The Ins and Outs of Inventory Turnover
What is inventory turnover?
Inventory turnover, also known as stock turnover ratio, is the measure of how fast a company sells its inventory and the speed at which the inventory is replaced. The inventory turnover ratio of a company helps to provide an understanding of the products that are most popular with consumers and results in the majority of the sales. It is expected that, the longer products remain in a company, the more profits will be negatively impacted.
A good position for your company is to ‘turn’ inventory quickly because this means you are selling more inventory. Inventory turnover gives a company an indication of how it can turn its products into cash. Efficient inventory management is a key indicator of a company’s success. Piles of products in storage signify added costs. Therefore, the quicker the inventory is sold, the better for the company’s bottom line. High inventory turnover only benefits a company if the products are sold at a profit. Selling a high amount of loss-making products will have a negative effect on a company’s profits over the long term.
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The Advantages of High Inventory Turnover
High inventory turnover is generally a sign that you sell your products in an efficient way to replace them with new products. However, a high inventory turnover ratio can mean two things. Firstly, you are selling a high number of products or you are placing insufficient orders and cannot keep up with the demand from customers. If you are not running out of stock, your company should experience some of the following advantages of high inventory turnover:
- Fresh products – Customers are always on the lookout for different and new products. Slowly turning over your inventory may lead to your customers getting bored with your products and deciding not to revisit your store. A high and efficient inventory turnover rate will keep your customers interested in what your store has to offer.
- Consistent pricing – You can keep your prices stable and consistent when you turn over your inventory quickly. This is because you are less dependent on holding sales to get rid of extra inventory. Consequently, you can sell more products at the regular price. This allows you to receive the highest profit margins on your sale goods as well as keeping the quality of your products high. Your customers will be used to paying the normal price for your products instead of always expecting to pay a reduced price.
- Reduced waste – A high turnover rate guards your company from the wastage of expired or perishable items. For example, a food retailer that sells fresh vegetables will keep their stock fresh and reduce the amount of products that will rot and need to be thrown away.
- Increased buying power – You will be able to negotiate more beneficial deals with your suppliers when you have a high inventory turnover rate. You can work out a volume discount if you continue to buy more products from your suppliers. The discounts you receive can be used to achieve bigger margins on sales or can be passed to your customers.
The Inventory Turnover formula
There are two ways to work out your inventory turnover ratio.
The first method is a simple formula of Sales ÷ Inventory.
An example is, if you sold $50,000 in products and had $25,000 worth of inventory, your “inventory turn” is 2. This means that you turned over your inventory two times during a specific time period. Usually, inventory turn is calculated on a calendar year basis. You will need to work out how many times you have turned different products during that year.
The second formula for calculating your inventory turnover involves using the Cost of Goods Sold (COGS) ÷ Average Inventory. The COGS is the total cost spend in relation to manufacturing your products, including labor cost. COGS does not take into consideration costs that are not directly related to manufacturing your product, for example, shipping.
You may also be able to measure inventory turn during a specific period by using Number of Units Sold ÷ Average Number of Units, if you have a point of sale (POS) system.
It is recommended that you use weekly or monthly data of your inventory to work out the average value. This is because weekly or monthly calculations provide a more accurate picture of your inventory, as opposed to using a yearly calculation.
Here is an example of how the second inventory turnover ratio formula can be used:
Mary’s company sells bespoke furniture. Her COGS at the end of the year worked out to be $1,000,000. The value of her total inventory at the beginning of the year was $3,000,000 and at the end of the year was $2,000,000.
According to the above, Mary’s company’s average inventory for the year in question – (3,000,000 + 2,000,000) / 2 = 2,500,000.
Her inventory turnover ratio = 1,000,000 / 2,500,000= 0.4.
As a result, Mary’s inventory turned around two and a half times in that particular year. Therefore, it will take Mary at least two and a half years to sell all her bespoke furniture. This inventory turnover figure is not great for Mary and indicates that her sales and marketing campaigns are ineffective or she may have overstocked her store.
Although the inventory formula ratio will be different for every industry, it is generally accepted that companies should not have a ratio that is lower than three.
You can calculate your turnover based on different inventory valuations. Every inventory valuation means something distinct for your business. However, in relation to your business finances, cost is considered to be the most important valuation because it provides a measure of how your working capital is used.
Here are some inventory valuations you can use when calculating your inventory turnover:
- Units – Using units to determine turnover is useful to measure bulk items and selling space.
- Retail – Some retailers use the retail inventory method and use discounts and markdowns as variables to increase their turnover.
- Cost – Most companies use this inventory valuation method as a key performance indicator.
- Wholesale – This valuation method can be used to assess a company’s wholesale accounts.
Low inventory turnover
Low inventory turnover means that you are not selling your products quickly enough. In order to determine whether your inventory turnover ratio is low, you need to have knowledge of your industry and the market.
There are some scenarios where low inventory turnover can be very detrimental to a company. For example, a company that sells products with low margins will need to make a high number of sales to remain profitable. If this type of company experiences low inventory turnover over a long period of time, they could go out of business.
Low inventory turnover can be acceptable in certain types of business. This is the case for companies that sell products with high retail prices and high margins. For instance, a company that makes expensive and specialized machinery for the healthcare industry may only sell a few machines per year. In this case, the company is likely to have low inventory turnover but will still remain profitable.
A company can experience a decrease in its inventory turnover ratio for different reasons, including:
- The inventory is kept in the warehouse for an excessive time period.
- Too many products were bought in the first place.
- Ineffective or inadequate sales and marketing efforts.
- High inventory turnover
Industries, like grocery and retail, usually hold a large amount of inventory with low profit margins, therefore, they are more likely to have high inventory turnover ratios. These industries need to counterbalance lower per unit profits with higher unit sales volumes. A high inventory turnover is absolutely necessary to maintain positive cash-flow.
Generally, a high turnover rate is an indication that your company is profitable and is operating efficiently. The more inventory you hold, the more money you have tied up in your products. If you have borrowed this money, you will be liable to pay interest as well as storage costs. There are additional risks of carrying a large amount of excess inventory, for example, theft and damage.
There are times when a high turn rate can be a cause for concern, especially if you are not operating in a high inventory industry. A turn rate that is too high can be an indication that you are under-stocking certain products. For instance, where your turn on a product is 52, this means that customers are buying around four or five of these products every month. However, if it takes about four weeks to restock this product, you may have missed out on sales during the replenishing period.
How to improve your inventory turnover ratio
As we have seen, a high inventory turnover is not always an indication that a company is in good health. Therefore, high inventory turnover rates can be costly to companies if not approached correctly. A company that reduces prices that result in low margins, just to improve inventory turnover rates, will produce a negative effect on profits. This negative effect can also spread to the market because competitors will feel the need to reduce their prices and the market will be conditioned with lower rates. As a result, the whole industry’s turnover rate ratio could suffer.
Your company needs to put in place strategies for high turnover rates with high profit margins.
Here are some best practices to increase your inventory turnover and your profit margin:
- Use an effective open-to-buy system – An open-to-buy system is a retail management inventory tool that helps you to work out how much inventory you need to buy at the beginning of your business and how much you need to continue to buy every month. You can use your open-to-buy system to make a plan for the turn of different product classifications. You do not need a plan for every single product when using an open-to-buy system. Grouping products by categories will make it easier to plan and manage your inventory.
- Negotiate the dating on your purchases – When you order inventory for your company, you must agree to certain terms to pay the invoice. These terms are known as dating. This means that the time frame to pay the final bill will be on the invoice. For instance, net 20 indicates that you have 20 days to make payment or, in other words, 20 days of dating. You should aim to negotiate longer dating periods when you buy inventory with a low turn over. This helps to increase the likelihood that you would have sold the inventory before you need to pay your supplier.
- Spend time on well thought out sales and marketing – A great sales and marketing strategy can make the difference in relation to inventory turnover. With the popularity of social media, companies no longer need to allocate huge parts of their budgets to promoting their business. You can choose platforms, like Instagram or LinkedIn, to market your products. You can also harness the power of social media influencers to get your products in front of an engaged audience. However, marketing does not always need to take place online. We have 20 marketing ideas for your small business to help you increase your inventory turnover rates.
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