What is inventory turnover?Inventory turnover is the percentage of your inventory that you sell during a specified period of time. This number is helpful not only for better managing your products and supply levels, but also for getting a general feel for how your business is performing.If your inventory turnover is low, that usually means your sales are on the weaker side—products are sitting around for quite some time before actually being sold. Business owners who discover that their turnover needs some improvement might need to make some tweaks to their approach, such as lowering prices or changing products.If your inventory turnover is high? For the most part, that’s good news! Your goods are in demand and you’re moving product efficiently. However, there are some challenges here as well. Too high of turnover rate, and you run the risk of running out of product. It could also indicate that your products are priced low—maybe too low.
How is inventory turnover calculated?Inventory turnover might sound complex, but the math behind it is really quite simple. It uses numbers you should already have in your balance sheets and financial reports. There are actually two different ways to calculate your inventory turnover:
Method one:Sales ÷ Your Average InventoryDuring the year, let’s say you do about $70,000 in sales, and your average inventory balance is around $4,000.$70,000 ÷ $4,000 = 17.5This means you turn over your entire amount of inventory a little over 17 times each year. To figure out how many days you have inventory on hand, you just need to divide that number by 365. In doing so, you will discover that your average product is on the shelf for less than one day.Method two: Cost of Goods Sold ÷ Your Average InventoryUsing this method, you would divide your cost of goods sold by your average inventory balance.$23,000 ÷ $4,000 = 5.75This indicates that you are turning over your inventory nearly six times each year.“But, wait!” you’re thinking now, “That’s way different than the number the first formula gave me!” That’s true—these methods will spit out different results.So, which one should you use? Both of these equations have their pros and cons. The first is easy to calculate and gives an overall picture, but it doesn’t account for markup or seasonal cycles. The second is more accurate, but it requires a few more details to calculate.It’s often smart to run both of these formulas to get a clearer idea of how efficiently you’re running your business.
What is considered a “good” inventory turnover ratio?What is considered a strong inventory turnover ratio? Is there a benchmark number that you should be aiming for?It all depends on your individual business and the sorts of products you sell. A large business that does millions of dollars in sales will naturally have a much higher number than a one-person operation.But, generally, a higher inventory ratio is better. It means you’re fulfilling a demand and efficiently moving your products without having them sit on the shelf for months on end.However, if your products are turning over so fast that you feel like you can’t keep up (and are possibly even leaving orders unfulfilled), you might need to make some adjustments to decrease your turnover ratio. The best inventory ratio is the one that keeps your business as profitable as possible.
Can you improve your inventory turnover?Here are a few things you can do to increase your inventory turnover:
Now, let’s assume that you have the opposite problem—your inventory ratio is too high. You are moving your items so fast, you can’t keep up. You’d like to slow down your inventory turnover a little bit.Here are some things you can try:
- Lower your prices: Decreasing the price of your products (even for a limited time promotion) could help you move more product much quicker. People love a good deal.
- Step up your marketing: By focusing more on marketing the products you do have, you can increase demand for your items and thus sell more faster.
- Decrease your cost of production: If Lauren can score a better deal on the materials needed to produce your products, you can reduce the amount you’re investing in your inventory.
- Reduce the mmount of inventory on hand: Instead of maintaining an average inventory balance of $4,000, you can reduce that to $2,000—meaning you’d have less inventory to turnover at any given time.
- Raise your prices: Typically, increasing your cost leads to less goods sold—without negatively impacting the profit margin.
- Keep more inventory available: Having this buffer available increases the number for the second piece of the inventory turnover equation, meaning your turnover will be much lower and you won’t have to scramble to fulfill orders.
Wrapping upYour inventory turnover ratio is one of the many indicators of a healthy and efficient business, and knowing the basics of how to properly manage your inventory is crucial for your success.