Inventory Turnover Ratio – Formula and Tips for Improvement
The inventory turnover ratio is a good indicator of the performance of your company. Find a balance between sales and stock by using these formulas and tips.
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What is the Inventory Turnover Ratio?
Inventory turnover ratio is the number of times a company depletes and replaces its inventory through sales during an accounting period.
In manufacturing, the inventory accounted for when calculating the inventory turnover ratio includes finished goods, raw materials, and work-in-progress goods.
Inventory turnover is an indicator of the performance of the business – if the inventory turnover ratio is high, then usually goods are sold quickly and the company carries little to no excess inventory; if inventory turnover is low, sales might be weak and there could be a large amount of excess stock.
Thus, it is a reflection of how effectively the company caters to the market, and how efficient it is in inventory management.
There is a balance, however, to be found when managing inventory – if inventory turnover is very high, then it might be an indication of inadequate inventory levels, which could cause missed business opportunities due to not being able to fill customer orders.
Conversely, when the inventory turnover ratio is low, it could signify either low sales or overstocking, both of which will negatively affect your bottom line, the former by not bringing in revenue, the latter by tying up cash that could be used elsewhere.
Therefore, the inventory turnover ratio is also a good indicator of the level of syncing between the sales and procurement departments.
How to Calculate the Inventory Turnover Ratio?
Calculating the Inventory Turnover Ratio is quite simple, provided that you have accurate data available.
Specifically, you will have to know the Cost of Goods Sold (COGS) and the Average Inventory of your company.
The Cost of Goods Sold comprises the direct material and labor, and overhead costs incurred in manufacturing the products a company sells. It does not account for other costs such as those for distribution, marketing and sales, or administrative expenses.
Read more about Calculating the Cost of Goods Sold in Manufacturing.
Average Inventory is used due to companies having different inventory levels during different times of the year – for example, high levels right before holiday shopping, and low levels at the start of the year.
It’s the average value of inventory within a set time period, calculated by taking the arithmetic mean of the starting and ending inventory values.
To get the Inventory Turnover Ratio for a particular accounting period, just divide the COGS with the Average Inventory.
Days Sales of Inventory
Days Sales of Inventory is a similar concept to the Inventory Turnover Ratio, one that measures the days it takes to sell the inventory at hand.
It puts the inventory turnover ratio into an easily comprehensible perspective: how long will it take to sell the goods in stock?
To calculate it, just flip the Inventory Turnover Ratio formula and multiply it by 365.
What is the Ideal Inventory Turnover Ratio?
Generally speaking, there is no universal ideal Inventory Turnover Ratio – the perfect ratio varies industry by industry, product to product.
If you produce fast-moving consumer goods like food or drink items, or other perishables, then your ITR should be much higher than, for example, a company that builds custom furniture.
Even though some sources say the inventory turnover ratio in any given company should be between 4 and 6, some that it should be between 5 and 10, you can find the ideal number for your business only by analyzing your own inventory and sales.
How to improve Inventory Turnover?
Inventory turnover can be improved with many different strategies, which generally fall under the jurisdiction of sales, marketing, inventory, or procurement management. The best results can be achieved, however, by fine-tuning all of the areas at the same time.
1. Collect data and use forecasting
Use an MRP system to collect and analyze data regarding your inventory – about what sells and what does not. This data will allow you to better predict and understand customer trends, develop a better procurement strategy, identify stock that has become obsolete, and increase inventory turns.
Read more about Demand Forecasting and What MRP Software Can Do With It.
2. Develop your marketing strategies
Manufacturers often think that marketing is not for them. But a well-planned and well-executed marketing strategy is a good way to increase sales and inventory turnover. A developed manufacturing brand could increase customer awareness and loyalty. The campaigns should be highly targeted and the marketing costs and the ROI of the campaigns should be tracked.
3. Analyze your inventory
Inventory control techniques such as ABC analysis will help you categorize your SKUs according to their business value. By using the Pareto principle, otherwise known as the 80/20 rule, ABC analysis divides your inventory into three groups, allowing you to designate resources for different SKUs in a more cost-effective manner, and ultimately increase your inventory turnover.
Read more about ABC Analysis in Inventory Management.
4. Optimize your procurement processes
Smart ordering processes can increase profits as well as inventory turnover. By utilizing procurement software and inventory management techniques such as safety stock and reorder point, or Just-in-Time, you can make sure that you do not stock up on excessive inventory, keeping holding costs low and inventory turns high.
Read more about Safety Stock, Reorder Point, and Just-in-Time Manufacturing.
5. Review your prices
The wrong pricing strategy could be the reason behind slow inventory turns. Having regular discounts could temporarily increase inventory movement but be detrimental for the long run as people will get accustomed to waiting for another discount to make the purchase. Instead, do regular analyses of your costs and your prices, of the market situation, of your target group – and adjust your business accordingly. It may be possible to lower prices without making sacrifices in quality and even cut costs at the same time through systematic effort.
Read more about the Cost of Quality and How to Calculate It.
6. Eliminate stale and excess inventory
Products that have sold well in the past do not necessarily sell well forever. That is why you should regularly review your inventory, dispose of stale and slow-selling merchandise with special offers and discounts, and invest the money you made into goods with higher turnover. Excess materials can also be sold back to the supplier – usually, they would be happy to buy them with a discount and sell them to another customer.
The inventory turnover ratio is an important KPI with which to assess the performance of your whole business.
It is a good indicator of how well your company caters to its market, and how well the sales and procurement departments sync up.
If inventory turnover is low, it usually means that sales are slow and there is excess inventory tying up cash; if inventory turnover is high, inventory is depleted at a fast pace – which could be a good thing or an indication of regular stock-outs.
You can find the ideal inventory turnover rate by tracking and analyzing your stock movements and determining the right ratio specifically for your company.
By setting a goal, you can use sales, marketing, procurement, and inventory management methods to fine-tune your inventory turnover.
You may also like: Procurement Management – A Quick Guide for Small Manufacturers.