Original source: Oracle Netsuite

Inventory Turnover Ratio Defined: Formula, Tips, & Examples

Sometimes a product flies off the shelf. Other times, you can’t discount deeply enough. Generally, however, items drift along somewhere in the middle, meaning all companies need a handle on what’s moving and how quickly. That inventory turnover calculation informs everything from pricing strategy and supplier relationships to promotions and the product lifecycle.

Turnover ratio also reveals a lot about a company’s forecasting, inventory management and sales and marketing expertise. A high ratio implies strong sales or insufficient inventory to support sales at that rate. Conversely, a low ratio indicates weak sales, lackluster market demand or an inventory glut.

Either way, knowing where the sales winds blow will inform how to set your company’s sails.

What Is Inventory Turnover?

Inventory turnover refers to the amount of time that passes from the day an item is purchased by a company until it is sold. One complete turnover of inventory means the company sold the stock that it purchased, less any items lost to damage or shrinkage.

Successful companies usually have several inventory turnovers per year, but it varies by industry and product category. For example, consumer packaged goods (CPG) usually have high turnover, while very high-end luxury goods, such as luxury handbags, typically see few units sold per year and long production times.

A number of inventory management challenges can affect turnover; they include changing customer demand, poor supply chain planning and overstocking.

Key Takeaways

• Inventory includes all goods, raw or finished, that a company has in stock with the intent to sell.
• Inventory turnover is the rate that inventory stock is sold, or used, and replaced.
• The inventory turnover ratio is calculated by dividing the cost of goods by average inventory for the same period.
• A higher ratio tends to point to strong sales and a lower one to weak sales. Conversely, a higher ratio can indicate insufficient inventory on hand, and a lower one can indicate too much inventory in stock.

What Is Inventory Turnover Ratio?

The inventory turnover ratio is the number of times a company has sold and replenished its inventory over a specific amount of time. The formula can also be used to calculate the number of days it will take to sell the inventory on hand.

The turnover ratio is derived from a mathematical calculation, where the cost of goods sold is divided by the average inventory for the same period. A higher ratio is more desirable than a low one as a high ratio tends to point to strong sales.

Knowing your turnover ratio depends on effective inventory control, also known as stock control, where the company has good insight into what it has on hand.

Inventory Turnover Ratio Explained

Calculating and tracking inventory turnover helps businesses make smarter decisions in a variety of areas, including pricing, manufacturing, marketing, purchasing and warehouse management.

Ultimately, the inventory turnover ratio measures how well the company generates sales from its stock. number of KPIs that can provide insights into how to increase sales or improve the marketability of certain stock or the overall inventory mix.

How Inventory Turnover Ratio Works

Average inventory is typically used to even out spikes and dips from outlier changes represented in one segment of time, such as a day or month. Average inventory thus renders a more stable and reliable measure.

For example, in the case of seasonal sales, inventories of certain items — like patio furniture or artificial trees — are pushed abnormally high just ahead of the season and are seriously depleted at the end of it. However, turnover ratio may also be calculated using ending inventory numbers for the same period that the cost of goods sold (COGS) number is taken.

Lastly, the formula can also be used to calculate how much time it will take to sell all the inventory currently on hand. Days sales of inventory (DSI) it is calculated like this for a daily context:

(Average inventory / cost of goods sold) x 365

How to Calculate Inventory Turnover Ratio (ITR)?

Companies can calculate inventory turnover. This standard method includes either market sales information or the cost of goods sold (COGS) divided by the inventory.

Start by calculating the average inventory in a period by dividing the sum of the beginning and ending inventory by two:

Average inventory = (beginning inventory + ending inventory) / 2

You can use ending stock in place of average inventory if the business does not have seasonal fluctuations. More data points are better, though, so divide the monthly inventory by 12 and use the annual average inventory. Then apply the formula for inventory turnover:

Inventory Turnover Ratio = Cost of Goods Sold / Avg. Inventory

Inventory Turnover Formula and Calculations

Whatever inventory turnover formula works best for your company, you will need to draw data from the balance sheet, so it’s important to understand what these terms and numbers represent.

Cost of Goods Sold (COGS)

Cost of goods sold, aka COGS, is the direct costs of producing goods (including raw materials) to be sold by the company.

Average Inventory (AI)

Average inventory smooths out the amount of inventory on hand over two or more specified time periods.

Beginning Inventory + ending inventory / number of months in the accounting period

Inventory Turnover Ratio

The inventory turnover ratio is a measure of how many times the inventory is sold and replaced over a given period.

Inventory Turnover Ratio = Cost of Goods Sold / Avg. Inventory

Inventory Turnover Ratio Examples

Cherry Woods Furniture is a specialized supplier of high-end, handmade dining sets made from specialty woods. Over Q3, its busiest period, the retailer posted $47,000 in COGS and $16,000 in average inventory. To find the inventory turnover ratio, we divide $47,000 by $16,000. The inventory turnover is 3.

In the second example, we’ll use the same company and the same scenario as above, but this time compute the average inventory period — meaning how long it will take to sell the inventory currently on hand. We already know the inventory turnover ratio is 3. To calculate how many days it will take to sell the inventory on hand at the current rate, divide 365 days in the year by 3, which equals 121.67 days.

Why Do Inventory Turns Matter?

Inventory turns matter for several reasons. A slow turn can indicate decreased market demand for certain items, which can help a company decide to change pricing, offer incentives to deplete inventory faster or change the mix of goods offered for sale in the future. These are all important decisions — for a company to remain financially healthy and competitive, it needs to keep its product mix aligned with customer demand.

A fast turn may indicate that a company’s purchasing strategy is not keeping pace with market demand, that it’s experiencing delays somewhere in the supply chain or that a particular item is seeing a surge in demand. This information can help a company decide whether to raise prices, increase its orders, diversify suppliers, feature a product prominently in its marketing or buy additional related inventory.

Material requirements planning, or MRP, is a related process to understand inventory requirements while balancing supply and demand.

What Is the Best Inventory Turnover Ratio?

In general, the higher the ratio number the better as it most often indicates strong sales. A lower ratio can point to weak sales and/or decreasing market demand for the goods.

However, there are exceptions to this rule. For example, high-end goods tend to have low inventory turnovers. A farmer doesn’t need to purchase a new tractor annually, and most people aren’t scooping up designer jewelry on a whim.

A ratio that is too high, however, is self-defeating. It may mean your company isn’t purchasing enough inventory to support the rate of sales. Or, you may not be realizing as much profit as you could — see if inching up pricing stabilizes the ratio while also improving your unit margins.

Differences in Inventory Turnover by Industry

High-volume, low-margin industries tend to have high inventory turnovers. Conversely, low-volume, high-margin industries tend to have much lower inventory turnover ratios.

For example, Super Coffee more caffeinated beverages at lower prices and lower margins than a specialty supplier like Kali Audio professional-style loudspeakers and monitors for recording studios at higher margins in the same accounting period.

Retail inventory management is part art, part science and demands an understanding of sales patterns, profit margin, seasonality and other factors. In many cases, retailers use a vertical-specific inventory method, known as cost-to-retail, that estimates the ending inventory value by using the ratio of inventory cost to the retail price.

What Should I Do About a Low Inventory Turnover Ratio?

A low ratio needs some inventory analysis to discover the cause. Are competitors offering a lower price? Then revisit your pricing strategy. Is market demand for these goods fading? Then a new stock mix is probably in order. Is the purchasing strategy no longer working and inventory is piling up? Then consider adapting your purchasing policy and processes accordingly to prevent tying up too much capital in inventory.

Are salespeople underperforming? Consider training to address the way purchasing decisions are now made, or stress the need for sales leaders to come to the table with realistic, not overly optimistic, projections.

Why Is a Higher Inventory Turnover Ratio Better?

Generally, a higher ratio is better because it means strong sales are depleting your stock at a rapid pace. That’s good news for your company, right?

Maybe. It could also mean a surge in popularity of these goods — increased market demand, in other words — so you may want to increase your orders to suppliers before your competitors buy them out. However, it could also mean you’re not buying enough inventory or you lack supply chain visibility, which is limiting the sales you can make. That spells opportunity, if you can increase your stock of popular items.

Can Inventory Turnover Ever Be Too High?

Yes, it can. If the inventory ratio is too high, meaning somewhere in the double digits, then your company is limiting its revenue by curtailing sales to fit a too-small inventory supply. It usually takes time for new stock to arrive and be placed in the sales cycle. That’s lost time and lost opportunity, too.

Aim to increase inventory purchase amounts to bring your ratio down to a more moderate, and profitable, range.

Ideal Inventory Turnover Ratio

For most industries, the ideal inventory turnover ratio will be between 5 and 10, meaning the company will sell and restock inventory roughly every one to two months. For industries with perishable goods, such as florists and grocers, the ideal ratio will be higher to prevent inventory losses to spoilage.

How Else Can Inventory Turnover Ratio Be Used?

Inventory turnover ratios are used in several ways to improve inventory management, pricing strategies, supply chain execution and sales and marketing, among other company success factors.

Here are three common uses:

Turnover trends

Inventory turnover ratios are an effective way to spot both emerging trends driven by market demand and obsolete, or slow-moving, inventory. That way you can get an early and important clue on whether to scale up or down on any product line or brand. This gives you much better control over inventory and a better harvest of sales opportunities.

Segments and SKUs

Inventory turnover is typically measured at the SKU (stock-keeping unit) level, or segment level for tighter controls on specific stock levels. Inventory segmentation refers to segmenting, or classifying, SKUs based on metrics that make sense for your business. As an example, a retailer might group categories to see how products are performing against others in your portfolio.

Alternatively, inventory turnover can also be used at an aggregated level, where you bundle disparate items by, for example, geographic location of retail outlets.

80/20 rule

The Pareto principle applies to a lot of areas in business and life; when it comes to inventory, it means 80% of your company’s sales, sales revenues are likely generated by 20% of the SKUs you carry.

Loss leaders — products deliberately and strategically priced to drive little or no profitability — will always be useful to drive customers into virtual and brick-and-mortar stores, where they might be enticed to buy more, or more profitable products, for example. It’s important to know what that stock segment is so you can keep plenty of inventory on hand.

5 Inventory Turnover Optimization Techniques

A primary way to apply inventory turnover ratios in a practical manner is to optimize your inventory management.

Here are five ways you can do that:

1. Streamline the supply chain. Suppliers with the lowest prices may or may not be the best choice. If a product is central to your sales or is seeing a surge in market demand, faster or guaranteed delivery times for those items or vital components may be more important. In any case, streamlining the supply chain to eradicate inefficiencies will benefit your sales, profits and overall margins.
2. Adjust your pricing strategy. Adjust pricing to realize larger margins on items in high demand and to free capital by moving old inventory, also known as dead or obsolete inventory, out. If items just won’t sell, consider donating that stock to charity and taking a tax deduction or offloading it through a secondary channel.
3. Check or change your ranking in your industry. Are your inventory turnovers in line with the rest of your industry? Are there opportunities for you to maneuver a better strategic position on competitive items when you note emerging trends in your inventory ratios? You can grab more market share and increase your ranking within your industry by managing your inventory more strategically.
4. Improve forecasting. Sales numbers and inventory reports supply much needed hard data that make inventory forecasting more accurate. This data can also help with future sales planning, such as suggesting ways to change your product mix or bundle items in creative ways to move slower inventory at potentially a higher margin.
5. Automate purchase orders. Automation adds efficiencies and may cut costs on its own. But when you couple it with an order management system that facilitates reordering of inventory that sells well so that it is always in stock, you net even more wins. Consider using an inventory system that will automatically generate purchase orders for your buyers to review; the result will be better control and fewer errors.

Improving Inventory Turnover With Inventory Management Software

Inventory management software comes with many features that will help you modernize and optimize your inventory management processes and policies. For example, such software enables your company to switch to the perpetual inventory method in accounting with a continuous real-time record of inventory. Computerized point-of-sale systems and enterprise asset management software immediately reflect changes in inventory by tracking sales and inventory depletion or restocking.

Companies that use the perpetual inventory method versus a periodic inventory system can use a moving average inventory to compare mean inventory levels across multiple time periods. Moving average inventory converts pricing to the current market standard to enable a more accurate comparison of the periods.

When combined with an ERP system, inventory management software can help in streamlining your supply chain, SKU assignment and management, automated purchase orders and other functions and features. That will reduce errors, add efficiencies, give you more control, increase customer satisfaction and generally make your company more profitable.