What Is Inventory Turnover?
Knowing Your Inventory Turnover Rate Can Make a Difference on Profits
Inventory turnover is a gauge of how fast a retailer sells through its inventory and needs to replace it. This metric is vital for understanding which products attract consumers and drive sales for the retailer. 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.
Figuring the Ratio
The formula for assessing inventory turnover is a simple one: Sales ÷ Inventory. For example, if your store sold $100,000 in goods and had $50,000 worth of inventory, then your "inventory turn" would be 2, meaning you turned over your inventory two times for that time period 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.
A Different Formula
Another way to calculate inventory turnover rates is by using Cost of Goods Sold (COGS) in this formula: Cost of Goods Sold ÷ Average Inventory. Some point of sale (POS) systems measure turn during a specified period of time as Number of Units Sold ÷ Average Number of Units.
While one might think that higher turn rates are better, the truth is if your turn rate is too high it may mean you are not stocking enough of that particular stock keeping unit (SKU.) For example, if you have a 52 times turn on an item, then you are selling four to five per month. If it takes three weeks to replenish that stock, then you will have missed sales during that period if you are selling at an average of one per week. The remedy here is to raise your backstock and lower the turnover to make sure you do not miss any sales.
On the other end, if you have a turn of 1 on an item and you have 12 of that item on hand in backstock, then you have way too many of that SKU. In this scenario, you have a 12-month supply. For most retailers, a turn of 2 to 4 is ideal. This matches the replenishment rate of the item within the sales cycle. This means that you get the new one in before you need it.
Striking the right balance between inventory levels and demand is the intent of figuring out inventory turnover rates. Many retailers make the mistake of being building up too large of a supply that sees little movement. Remember, inventory in the back room is like 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 taking longer to sell than is beneficial to the business.
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. With a good open-to-buy system, you can 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 faster. But with an open-to-buy system in place, you can manage that easily.
Another solid way to manage your inventory is with dating on 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 but must be paid for within 30 days. It can mean the retailer is forced to pay the vendor before they have sold the items.
Walmart is regarded as an expert in finding a balance in relation to inventory with much of its success tied to controlling inventory turns. Many of their turns are greater than the dating terms on the invoice. In effect, Walmart sells some merchandise BEFORE it must pay for it—in some cases up to 30 days in advance.