Purchasing inventory requires a deft hand. Buy too much, and you might pay extra holding costs and risk inventory going obsolete. Purchase too little, and you may not be able to fulfill customer demand. You can use the inventory turnover ratio to analyze inventory trends and adjust your purchasing patterns correspondingly to optimize inventory levels.
The Inventory Turnover Ratio
The inventory turnover ratio, also called the inventory turnover formula, calculates how many times during a specific accounting period you completely exhaust your inventory. To calculate inventory turnover, divide your periodic cost of goods sold by your average inventory during the period. You can find cost of goods sold on your income statement and the inventory balances on your balance sheet. For example, if your average monthly inventory balance was $15,000 and cost of goods sold was $10,000, your inventory turnover ratio is 0.67, which means you sold 67 percent of your inventory stock during the month. You can evaluate your inventory turnover rate for each month over the last few years and look for any trends.
High Inventory Turnover
If your turnover rate is increasing, that’s usually a good thing. A high rate means you’re quickly cycling through a batch of inventory and moving product efficiently. The downside to a high turnover rate is that you’re at risk of running out of a product. If you can’t provide customers with the products they want, you may lose their business. For this reason, it’s best to have a buffer stock of inventory when turnover rates are high.
Low Inventory Turnover
A decreasing inventory turnover rate means that some of your products aren’t selling as quickly as they used to. If you begin to stock more expensive, higher-end products, a decline in turnover is normal. So as long as your products aren’t likely to spoil or become obsolete, slower-moving inventory is OK. However, older inventory can be harder to sell for many businesses and takes up valuable space that could be used for better-selling items. For businesses dealing in perishable goods, slowing inventory turnover can be a big problem.
Inventory Management and Forecasting
If you’re not happy with the turnover trends you see, it may make sense to reevaluate your inventory management system. If you haven’t done so yet, you can create a quantitative system to forecast product demand. If you’re willing to make the investment, there’s inventory management software to get the job done. Otherwise, you can set up a system yourself using a spreadsheet. You will input historical sales data for each product line and then take advantage of Excel’s forecast function to estimate future demand.
Use your expertise and inside information to fine-tune these numbers. If you have a few major customers, it’s also smart to keep in regular contact with them about their upcoming needs.
Once you’ve forecast sales, use that data to plan inventory purchases. A high turnover rate means you should consider larger, more frequent inventory purchases, while a low rate indicates the opposite. The Parker Avery Group recommends the forward weeks of supply approach to forecast inventory levels. A forward weeks of supply chart allows you to record estimated weekly sales, beginning product inventory balances, and your desired stock buffer. Subtract the beginning inventory level for the week and stock buffer from predicted sales to calculate how much inventory you need to purchase that week. If the thought of calculating inventory needs on a weekly basis is too daunting, you can perform the calculation on a monthly or quarterly basis instead.