Meet Lauren. She runs a business selling custom made jewelry both online and at various craft shows in her community. She loves what she does, but she’ll be the first to admit that managing her inventory usually has her tearing her hair out.
When her jewelry sells fast, she’s thrilled—but, she’s also left scrambling to order more supplies and make more pieces for her customers. But, when her items are slow to move? It’s frustrating, and she’s left wondering if she needs to change her approach and pricing structure.
Before jumping to any conclusions, Lauren has decided that she needs to crunch the numbers and get a better idea of how fast she’s moving her products. To put it in fancy accounting terms, she needs to calculate her inventory turnover.
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 (leading to some unhappy customers). 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 two different ways that your inventory turnover can be calculated:
Sales ÷ Your Average Inventory
So, let’s go back to Lauren. During the year, she does about $70,000 in sales, and her average inventory balance is around $4,000.
$70,000 ÷ $4,000 = 17.5
This means she turns over her entire amount of inventory a little over 17 times each year. To figure out how many days she has inventory on hand, Lauren just needs to divide that number by 365. In doing so, Lauren discovers that her average product is on the shelf for less than one day—which makes sense, as she completes a lot of custom and commissioned orders.
Cost of Goods Sold ÷ Your Average Inventory
Using this method, Lauren divides her cost of goods sold (the amount of money needed to produce her jewelry) divided by her average inventory balance.
$23,000 ÷ $4,000 = 5.75
This indicates that Lauren is turning over her 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. Hey, it can’t hurt, right?
What Is Considered a “Good” Inventory Turnover Ratio?
So, now you have one big question: What is considered a strong inventory turnover ratio? Is there a benchmark number that you should be aiming for?
Unfortunately, there isn’t a black and white answer here—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 like Lauren. Back in 2012, for example, Apple turned over its inventory every five days!
Tip: Use a handy benchmarking tool like this one to get a sense of what the standard inventory turnover ratio is in your given industry.
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, as with anything, there is such thing as too much of a good thing. 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?
Let’s say that Lauren has decided that she’d like to further improve her inventory turnover. She thinks her number is strong, but she’d like to sell the entirety of her inventory a few more times per year.
Fortunately, there are some steps she can take to improve it. Here are a few things Lauren could do to increase her inventory turnover:
- Lower Her Prices: Decreasing the price of her products (even for a limited time promotion) could help Lauren move more product much quicker. People love a good deal.
- Step Up Her Marketing: By focusing more on marketing the products she does have, Lauren could increase demand for her items and thus sell more faster.
- Decrease Her Cost of Production: If Lauren could score a better deal on the materials needed to produce her jewelry (think wire, hooks, and beads), she could reduce the amount she’s investing in her inventory.
- Reduce the Amount of Inventory On Hand: Instead of maintaining an average inventory balance of $4,000, Lauren could reduce that to $2,000—meaning she’d have less inventory to turnover at any given time.
Now, let’s assume that Lauren has the opposite problem—her inventory ratio is too high. She is moving her items so fast, she can’t keep up. And, instead of continuing to crank out jewelry pieces into the wee hours of the morning, she’d like to slow down her inventory turnover a little bit.
Here are some things Lauren could try:
- Raise Her Prices: Typically, increasing the 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 Lauren’s turnover will be much lower and she won’t have to scramble to fulfill orders.
Your 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.
This concept might sound complicated and overwhelming. However, if you dip your toes in and familiarize yourself with it, you’ll soon realize—much like Lauren—that it’s not nearly complex as you initially assumed. Keeping your finger on the pulse of your inventory turnover will always pay off in the long run!