What is inventory turnover ratio?
Inventory turnover ratio measures how many times inventory is sold or used in a given time period. To calculate it, you must know your cost of goods sold and average inventory — metrics your inventory management software might be able to help you figure out.
- Cost of goods sold: Also known as COGS, cost of goods sold is the direct cost associated with producing or purchasing the products sold to a consumer.
- Average inventory: This refers to the average cost of inventory over multiple periods of time.
The ratio can help determine how much room there is to improve your business’s inventory management processes. A high turnover ratio usually indicates strong sales and low holding costs, for example, while a low ratio might mean your business is stocking too much inventory or not selling enough.
» MORE: Best free inventory software
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How is inventory turnover ratio calculated?
To calculate the inventory turnover ratio, divide your business’s cost of goods sold by its average inventory.
As an example, let’s say that a business reported the cost of goods sold on its income statement as $1.5 million. It began the year with $250,000 in inventory and ended the year with $750,000 in inventory.
- Average inventory = ($250,000 + $750,000) / 2 = $500,000
- Cost of goods sold = $1.5 million
- Inventory turnover ratio = $1.5 million / $500,000
- Inventory turnover ratio = 3
This means the business sold out its entire inventory three times over throughout the fiscal year. Put another way, it takes an average of about 122 days (365 / 3) to sell out its inventory.
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What is a good inventory turnover ratio?
The higher your inventory turnover ratio, the better — within reason. Small-business owners should consider their product type and which inventory turnover ratio range is considered normal for their industry.
For example, grocery stores, bakeries and other businesses that sell food and perishable goods typically need to have the highest inventory turnover, because their products will expire and lose their value much faster than, say, a designer shoe store's inventory.
However, for non-perishable goods like shoes, there can be such a thing as an inventory turnover that's too high. While high inventory turnover can mean high sales volumes, it can also mean that you're not keeping enough inventory in stock to meet demand.
If your inventory turnover is low, your stock might be spending too much time sitting on your shelves, not being sold. That translates into money being wasted on inefficiently used storage space, plus the possibility that the longer the inventory sits around, the more likely it’ll get damaged or depreciate in value.
» MORE: Best small-business apps
What does inventory turnover ratio tell you?
Inventory turnover ratios can hint at whether there’s room for your sales and inventory management processes to improve. Here are several ways to address a low inventory turnover ratio:
Order conservatively
Over-ordering or producing larger batches of a product than you can sell is a common culprit of a low inventory turnover ratio. While you never want to order so little product that your shelves are bare, it's typically in your best interest to order conservatively, especially for a new product that you've never offered before.
Move products around
Identify which products are likely to be “impulse buys” for your customers and move them to high-traffic areas of your store. You can apply this same principle when you build your e-commerce website by featuring a particular product on your homepage or making a particular product image larger and more prominent within a section. As you test out different placements, pay attention to your inventory turnover ratio before and after each change to help you determine what’s working and what isn’t.
Invest in marketing
Advertising and marketing efforts are another great way to boost your inventory turnover ratio. Consider promoting products that have been sitting around for a while to consumers outside your established customer base. You could also use email marketing and social media marketing to highlight specific products to existing and prospective customers.
Know when to discount
When inventory sits in your store for a long time, it takes up space that could be used to house better selling products. By hanging onto that old inventory, you could be missing the opportunity to sell another product several times over. With that in mind, offering discounts or a buy-one-get-one deal to move old inventory can be a worthwhile strategy.
This article originally appeared on Fundera, a subsidiary of NerdWallet.
