Retail businesses looking for ways to boost their sales and improve their bottom line can benefit from better managing their inventory and finding out how much stock they should hold.
This is what inventory management is all about: finding out how much inventory you should be holding at any given time. If the stock you have on hand is too much, you’ll end up overspending in storage costs. Similarly, if it’s too low, you can potentially miss out on sales.
One way to determine the “right amount” is by calculating and tracking a metric called inventory turnover ratio. In this article, we’ll explain what the inventory turnover ratio is and how you can work toward improving it.
What Is Inventory Turnover?
Inventory turnover is referred to as the number of times a business sells its inventory per year. For accounting purposes, it’s calculated for one year, but you can also determine it on a month-to-month or quarterly basis.
By calculating the average inventory for one year, you’re able to get a better idea about how your business is performing financially. If you analyze inventory data over a year, you’ll observe the highs and lows in trends due to changes in product demand.
Here’s why tracking inventory turnover matters for your business:
To be in a better financial position. Inventory turnover ratio is an important metric to help you manage and grow your company. This number also gives banks an idea about the liquidity of your assets. If your inventory sells quickly, they’ll be more willing to provide you with a loan (with your inventory as collateral).
To make smarter business decisions. By carefully tracking inventory turnover, you’ll be able to make better purchasing decisions and fulfill customer orders. This measurement gives you insights about what products you need to order, which items need to go on sale, and which ones you should order in advance by taking into account the manufacturing, production, and shipping phases.
Next, let’s look at the formula for calculating the inventory turnover ratio and some examples:
Inventory Turnover = Cost of Goods Sold (COGS)/Average Value of Inventory
Example #1: For example, if company A’s annual inventory amount is $75,000 worth of goods and annual sales are $600,000, its average inventory turnover will be eight times.
Inventory Turnover = $600,000 in sales/$75,000 worth of inventory = 8
This means that during that year, company A replenished its inventory eight times.
Example #2: Company B’s sales for one year are $300,000 worth of goods and holds an average inventory of $800,000.
Inventory Turnover = $300,000 in sales/$800,000 worth of goods per year = 0.375
Its inventory turnover ratio is 0.375, which means that company B is spending too many dollars on holding stock and goods are moving slowly. This indicates that the company is performing inefficiently in purchasing, sales, and marketing areas or there is a macro-economic factor responsible (such as economic slowdown).
The optimal inventory turnover ratio range is between 2 and 4.
A lower inventory turnover number often means inefficient sales staff or a decline in product demand. Generally speaking, the higher the inventory turnover rate, the better your business is performing.
However, it’s important to note that a higher turnover ratio can also be bad for business. For instance, if your company is turning over its inventory 10 times per year, that indicates your purchasing levels are low, which causes products to sell quickly.
4 Ways Businesses Can Improve Their Inventory Turnover
Here are some ways you can improve the profitability and performance of your inventory:
#1: Use an Inventory Management System
Before you begin improving your inventory turnover, you’ll need to measure it. Make sure that you equip your business with a good point-of-sale and inventory management system that offers real-time tracking of sales and inventory levels.
These retail tools enable you to monitor your inventory and generate reports that give you useful insights about how your stock is performing.
Managers use advanced technology and software like warehouse management systems (WMS), enterprise resource planning (ERP) tools, and inventory optimization software to monitor inventory turnover down to individual items.
An inventory optimization platform can help keep costs low and help you with:
Demand forecasting. Past performance and product demand can help you determine possible future trends while taking into account the possibility of change in product demand.
Inventory redistribution. This enables businesses to redistribute stocks to other warehouse locations that are experiencing higher demand for those products.
Identifying obsolete inventory. In case any of your products become outdated, you’ll have to identify and remove them from your inventory and warehouse.
Data integration and analysis. Integrated inventory systems can easily collect records of purchased items and perform turnover analysis.
#2: Know Industry Benchmarks
Once you’ve calculated your company’s inventory turnover ratio, you’ll need to compare it with other businesses in your industry. For example, the CSIMarket reported that the average inventory turnover for the grocery store sector in 2018 was 13.56. This means that, on average, a grocery store replenished its total inventory more than 13 times per year.
Therefore, if your grocery store has an inventory turnover ratio of 14, it indicates that your store is performing better than the industry average. However, in case your products are moving slowly, you might have to analyze your sales numbers, marketing, and warehousing operations to figure out how you can improve your inventory turnover.
Whether a business has a high or low inventory turnover ratio depends partly on the industry in which it operates. Some industries (like luxury cars), have low inventory turnover ratios but generate large returns on the sale of each item.
#3: Make Sure Different Internal Departments Are on the Same Page
Another way to optimize your inventory turnover rate is by making sure different departments within your organization (including sales personnel, purchasing staff, marketing officers, and senior executives) are all on the same page. You need to make sure that everyone involved has access to inventory information and turnover analysis reports about which items are selling more often and which ones don’t receive orders.
Here’s how different departments can help improve your business’ inventory turn rate:
The sales staff are the customers’ first point of contact and can provide valuable insights about which products are performing well and which ones aren’t.
Your marketing team might need to step up their promotional activities and ad campaigns to receive more customer orders.
Managers and purchasing staff will have to re-evaluate inventory turn to identify which products reap the most returns and which ones don’t sell often and that you should discontinue.
Even if you’re running a small retail store, you will benefit by keeping your employees in the loop about your inventory performance. Do this regularly to ensure that your staff always knows which items are best-sellers and can identify the ones that need to be retired.
#4: Move Inventory Faster
In case your inventory turnover is low, you’ll need to work towards increasing your sales efforts to sell more items. Every retail store works differently, and no turnkey solution will help you boost your sales numbers.
That said, if your inventory is moving slowly, there are several things you can do reverse it. First, you’ll need to reduce the average amount of inventory you hold. There are several ways to do this, such as by improving your marketing and sales efforts to move inventory faster.
Here are some ways you can move inventory faster:
Promotions. Running promotional campaigns can help you move more of your inventory items and boost overall sales. Discounts are also a great way to sell more products and build strong relationships. You should also consider negotiating discounts with your manufacturers and suppliers so that you can reduce costs on future orders.
Pre-orders. Encourage customers to pre-order products. While this may not be an option for every business, pre-orders can help gauge customer interest and demand for your products.
Purchase fewer products more frequently. Change up when and how you purchase inventory to combat a low inventory turnover ratio. For instance, instead of buying stock for six-months’ demand, you should buy inventory for only one months’ demand. By reducing the amount of stock you hold at a given time, you’ll be able to minimize the risk of loss in case products don’t sell or go obsolete.
Identifying which products are selling more and which ones are staying on shelves longer will give you useful insights about your business’ performance. A healthy stock turnover ratio enables you to complete customer orders on time, improve your bottom line, and utilize your company’s assets efficiently.
What are some of the metrics you use to gauge the profitability of your business? Let us know by commenting below.