Inventory Turnover: What is It and How It Is Calculated?
One of the best strategies for strengthening your bottom line and boosting efficiency within your business is to take a closer look at inventory management data. As a whole, metrics like efficiency ratios can help businesses to assess their own performance in using assets effectively. One such efficiency ratio is the inventory turnover ratio. This important metric can help businesses to better understand and, if needed, shift their approach to inventory management.
What Is Inventory Turnover Ratio?
Inventory turnover ratio refers to how quickly a company’s inventory is sold and replaced within a set period of time, such as one year or one month. This financial metric, also called stock turnover or inventory turnover rate, can shed light on how effectively a company is utilizing its assets (inventory) to generate sales.
Why Is Inventory Turnover Ratio Important?
Learning how to calculate inventory turnover ratios and apply your findings to your business operations moving forward can help you make critical decisions. This metric can help shed light on the impacts of poor inventory management that may not have been noticeable before. For example, if a company’s inventory turnover ratio is lower than the industry average, they may need to carry less inventory. In other cases, abnormally high inventory turnover ratios can signal insufficient inventory with a risk of stock outs.
Calculating inventory turnover ratio and making adjustments in your inventory management practices can help you notice and address issues such as obsolete inventory and stockouts. Through this process of evaluation, businesses can better optimize their inventory on hand in order to meet customer demand while avoiding unnecessarily high carrying costs and expiring inventory.
How to Calculate Inventory Turnover
The formula for calculating inventory turnover ratio is as follows:
Inventory Turnover = Cost of Goods Sold (over 12 months) ➗Average Monthly Inventory On Hand
It’s essential to understand each element of this formula in order to come up with the correct calculation. Cost of goods sold (COGS) is also known as cost of sales. This term refers to the amount a company paid for its inventory.
Calculating the average inventory on hand for the denominator in this formula accounts for seasonality effects. To calculate average inventory on hand, add the value at the end of the period (such as the year) to the value at the beginning of the period, and then divide by two. Alternatively, you can average the inventory value at the end of each month of the year to get average inventory on hand.
Factors That Affect Inventory Turnover Ratio
There is no predetermined, one-size-fits-all goal for inventory turnover ratio because a wide range of factors impact inventory turnover. These factors include:
- Industry dynamics: Product perishability, seasonality, customer trends, and other industry-specific aspects all play a role in inventory turnover ratio.
- Sales fluctuations: Many companies use inventory turnover ratio to analyze the success of their sales and marketing efforts. Lower turnover may point to a period of lower sales or a dip in customer demand.
- Inventory management: Companies without a dependable inventory management strategy are more likely to see abnormalities in their inventory turnover ratio. For example, a company may have a high inventory turnover ratio if they experience frequent stockouts, because their average inventory on hand is low. This is not necessarily a positive indicator, since stockouts mean that customer demand is not being met. Similarly, low inventory turnover ratio may mean that a company is carrying too much product, which can hurt their bottom line due to carrying costs and obsolescence.
Limitations of Inventory Turnover Ratio
While the inventory turnover ratio provides valuable insights, it is also important to keep in mind that it does not necessarily capture the entire picture. A few limitations of this metric include:
- Calculation based on COGS: While COGS is an important metric for any business, it does not take into account all aspects of the true cost of inventory.
- Not considering inventory carrying costs: One of the most significant limitations of inventory turnover ratio is that it does not account for carrying costs such as storage expenses, insurance, obsolescence, and more.
- Industry-specific factors: Tracking your own inventory turnover ratio and comparing it to your historical data may help you stay on top of changes and identify their causes. However, because every industry has its own unique characteristics that affect inventory turnover, comparison across industries may not yield accurate analysis.
For even more actionable data, businesses leveraging eTurns TrackStock can use the following calculation:
Inventory Turnover = Usage ➗Average Inventory On Hand, where usage refers to the pulled consumption value.
Because eTurns TrackStock provides daily usage data, users can gain more actionable insights than they could through calculations hinging on COGS.
The eTurns TrackStock app can help companies improve their inventory turnover ratio and lower their inventory carrying costs through helpful inventory optimization tools. For example, using TrackStock’s Min/Max Tuning feature allows businesses to carry the ideal amount of inventory based on their past usage, eliminating stockouts while also avoiding excess carrying costs. Features like these help businesses boost efficiency and save money, which will be reflected in future inventory turnover ratios.
Contact us to learn more about improving your inventory turnover ratio!