What Is Inventory Turnover Ratio?

Inventory turnover ratio definition

What is inventory turnover? Inventory turnover is a value that shows how often your inventory turns over or moves, measuring how fast companies sell products. Ultimately, it's the number of times you replace your inventory compared to the cost of the stock over a period of time.

Inventory management is crucial because mistakes can affect your inventory turnover ratio, including a slower-than-usual supply chain, overstocking, and changes in customer demand. The inventory ratio will explain how many times you sold and replenished inventory to help you understand mistakes made during the management process, changes in consumer buying habits, and more.

How can inventory turnover ratio help your company?

Knowing your inventory ratio can improve your business in several ways. Most importantly, your inventory turnover ratio can help you make better business decisions in terms of pricing, manufacturing, marketing, and warehouse management.

For example, if your inventory isn't turning over and people aren't buying your products, it could indicate that your prices are too high or too low, depending on current market conditions. In addition, it may also mean you're not effectively marketing products, so your customers don't know you have inventory in stock to purchase.

Your inventory turnover ratio tells you how many sales you generate from the products in your warehouse, giving you a baseline number to help you determine new ways to improve your ratio and increase online sales.

Most companies should strive for a high turnover ratio since it reduces the costs associated with storage. If you rent your storage space from another company, you can decrease how much you spend monthly on inventory that hasn't moved. Meanwhile, owning your warehouse means freeing up space for faster-moving products that increase your bottom line.

On the other hand, a low inventory turnover ratio means your products aren't selling or you're carrying too much inventory at one time, which can be expensive. In addition, a slow turnover can indicate a change in consumer behavior, such as a decrease in market demand. You may consider updating your pricing to reflect new consumer behaviors if this is true.

Ultimately, your inventory turnover ratio can give you insight into your business. Additionally, your inventory affects the growth of your business, so you should know your turnover ratio and brainstorm ways to improve it.

How to calculate inventory turnover ratio

The inventory turnover ratio formula divides the cost of goods sold (COGS) by the average inventory.

• The cost of goods sold is the cost associated with producing goods, such as material supplies, paying employees to produce them, and so forth.
• The average inventory is the value of your stock in a certain period.

The easiest way to calculate your inventory turnover ratio is by choosing a set timeframe, such as a month, quarter, or year, to give you insight into your business throughout a specific period. Then, you can compare more granular metrics to help you determine why your turnover ratio changed.

It's a good idea to calculate your turnover ratio every month, quarter, and year to give yourself an idea of different patterns that can affect your bottom line. For example, you may find you have a higher turnover ratio during the holidays, so you'll need to purchase or produce more products around those months. Meanwhile, your inventory turnover ratio may be lower during certain times of the year, so you could save money by having fewer products on hand.

In addition, if you notice your inventory ratio decreasing over time, you can start to brainstorm why it's happening by seeing when it started and for how long it has decreased.

Inventory turnover ratio example

If you've never calculated your inventory turnover ratio, we've put together a sample calculation to get you started.

Let's say you're measuring your inventory ratio over a period of one quarter.

If your COGS is $50,000 with $20,000 in average inventory, you'll find your inventory turnover ratio by dividing $50,000 by $20,000.

You can also use the inventory turnover ratio formula to find the average length of time it takes you to move the inventory you have on hand.

To find the average number of days it takes to sell your products, you'll divide 365 (the number of days in a year) by 2.5 (your turnover ratio) to obtain a value of 146. This means it takes your business an average of 146 days to move your inventory.

Low vs. high inventory turnover ratios

Inventory rates vary by industry. However, once you calculate your ratio, you'll have a baseline to compare against your competitors.

A high inventory turnover ratio means you're turning your inventory quickly. As a result, it's not spending too much time on the shelf, and you're earning a regular profit. This indicates the products you're selling are in high demand.

Conversely, a low inventory rate indicates that your products are in low demand. Ultimately, your products are taking too long to sell to consumers. If you have a low inventory ratio, you'll need to figure out what's causing it, especially if it's changed over the course of a few months.

What is a good inventory turnover ratio?

Different industries have different standards for what constitutes a good inventory turnover. However, low-margin industries tend to have higher turnover ratios in general because their products cost less, so more people are willing to buy them. However, low-volume, high-margin industries have lower turnover ratios because fewer people purchase them.

For example, a company that sells popular pet food is likely to have a high inventory turnover rate compared to one that sells high-end automobiles. However, even companies in the same industry can have different turnover ratios, and they could be considered healthy or good for those companies. Say you have two companies that sell bed sheets. Company A sells bed sheets made out of cotton. They're good quality but not the best on the market. Company B sells premium bedsheets made from higher-quality materials. They're expensive but more luxurious.

Which company do you think would have the higher turnover ratio? If you guessed company A, you're correct. However, a higher turnover ratio doesn't mean they're making more money than company B because company B's products are priced higher.

Inventory management depends on an understanding of different metrics. While your inventory turnover ratio is important, there are other things you should focus on. Essential metrics to know and keep an eye on include profit margin and customer spending habits.

Ways to improve your inventory turnover ratio

While inventory turnover ratios vary by industry and business type, your goal should be to increase it to help move products faster and boost your sales. Here are a few ways to improve your turnover ratio:

Streamline your supply chain

The clock begins as soon you start producing a product or purchasing it from a supplier, and the longer you own the product without selling it to a customer, the more money you lose. Streamlining your supply chain to get products into your inventory faster means selling them more quickly.

Adjust your pricing

Product marketing is all about finding the right price points to increase sales. While your pricing doesn’t always impact your inventory turnover ratio, it could affect how fast you're able to move products. If your pricing is too high, customers won't purchase your merchandise, so reducing the price may help products move faster, especially if they've been sitting in your inventory for a while.

Improve forecasting

By using inventory management software, you can improve your forecasting through data tracking to determine when you need to order more merchandise based on how fast you can sell it. In addition, specialized software can perform some complicated calculations to help you predict the right times to restock.

Stock up on popular products

Stocking up on popular, must-have products can help you sell faster to your target audience. This ensures you can make sales regularly instead of carrying excess inventory.

Offer discounts on excess inventory

You can adjust your pricing on items that take too long to sell by offering massive discounts to get your inventory moving again. For example, if you need to clear last year's inventory, you can offer exclusive deals to customers.

Key takeaways: Using inventory turnover ratios at your business

Your inventory turnover ratio is a reflection of your organization's health. If your ratio is too low, it means you're not turning the product around fast enough. Performing competitive research and market research can help you find the right price points to improve your turnover rate. You can also improve your e-commerce marketing to ensure customers know about the products you have to offer.

Mailchimp makes it easy to improve your inventory turnover ratio by providing you with the tools necessary to convert website visitors into paying customers. Use the website builder to create a website that sells or automate abandoned cart emails to bring consumers back to your website.