What is Inventory Turnover Ratio?
August 11, 2022
If you are a small business owner stocking inventory, you’ve likely heard the term “inventory turnover ratio.” The individual words are easy enough to parse, but what about the overall term?
What does this metric mean for your business? How is it measured? What steps should you take to ensure that your inventory turnover ratio is good?
Why Turnover Ratios are Important
Businesses worldwide use inventory turnover ratios to measure how well they sell their inventory. These ratios outline how often they sell through their list each year (i.e., turnover) and give them a sense of whether they need to stock up or down.
Turnover ratios can help you measure how quickly you sell your inventory and your business’s overall profitability. If turnover ratios are low, it might imply low sales and overstocking.
Low turnover ratios could also imply missed fashion trends or technological advances, challenging market conditions like tough competition, or even just the nature of the business. As such, business owners will have data to identify how to pivot their current business strategy.
If your turnover ratio indicates that your business isn’t making enough money, you need to take steps toward improving your sales performance. To boost sales, your new strategies could involve changing your pricing structure or adding more products or services to your slate of offerings. You must give customers more reasons to choose your brand over the many other options available on the market.
Different Kinds of Inventory Turnover Ratios
Inventory turnover will depend on your industry, and different turnovers rely on reports at the end of the day, week, month, quarter, or year.
Annual turnovers show the progress of your yearly income and help you monitor and compare your revenue year to year. Quarterly, monthly, and weekly turnovers will show you stock levels within that period.
Daily turnovers are most commonly used in the food service industry—inventory tends to move much more quickly and must be tracked more closely to deliver a top-notch customer experience.
The Benchmark Numbers
Businesses use benchmarking to measure internal and external progress, competition, and global standing among other organizations. The higher the benchmark number, the better, as it indicates more sales per unit of time.
If you want to set specific targets for your company, consider industry standards before setting any goals.
Every business will have unique benchmark numbers for each type of turnover ratio based on its industry and product category. However, there are some standard benchmarks that most companies can use as a starting point.
Generally, a good inventory turnover ratio is between 5 and 10 for many industries.
Inventory Turnover Ratio Calculation
Calculating inventory turnover ratio is simple: divide last year’s cost of goods sold by this year’s average inventory.
Inventory Turnover = (Cost of Goods Sold) / (Average Inventory)
Average Inventory = (Beginning Inventory + Ending Inventory) / 2
Cost of Goods Sold (COGS) refers to all the expenses you incur to create and distribute your products. It includes direct costs (raw materials, storage, shipping) and indirect costs (logistics, warehousing utilities, office equipment).
If you want to compare two years in your business cycle (for example, if one ended with a higher price point than another), divide each year’s cost of goods sold (COGS) by its ending inventory before comparing.
Year 1 Total = (Annual Cost of Goods) / (Annual Ending Inventory)
Year 2 Total = (Annual Cost of Goods) / (Annual Ending Inventory)
Business owners, when calculating turnover ratios, may substitute COGS in the formula by sales numbers, which is often more readily available than COGS. However, sales numbers include retail markup which is not included in the accounting for inventory (i.e., the cost of goods on hand) in financial statements. As such, COGS is the more accurate metric to use when calculating inventory turnover.
A closely related metric to Inventory Turnover is Average Days Inventory Outstanding (DIO). Also called days inventory outstanding, this is another inventory management metric that measures the number of days required to sell all of the inventory held on average. The formula for DIO is as follows:
Average Days Inventory Outstanding = (Average Inventory) * (Number of Days in Period) / (Cost of Goods Sold)
How To Interpret Inventory Turnover
Generally, a high inventory turnover ratio is good because it indicates that a company’s products are selling relatively quickly. On the other hand, too high turnover numbers may indicate that slightest supply chain delays might lead to stockouts.
Note that these ratios must be interpreted relative to their industry, competitors, and target audience. For example, a luxury sports car dealer (high production costs, low number of daily sales, fewer sales needed for profit) will have significantly lower inventory turnover than a fast food restaurant (low production costs, high number of daily sales, high sales needed for profit).
Factors To Consider When Setting Target Turnover Ratios
The more time it takes to produce a product or set up a service, the higher your turnover ratio will be. Similarly, suppose the location of your business is in an area where labor costs are high and materials are expensive. In that case, you’ll want to set a higher target turnover ratio than if your expenses were lower.
Here are other things to consider:
The Nature of Your Product
The number and nature of your product’s components will play a large part in determining whether certain stock levels match demand.
Your Product’s Shelf Life
If you have a product or service with a long shelf life, you need to set a higher target turnover ratio than if your products are perishable and must sell quickly.
For example, if you’re in the grocery business, fresh produce must be sold entirely within days of being harvested. In contrast, canned goods can sit on store shelves for months before they’re purchased, which isn’t something you should be worried about.
The Size of Your Inventory
The larger your inventory list relative to your sales volume, the more flexible you can set turnover ratios. You must strike a balance between keeping some products on hand and the costs associated with storing them.
The Time Between Stock and Sale
Finally, consider how much time passes between when you purchase inventory and when you sell it. The longer the lag time, the more time you have to sell the stock before it goes stale and you are forced to sell at a discount.
In most cases, it’s best to set turnover ratios as high as possible so that inventory turns over quickly and doesn’t sit around for long periods. It is especially important if your inventory list is perishable or needs frequent reordering. A high turnover ratio will ensure you always have fresh products on hand.
Inventory turnover ratio measures how many times a company’s inventory sells in a given period. The ideal target for an inventory turnover ratio varies significantly depending on your industry and business goals.
If you’re a new business owner, consider the nature of your products, the size of your inventory, and the lag time between stock and sale. Soon you can set target inventory turnover ratios that will ensure long-term success for your enterprise.
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