How to Calculate Inventory Turnover and Why You Should Care
Inventory turnover is a critical accounting tool that retailers can use to ensure they are managing the store's inventory well. In its most basic definition, it is how many times during a certain calendar period that you sell and replace (turnover) your inventory.
The figure you end up with will indicate how fast the products sell on average. Inventory turnover can help you gauge how sales strategies are affecting the retail store's bottom line over time. Turnover is also an indicator of the quality of your customer experience. You will see that as I explain more.
What Is the Significance of Inventory Turnover?
Retailers that handle inventory need to know how quickly their products sell and how often they need to replace them. Manufacturers and wholesalers keep track of their 'turns' and retailers should do the same. Manufacturers don't want to be stuck with a lot of leftover inventory at the end of the season. The markdowns they take are just like the ones you do if you have leftover inventory.
Inventory turnover will help you understand – in concrete numbers – how your current inventory strategy is working. Are you stocking too much? Are you stocking too little? Are you stocking products that customers don't want? Are you seeing great results from a recent change in product or marketing?
Also called "stock turns" or "stock turnover," inventory turnover is a vital number to your retail business's accounting. When it is used with the rest of the data on your profit & loss sheets, it can give you useful insights into the health of your business. It can also help guide you to make changes if needed.
It is a good idea to calculate your turns on a regular basis. Whether you run the numbers annually, seasonally, quarterly, or monthly will depend on the size, type, and age of your store.
How to Calculate Inventory Turnover
Controlling inventory turnover is key to keeping your shelves stocked with interesting, fresh products that keep the cash flowing – after all cash is king in retail. You want to buy the merchandise, move it quickly, and then repurchase more products for your customers.
In general, higher inventory turns are a good indicator that you're moving merchandise, which should mean that business is good. However, if the turnover becomes too high, sales may be lost because of reduced customer selection.
Inventory turnover can be calculated in whole, as well as by department or merchandise category. In fact, you should always look at your turnover metrics by department. Some items just turn slower than others.
In order to calculate inventory turnover, you need to know two numbers: Cost of goods sold (COGS) and average inventory.
To find your COGS:
COGS = Beginning Inventory + Purchases - Ending Inventory
This should include your wholesale costs for the inventory and any additional costs, such as shipping and handling, that you have paid. Also, be sure to subtract the cost of any scrapped or lost items.
To find your average inventory:
Average Inventory = Beginning Inventory + Ending Inventory / 2
The values of your inventory should be found on the company balance sheet for each accounting period.
To calculate your inventory turnover:
Inventory Turnover = COGS / Average Inventories
The result you come up with will give you the inventory turnover ratio. If you divide that into the number of days used in your accounting period, you receive the average number of days that you held the inventory.
Days Inventory Held = Days in Accounting Period / Inventory Turnover Ratio
An Example of Calculating Inventory Turnover
Let's use a set of easy, fictional sales numbers to put these calculations into perspective.
- Opening inventory: $10,000
- Closing inventory: $20,000
- Additional purchases: $50,000
- Number of days in period: 90
|Cost of Goods Sold||$10,000 + $50,000 - $20,000||= $40,000|
|Average Inventory||$10,000 + $20,000 / 2||= $15,000|
|Inventory Turnover Ratio||$40,000 / $15,000||= 2.67|
|Average Days Held in Inventory||90 / 2.67||= 33.7|
With this example, the retailer held onto their inventory an average of 33 days in a 90-day period. They are turning over about once a month. Is this a good turnover rate? All that depends on your merchandise.
One of the best practices for retailers is to join a trade association where they can compare numbers and results with similar retailers. In other words, compare your turns with another shoe store (since you sell shoes too) versus a sporting goods store.