Inventory turnover is a measurement that reveals how quickly a business sells through its inventory and needs to replace it. A high inventory turnover signals high sales volume. A low inventory turnover signals low sales volume.
Here's what you need to know to calculate inventory turnover for your business and what it tells you about your sales.
What Is Inventory Turnover?
Inventory turnover is simply a way of referring to how quickly you sell through ("turn") your inventory. Measuring inventory turnover can help you place more accurate orders when you need to restock or update your inventory for a new season.
- Alternate name: Turns
Inventory turnover is commonly expressed as a ratio. It is a kind of efficiency ratio that helps you gauge how effectively you're turning your assets into profits.
How Do You Calculate Inventory Turnover?
Inventory turnover is measured for a specific timeframe, so the first step in calculating your turns is picking a time period. Then, figure out your average inventory by averaging the costs of inventory from the beginning and end of that time period. Finally, to calculate turns, divide your cost of goods sold by the average inventory.
How Inventory Turnover Works
This metric is vital for retailers who want to understand which products attract consumers and drive sales. The longer items stay in a retailer's possession, the bigger the hit on potential revenue and profits they can expect. The faster you "turn" your inventory, the more inventory you will need (and hopefully sell).
If you just need a general idea of your inventory turnover, you can do a simple back-of-the-envelope calculation to give you a sense of your turns. Instead of calculating your cost of goods sold, you can divide your overall sales by your inventory. This number isn't as specific, since you aren't calculating costs associated with sales, but it'll give you a good idea of how quickly you're selling through your inventory.
For example, if your store sold $100,000 in goods and had $50,000 worth of inventory, then your "inventory turn" would be two, meaning you turned over your inventory twice during that time being measured.
Inventory turn is typically looked at on a calendar year basis. You calculate how many times you will turn that item in a year. Even though you may be assessing a shorter period, you can extrapolate that time period out to equal one year.
Striking a Balance
Measuring your inventory turnover can help you strike the right balance between inventory levels and demand. Many retailers make the mistake of building up too large of a supply that takes up valuable inventory space without generating the sales needed to justify such a large inventory.
Remember, keeping inventory in the backroom is like keeping your cash in jail. Having inventory does you no good until you sell it.
A vendor might entice a retailer on a special "closeout" deal on merchandise, which can lead to a build of goods that takes longer to sell than is beneficial to the business.
Of course, this problem can easily go the other way, as well. Too little inventory gives customers too few options. They may choose to shop at another store that has more to offer. Closely watching your inventory turnover can help you find a happy medium between these two unfavorable scenarios.
Inventory Management Best Practices
There are some best practices you can adopt for managing the cash flow of your business in relation to inventory turnover rates. You do this by using an open-to-buy system with your inventory planning. This allows you to plan the turns you want for an item by category and classification. There is no need to set the turns at the same level for every product in your store. Some will turn slower, and some will turn faster. With an open-to-buy system in place, you can easily manage those differences.
Another way to manage your inventory is by dating your purchases. Dating is the amount of time you have to pay the vendor for the merchandise. Many retailers get strapped for cash because they bought inventory that has a low turn and must be paid for within 30 days. This means the retailer is forced to pay the vendor before they have sold the items.
Limitations of Inventory Turnover
In general, higher turnover is better, but that isn't always true. As with many financial ratios, context is important. If your turn rate is too high, it may mean you are not stocking enough of that particular unit. This issue can be exacerbated by shipping delays.
It's also important to only compare your turns to another business that's largely identical to yours. A lot of factors can impact inventory turnover, and many of those factors can justify a lower turnover rate. Comparing turns between businesses in two different industries is almost entirely worthless. Even when businesses are in the same industry, it's important to consider aspects like retail locations, vendor relationships, shipping logistics, and other factors that could impact inventory turnover.
- Inventory turnover happens when a business sells through its inventory and needs to order more.
- Inventory turnover is often measured as a ratio that expresses how many times in a given period that a business sells through its inventory.
- Businesses should seek to strike a healthy inventory turnover rate that keeps items on the shelf without burning too much cash on inventory storage costs.