How do you track the efficiency and performance of your business, what metric would you use? Are sales over time a good metric? Not really. Looking at sales might tell you the performance of your business but it doesn’t tell you if it is an efficient business. Introducing the metric inventory turnover ratio, which is the number of times a company sells and replaces its stock of goods during a period of time. This metric will help you see how well your business sells and purchases over a period of time.
How To Calculate Inventory Turnover?
For all the new learners, here is a stepwise approach to calculating the inventory turnover ratio.
1. Find the cost of goods sold over the time period. You can get from your balance sheet if you are calculating yearly.
2. Calculate your average inventory value by taking an average of the inventory value at the beginning period and ending time period.
3. Finally, to calculate Inventory Turnover, you can divide the cost of products sold by the average inventory for the same period.
What Inventory Turnover Tells You
Inventory turnover provides insights as to how the company is managing purchase costs and how effective their sales efforts have been. Below are some important interpretations of inventory turn ratios:
1. A higher the inventory turnover indicates good sales i.e company is selling product very quickly and there’s demand for their product.
2. Low inventory turnover, on the other hand, would likely indicate weaker sales and declining demand for a company’s products.
3. Inventory turnover shows how a company is managing stock. Too low means inventory is being purchased over demand and too high means inventory isn’t being purchased enough to meet demand.
4. An inventory turnover maintains checks and balances between sales and purchasing. It prevents excess purchases while fulfilling sales opportunities.
What’s a Normal Inventory Turnover Ratio?
A company’s inventory turnover varies greatly by industry. When making inventory turnover ratio comparison between companies, it is important to take note of the industry, or the comparison will be off.
For example, Retail stores and grocery chains typically have a much higher inventory turn rate since they sell products that will spoil over time. However, companies that manufacture heavy machinery, such as construction equipment, will have a much lower turnover rate since each of product may sell for millions of dollars and are slow moving products.
Companies that manufacture heavy machinery, such as airplanes, will have a much lower turnover rate since each of product may sell for millions of dollars and take an extended period of time to produce and sell. Hardware companies may turn their inventory three or four times a year, while a department store may turn their inventory over six or seven times per year.
To find the ideal inventory turnover ration, compare the inventory turnover rate of a company against your competitors. This will give you insights into the efficiency of each company’s ability to manage inventory, sell and the number of days it takes for a company to sell through its inventory.
How To Improve Your Inventory Turnover Ratio?
Inventory Turnover is used to measure the inventory management efficiency of a business. A higher value of inventory turnover indicates faster inventory movement and less cash tied up in inventory and a lower value means inefficiency in managing inventory levels.
Here are a few steps companies can take to improve inventory turnover:
Improve Forecasting: Understand demand better, talk to your customers, follow industry trends and news, survey your sales reps and analyze past sales data to determine seasonal trends.
Review Pricing Strategy: Analyze what will increase your overall sales. Reducing prices may not be the answer but rather try out different pricing strategies for different customers.
Sell Best Selling Products: Focusing more on best-selling items and pushing sales reps to sell more of your best selling products to increase your overall turnover ratio.
Increase Product Demand: Improve your marketing strategy by designing a targeted and cost-effective marketing campaign. This should result in more sales and more inventory movement.
Now that you have learned what inventory turnover is and how to use it to help your business, you need to use an inventory management system that can help you monitor this ratio, provide insights and help your business run efficiently.