Inventory turnover is a metric that measures how often a company's inventory is sold and replaced over a specific period, such as a month or a year. It reflects how efficiently a business manages its inventory in relation to its sales or production processes. Inventory turnover is measured by what’s called the inventory turnover ratio.
What is Inventory Turnover Ratio?
The inventory turnover ratio reflects how well a brand converts its inventory into sales. This ratio measures how often a business sells and replaces its inventory within a specific period, providing insights into operational efficiency, cost management and profitability. A high turnover indicates strong sales or effective inventory management, while a low ratio may suggest overstocking, obsolescence or weak sales performance.
Inventory is either moving at a healthy clip or it’s sitting around.
How to Calculate Inventory Turnover Ratio
The formula to calculate the inventory turnover ratio is relatively simple. It is the cost of goods sold (COGS) divided by average inventory. COGS is the direct costs of producing or purchasing the products sold during the period. Average inventory is the mean inventory value over a specific timeframe. Average inventory is calculated by adding beginning inventory and ending inventory and dividing that sum by two.
Example Calculation
Suppose a company has a COGS of $500,000 for the year and an average inventory of $100,000. The inventory turnover ratio would be 5, or 500,000 / 100,000.
This means the company sold and replaced its inventory five times during the year.
Why Does Inventory Turnover Ratio Matter?
The inventory turnover ratio is crucial for measuring operational efficiency. A high ratio signifies efficient inventory management and a strong alignment between supply and demand.
It also informs cost management and cash flow optimization. Maintaining an optimal inventory level reduces storage, insurance, and obsolescence costs. Quick inventory turnover frees up cash for other operational needs or growth opportunities.
The ratio also provides visibility into customer satisfaction. Fast turnover often reflects meeting customer demand promptly, enhancing satisfaction and loyalty. If the ratio is low, there’s a good chance customers are unhappy.
What is a Healthy Inventory Turnover Ratio?
A "healthy" inventory turnover ratio varies by industry. Drilling into retail, brands like to see five to 10 inventory turnovers per year. Of course, this depends on the product type. For example, luxury goods typically see a lower turnover ratio due to higher price points, longer sales cycles, etc.
Either way, a balance is crucial. Too high a ratio may indicate stockouts or missed sales opportunities, while too low a ratio suggests inefficiencies.
How Brands Can Improve Their Inventory Turnover Ratio
There are a number of levers brands can pull to improve their inventory ratios.
- Optimize Stock Levels: Use demand forecasting to align inventory levels with market needs.
- Enhance Sales Strategies: Promote slow-moving products through discounts, bundles, or marketing campaigns.
- Streamline Supply Chains: Reduce lead times by working with reliable suppliers and using technology for inventory tracking.
- Adopt Just-in-Time (JIT) Practices: Minimize inventory holding by receiving goods only as they are needed for production or sales.
- Diversify Product Mix: Focus on high-demand items and phase out underperforming products.
A Vital Metric
The inventory turnover ratio is a vital metric for assessing and improving a company's operational health. It informs inventory management and cost reduction strategies and, ultimately, is used to drive profitability.
