ratio helps 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 by implementing and using a strong inventory management system, particularly one that allows you to set up automatic reorder points on all of your inventoried items.
When a product’s quantity in stock gets too low, you will be alerted that it is time to order more. By doing this, you can overstocking or understocking, and your inventory turnover ratio will naturally climb or fall to its ideal level.
If you are interested in learning how Fishbowl’s flexible inventory management solution can help your business now, you can book a demo.