Imagine there’s a product that you just can’t keep in stock. The inventory is turning over faster than you can replenish it.
That sounds like a win, but customers are growing frustrated because it’s rarely in stock and the wait times are getting longer with every stockout. And the stress of scrambling to fill dozens of orders when a shipment arrives is straining your warehouse team.
The solution to this problem is keeping more of this product in stock to lower reorder frequency — but that would harm your inventory turnover ratio, which is currently quite high. You thought that was a good thing, but now, you might not be so sure.
Don’t worry — you’ve come to the right place to untangle this dilemma. In this article, we’ll break down what the inventory turnover ratio is, whether or not there’s an optimal number, and how you can use this metric to better manage your stock. We’ll even explore how inventory management software like Fishbowl can streamline the process and help you calculate your turnover ratio formula with ease.
Inventory turnover ratio: An overview
The inventory turnover ratio is a common key performance indicator (KPI) that measures how many times a business sells and replaces its entire inventory within a given period, typically a year. This metric, also known as stock turn rate or inventory turnover rate, provides insights into how efficiently you’re managing your stock.
A high inventory turnover ratio indicates that your products are selling quickly and capital isn’t sitting idly on your warehouse shelves, while a low ratio could signal issues like overstocking or sluggish sales. But if your ratio is too high, you might constantly run out of a product, leading to stockouts and frustrated customers. Finding the sweet spot depends on your industry and type of product you sell.
Why the inventory turnover ratio is important
The inventory turnover ratio reveals to business owners where they may need to improve efficiency. By understanding your turnover rate, you can optimize inventory control processes, prevent costly stockouts, and ultimately improve your bottom line. Here’s more about why this ratio is so important.
Accurate estimates for stocking
When you don’t know how much product is actually leaving the warehouse, you aren’t sure how much to reorder. Calculating your inventory turnover ratio determines the amount of inventory moving in and out, helping you find a way to maintain safety stock without overstocking.
Reduce expenses
Managing inventory is expensive, from placing orders to storage spaces and wages for warehouse workers. Knowing your inventory turnover ratio helps you avoid spending valuable cash on inventory you don’t need, which in turn saves on a litany of overhead and holding costs. This includes employee wages for relocating or reorganizing stock, costs associated with storage space, and reduced profits when you discount products to avoid dead stock.
Improved cash flow
If a business spends too much revenue on inventory, it risks not having enough money to pay employees, bills, and lenders when items don’t sell. Those reduced expenses that come from strategic reordering turn into more profits for your business.
Keeping track of inventory over time
The inventory turnover ratio can track a company’s performance over time. By comparing one year’s inventory turnover ratio to the year before, business owners can identify any areas where they need to improve efficiency or identify sales trends.
Calculating the inventory turnover ratio
Calculating your inventory turnover ratio is straightforward:
Cost of Goods Sold (COGS) / Average Inventory = Inventory Turnover Ratio
- COGS: The total cost of goods sold during the period. This includes the cost of raw materials, direct labor, and manufacturing overhead.
- Average inventory: The average value of your inventory during the period. (Which time period you use is up to you — it can be a month, years, or any other frequency that makes sense for your business.) To calculate average inventory, add your beginning inventory and ending inventory, then divide by two.
(Beginning Inventory + Ending Inventory) / 2 = Average Inventory
Example:
Let’s say your business had $50,000 in COGS last year and an average inventory value of $10,000:
$50,000/$10,000 = 5
Your inventory turnover ratio would be 5, meaning you sold and replaced your entire inventory five times during the year.
You can also calculate the days sales of inventory (DSI), which tells you how many days, on average, it takes to sell your inventory. The formula is:
DSI = (Average Inventory / COGS) x 365
In our example, the DSI would be 73 days: ($10,000 / $50,000) x 365
Limitations of the inventory turnover ratio
While a valuable tool for assessing inventory efficiency, the inventory turnover ratio has limitations. Remember these factors to avoid misinterpreting your results or arriving at the wrong conclusions:
Seasonal fluctuations
For businesses with seasonal demand, the inventory turnover rate can vary significantly throughout the year. A swimwear retailer, for example, will have a higher turnover rate in the summer months compared to the winter. There could be a spike before the holiday season when people are traveling to warmer climates but an otherwise low demand at that time. Consider these fluctuations when analyzing your inventory turnover ratio and comparing it to industry benchmarks. It might help to analyze your turnover rate over small timeframes, like quarters instead of years, to see how demand fluctuates.
Industry variability
Different industries have vastly different inventory turnover norms. A grocery store, with perishable goods and high sales volume, will have a much higher turnover rate than a luxury car manufacturer. Focus on benchmarking against businesses within your industry.
Cost variations
The COGS is a key component of the inventory turnover ratio formula. But COGS fluctuates due to changes in raw material prices, supplier costs, or currency exchange rates. These variations affect the accuracy of your turnover ratio, so keep these changes in mind when analyzing results over longer periods.
Overlooked carrying costs
While a high inventory turnover rate is generally desirable, it’s important to consider the associated reordering and carrying costs. Carrying costs include storage fees, insurance, taxes, and the potential for obsolescence or spoilage, while reordering might require rush shipping fees.
A very high turnover rate could indicate that you’re ordering small quantities frequently, which might lead to higher shipping costs or missed bulk order discounts. Fewer, larger orders might lead to a lower inventory turnover ratio but higher profits.
Ignoring lead times
The inventory turnover ratio doesn’t account for the time it takes to replenish your stock. If you have long lead times, a high turnover rate could lead to stockouts and lost sales if you don’t plan accordingly. Factor in lead times when managing your inventory levels.
What is a healthy inventory turnover ratio?
A healthy inventory turnover rate measures how efficiently a company sells and replaces its inventory over a period. But there isn’t an ideal turnover ratio. It’s a balancing act that depends on your industry, business model, and product types. Perishable goods like groceries require a much higher turnover rate than durable goods like electronics. To find your sweet spot, analyze your industry benchmarks, historical sales data, and carrying costs.
Having healthy inventory turnover isn’t about achieving the highest possible rate. It’s about finding the ratio that maximizes efficiency, minimizes costs, and keeps your customers happy. Having the right inventory management software — like Fishbowl — can make this process significantly easier by automating calculations, providing sales insights, and streamlining inventory control processes.
Optimizing your inventory turnover ratio
Improving turnover rates is an ongoing process, but here are some actionable tips to help you make the most of your inventory.
1. Refine your pricing strategy
Strategic pricing can significantly impact your turnover rate. Consider offering discounts or promotions on slow-moving items to drive sales and reduce holding costs. And, if certain products are flying off the shelves, test raising prices slightly to increase profit margins on the goods.
Dynamic pricing, where prices adjust based on demand and inventory levels, is also an effective strategy. You might change prices seasonally or review them quarterly to meet market demand.
2. Enhance forecasting
Accurate demand forecasting is key to optimizing your inventory turnover. Leverage historical sales data, market trends, and seasonality to predict future demand more precisely. This helps avoid overstocking and the associated carrying costs while preventing stockouts that could lead to lost sales.
3. Simplify your supply chain
Evaluate your suppliers and consider consolidating to reduce lead times and improve efficiency. Although having multiple suppliers safeguards against some supply chain risks, a streamlined supply chain gets products to market faster and lets you respond more quickly to changes in demand. This can be especially beneficial for perishable goods or items with short life cycles.
Improve your inventory turnover ratio with Fishbowl
Don’t forget the most important tip of all: investing in a robust inventory management software that tracks your stock in real time. And Fishbowl is the perfect solution.
Fishbowl’s cloud-based solution gives you complete control over your stock, providing insights into your turnover rate and sales trends with customizable reports. Plus, Fishbowl seamlessly integrates with QuickBooks for accurate accounting, ensuring your financial records stay up to date as your inventory turns over.
Book a personalized demo to learn how Fishbowl can streamline your operations and help you make data-driven decisions today.
