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What is inventory turnover and how to calculate it?

What is inventory turnover and how to calculate it?

inventory turnover

What is inventory turnover ratio?

Inventory turnover is the rate at which a business replenishes its stock during a given period due to sales. The inventory turnover ratio is a good indicator of the effectiveness of your sales strategy and how well you can generate sales.

 

    Why knowing your inventory turnover is essential?

    Businesses often have a significant amount of money tied up in their inventory. Having your warehouse over-stocked with slow-moving items ties up cash that would take a long time to recover through sales. It also impacts your warehouse efficiency because every item occupies valuable space and needs resources to manage them. Knowing your inventory turnover helps you make better pricing, marketing, manufacturing, and purchasing decisions.

     

    How to calculate inventory turnover ratio?

    Step 1: Determine COGS (Cost of Goods Sold)

    COGS is a measure of a company’s direct production and/or purchase costs of goods and services. You can determine your COGS using the formula:

    Cost of Goods Sold = Beginning Inventory + Purchases – Ending Inventory

    You can pull up your annual income statement to see your COGS or use our Free COGS Calculator

     

    Step 2: Determine average inventory

    The next step is to calculate the average inventory value for the same period. Calculate the average inventory for the same period using the formula:

    Average Inventory = (Beginning Inventory + Ending Inventory) / 2

     

    Step 3: Calculate inventory turnover ratio

    We can now calculate the inventory turnover ratio using the formula:

    Inventory turnover ratio = Cost of Goods Sold / Average Inventory

     

    Step 4: Calculate days inventory

    To give the inventory turnover ratio some daily context, we go one step further to determine the Days Sales Inventory (DSI) or days inventory. The DSI measures how many days it takes for inventory to turn into sales. A lower day sales value is ideal in most cases since it means that stock is cycled in fewer days. However, DSI values can vary between industries.

    DSI = (Average Inventory ÷ COGS) x 365

    Example of an inventory turnover calculation

    For the fiscal year 2019, ABC Corp reported a year-end inventory of $20 million, a beginning inventory of $19 million, and an annual COGS of $50 million.

     

    ABC Corp’s inventory turnover ratio:

    $50 million ÷ ($20 million + $19 million)/2 = 2.56

     

    ABC Corp’s days inventory:

    (1 ÷ 2.56) x 365 = 142 days

     

    This indicates that ABC Corp sells its entire inventory within a 142-day period.

     

    Interpreting the inventory turnover ratio

    Great! You’ve now determined your inventory turnover ratio. But what does it really mean for your business?

     

    • A high inventory turnover ratio generally indicates that you are selling goods quickly, and there is considerable demand for your products.
    • A low inventory turnover ratio, on the other hand, is bad news. It indicates weak sales and/or declining demand for your products.

    Therefore, inventory turnover reflects the effectiveness of your sales strategies and how well your purchase department can adapt inventory purchases based on demand trends.

     

    What is a good inventory turnover ratio?

    A good inventory turnover ratio is between 5 and 10 for most industries. In other words, you would be selling and restocking products every 1-2 months. It’s critical to maintain a good balance between having enough inventory to meet demand and not having to replenish frequently. 

     

    How to improve inventory turnover?

    Fortunately, there are a number of ways to improve your inventory turnover ratio. These include:

     

    • Identify and eliminate dead inventory to prevent it from occupying warehouse space and tying up cash. An inventory optimization software can help you easily identify slow-moving items and increase overall inventory performance.
    • Accurately forecast inventory demand and prioritize purchases based on forecasts.
    • Increase product awareness and inventory demand through a targeted marketing campaign to drive up your sales volume.
    • Periodically review demand trends and adapt to changes in demand, market conditions, and competition.

    Try out our free inventory turnover calculator now!

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