Inventory turnover is a critical ratio that retailers can use to ensure they are managing their store’s inventory and supply chain well. It is one of the crucial KPIs used to measure the overall performance of your business. Put simply, it is how many times during a certain calendar period you sell and replace your entire inventory.
Most small retailers are not thrilled when they find out they have excess inventory. Storage costs, insurance, damage, obsolescence, taxes and loan interest can add up to almost 30% of the cost of our inventory annually! These costs will only continue to rise as your excess inventory numbers climb. This is why inventory management is one of the best investments you can make for your business. When you trim away your excess inventory through inventory management, you leave your business running better than ever. So why is inventory turnover crucial to this process?
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What Is Inventory Turnover?
Inventory turnover is the number of times that a retailer sells and replaces its inventory. It is a measure of the rate at which merchandise flows into and out of your store. For example; if a retailer has an annual inventory turnover of eight, it means that they have completely sold out its entire inventory eight times over the whole year. In 2015, Amazon had an annual turnover of eight and Walmart had 7.8, whereas Costco has an inventory turnover of 11.2.
How Do We Calculate Inventory Turnover?
Inventory turnover can be calculated for the entire business as well as by department or item category. Assessing inventory turnover by item category would also be helpful to compare the performance of different items. This is important because not all turnover rates are the same; some items might turn more slowly than others. Consider, for example, that you have an online store where you sell T-shirts. Basic plain T-shirts could have a higher inventory turn than designed T-shirts. After all, people wear basic T-shirts more often, and they need them more than patterned ones.
In order to calculate inventory turnover, we need to know two dollar amounts for the calculated specific period: Cost of Goods Sold (COGS) and Average Inventory.
You can calculate your COGS for a specific period through the below formula:
COGS = Beginning Inventory + Total Purchase – Ending Inventory
These numbers should include the purchase prices for your inventory, and also any additional costs such as shipping, storing, or handling. Make sure to subtract the cost of any scrapped or lost inventory.
You can also calculate COGS by looking at your Profit & Loss Report.
You can calculate your Average Inventory for a specific period through the formula below, or by looking at your Balance Sheet:
Average Inventory = Beginning Inventory + Ending Inventory / 2
Finally, we can calculate Inventory Turnover based on the below formula:
Inventory Turnover = COGS / Average Inventory
If we divide the number of days within the calculated calendar period by the Inventory Turnover Ratio, we will find the average number of days that we held our inventory.
Days Inventory Held = Days in Accounting Period / Inventory Turnover Ratio
An Example For Calculating Inventory Turnover
We will calculate above ratios based on the example numbers. Let’s say that we calculate for our Q3 period:
- Beginning Inventory: Inventory Amount as of 06/01/2017: $50,000
- Closing Inventory: Inventory Amount as of 09/30/2017: $60,000
- Total Purchase Amount within Q3 2017: $120,000
- Total #Days in Q3: 90 days
|
Cost of Goods Sold |
$50,000 + $120,000 – $60,000 |
= $110,000 |
|
Average Inventory |
$50,000 + $60,000 / 2 |
= $55,000 |
|
Inventory Turnover Ratio |
$90,000 / $65,000 |
= 2 |
|
Average Days Held in Inventory |
90 / 2 |
= 45 |
With this example, the retailer held onto their inventory an average of 45 days in a 90-day period. They are turning over about once in 1.5 months. They cycled their entire inventory twice in the overall Q3 period.
How Do You Benchmark Your Inventory Turnover?
Is the above calculated Inventory Turnover a good ratio? That depends on your merchandise, business and sales model. As a retailer, it is important to ask yourself whether your merchandise is turning faster or slower than it was this time last year. One of the best practices for retailers is to compare numbers and results with similar retailers. In other words, if you sell T-shirts, compare your turnover rate with another T-shirt store. The best way to assess your inventory turnover ratio is to compare it to that of other stores in your particular retail niche. If you’d like a guide, you can click here to find your industry segment’s benchmark numbers.
Why Inventory Turnover Is So Important
High inventory turnover is key to keeping shelves stocked with fresh products and keeping the cash flowing. After all, cash is king in retail! The most successful retailers purchase inventory, sell it fast, and then repurchase more products for their customers at a high rate.
In general, higher inventory turnover is a good indicator that you’re moving merchandise, which should mean that business is good. However, if the turnover becomes too high, sales may be lost. This is because high turnover results in purchasing in small portions and short lead times. If your vendors drop the ball, you may be unprepared and could run out of stock.
Low turnover ties up your capital and eats up your gross profit. In order to get the most out of your inventory, you should settle on a turnover rate that balances customers’ needs with your need to maintain a solid return on investment.
If your Inventory Turnover is lower than the average for the industry, this could indicate that you are not selling inventory efficiently. It could mean that your inventory is backlogged, or you are accumulating inventory faster than you can sell it. A good way to solve for this in the retail industry, for example, is sticking with seasonal or trendy items in order to sell faster.
However, higher-than-average Inventory Turnover doesn’t always mean that you are doing great. It could be a sign of an ineffective sourcing strategy, in which a retailer purchases inventory too often in small quantities. Doing so can drive up the purchase price because of things like unnecessary shipment costs. It can also imply a risk of shortage in your supply chain, leading to inadequate inventory.
Erhan Musaoglu is the CEO and co-founder of Logiwa Corp., a supply chain management systems company. He has over 20 years of experience in the warehouse management industry, and has used his experience in industrial engineering and consulting to create multiple companies, including Unitec and IFS. In order to share his knowledge with larger crowds, he has lectured at various universities on e-Commerce supply chains and warehousing. His expertise and leadership in navigating the enterprise and B2B industry has led Logiwa to grow exponentially. He can be followed on Twitter at @ErhanMusaoglu or on LinkedIn.
