Every retailer knows how important (and challenging) inventory management is. It’s especially important for ecommerce retailers as stock sold online has the potential to move much faster than that in brick and mortar stores. It can be purchased 24/7 from all over the world.
When you manage your inventory well, it can lead to overall long-term success for your store. That’s why it’s important to understand key inventory metrics and what they mean. In this post, we’re going to take a closer look at what inventory turnover ratio is and how it affects your business.
What is Inventory Turnover?
To put it simply, inventory turnover is how many times stock is sold or repeatedly used in a specific amount of time, usually a year, depending on your business needs.
In other words, it’s the ratio of sales made to inventory that is held in stock. The ratio is calculated using the cost of inventory, but here is a simpler example using just units in the calculation.
Example: If your store sold 100 units over the course of the year, and you had an average of 100 units in stock during that year, then your inventory turnover ratio would be 1:1, which would be stated as 1. You could also say that you had one inventory turn or you turned over your inventory once.
That’s a fairly simple example. Let’s look at another one:
Example: Let’s say you sold 400 units, and still kept an average of 100 units in stock. The inventory turnover ratio would be 4. This tells us that you purchased and sold a lot of inventory throughout the year.
The inventory turnover ratio is just one number, but it’s one that can tell you a lot about how your inventory is moving through your store over the course of the year. Once you know your ratio, you can compare it to industry averages and see how your store is performing.
Typically, a low inventory turnover ratio indicates that your sales are low, and you have excess stock that isn’t moving. Conversely, a higher inventory turnover ratio indicates stronger sales (or large discounts), and that your inventory is selling quickly.
How is Your Inventory Turnover Ration Calculated?
The formula for calculating your inventory turnover rate involves two variables, your cost of goods sold (COGS) and average inventory (AI). Let’s look at how to get those two variables before we get to the inventory turnover ratio calculation.
Cost of Goods Sold
Cost of goods sold (COGS) is essentially the total expense, or costs, associated with obtaining your inventory. This can be a complicated calculation depending on your business and your products, because there are often many different expenses to consider. To simplify the process, you can also use figures from your balance sheet (at the beginning and end of the time period you’re using) to calculate your COGS:
COGS = Beginning Inventory + Net Inventory Purchases – Ending Inventory
Here’s an example:
If beginning inventory was $100,000, and there were net purchases of $200,000, and ending inventory was $140,000, then the COGS will be:
COGS = $100,000 + $200,000 – $140,000 = $160,000
This calculation is fairly straightforward, it’s the average of the beginning inventory and ending inventory for the designated period:
Average inventory = (Beginning Inventory + Ending Inventory) ÷ 2
Continuing with the above example, your average inventory calculation looks like this:
Average inventory = ($100,000 + $140,000) ÷ 2 = $120,000
Inventory Turnover Ratio Calculation
Now that you know how to obtain your COGS and AI, you’re ready to calculate your inventory turnover ratio by using the formula:
Inventory turnover ratio = COGS ÷ Average Inventory
Let’s finish the example:
Inventory turnover ratio = $160,000 ÷ $120,000 = 1.34
So, you can see that the inventory turnover ratio in our example is 1.34.
As we mentioned before, the higher the inventory turnover rate, the better the business is doing. However, to determine where your ratio should be, it’s important that you do a little homework and check industry averages. One business type may be healthy with a ratio between 2 and 4, while others are good between 4 and 6.
Why Does Inventory Turnover Matter?
Now you know how to calculate your inventory turnover ratio, but you may be wondering why it’s so important. Here are some reasons that you should definitely pay attention to your inventory turnover ratio:
- You’ll know how quickly your inventory is moving and whether you need to liquidate any excess
- You’ll know how you compare to industry averages
- You’ll have one of the most important measurements of overall store performance
- You’ll have a big-picture view of your business’ overall sales performance
- You’ll gain valuable insights into how your business manages inventory, costs, and sales
Effective Inventory Management is Essential
The key to having an optimized inventory turnover ratio is having an effective solution for your inventory management.
There are different software solutions that will help you manage your online store’s inventory, orders, costs, and sales, as well as providing you with reporting that make it easy to understand how your business is performing. To get started, here’s a great guide on how to find the perfect inventory software.