How to Calculate Inventory Turnover Ratio and Increase It?

What is Inventory Turnover? You are running a business, it’s going great, but how do you know that?

What is Inventory Turnover?

You are running a business, it’s going great, but how do you know that? The success of a business cannot be measured with mere assumptions. It has to be quantified into data and values.

Numbers never lie as they surely give you a clear picture of whether your business is booming or approaching failure. This is where the inventory turnover rate comes in.

The inventory turnover is a ratio that indicates how frequently a company is selling its physical products. This information can be used to help formulate a new business strategy or improve the current one.

After measuring inventory turnover, companies usually adjust the following:

  • Product pricing
  • Manufacturing volume
  • Purchase volume
  • Underselling merchandise

Calculating Inventory Turnover Rate

how to calculate inventory turnover

The turnover rate can be calculated by a simple formula known as Cost Of Goods Sold (COGS). This formula refers to the direct cost of producing goods that are sold by a company.

This cost also includes the cost of materials and labor directly used to manufacture the goods. Indirect expenses like distribution, salesforce, and logistics are usually excluded from this formula.

Here is the base formula to calculate Inventory Turnover Rate (ITR).

calculate inventory turnover formula

The inventory turnover rate is calculated by dividing the cost of goods sold by the average inventory.

So, if your COGS for 2020 totaled at 500,000$ and your inventory was at 100,000$, your turnover rate will be 5. Now is 5 a good number? It depends on your business goals and industry.

What is a Good Inventory Turnover Ratio? In general, a value between 5 and 10 is considered a good turnover ratio for many industries. This means that your stock is completely sold and re-stocked within a month or two.

However, do keep in mind that this isn’t a hard and fast rule. Your business may have a completely different model and goals. The most important part is optimizing your ITR according to your business needs.

Is Having Very High Turnover Good?

Having a high inventory turnover ratio is considered much better than having a low one. But, having an extremely high turnover ratio can mean that your products or services are underpriced.

In this case,  we recommend adjusting your pricing structure. But it’s a double-edged sword as implementing a drastic price increase can be off-putting for your customers.

Also, if you feel the need to continuously restock your inventory, it means your inventory levels are constantly low. A small hiccup in the supply chain can lead to a shortage and you might not be able to meet your customer’s demands.

Improving the Turnover Rate

Bundle Products  Together

People are often buying similar products together. Bundling your underselling products with best-selling items can benefit the sales of both. It may seem like a simple idea, but it’s a very powerful one.

It’s best to take a data-driven approach when it comes to bundling your offerings together. For example, if the data suggests that two products are doing well on their own,  there is no need to bundle them together.

Adjusting Prices

As discussed before, one of the causes behind your inventory turnover ratio being too low or high is due to its price. Ecommerce sites have made it easy to compare prices from different sellers.  Plus, customers nowadays research thoroughly before making a buying decision.

It’s a good practice to stay up-to-date with the industry trends and review your product pricing every now and then. However,   it’s not a guarantee that lowering the prices will net a good turnover score. It can impact your turnover ratio in either direction so it’s important to tread cautiously.

Launch a Marketing Campaign

A properly executed marketing campaign can give a huge boost to your inventory turnover rate. Capitalizing on trends and acting according to your customers’ buying patterns is recommended. This way, you can quickly increase sales with targeted promotions.

Conclusion

Information like inventory turnover rate, its calculation, and how it translates to your business can help you see your business operations in a new light and even potentially improve your turnover. The definition of a high or low turnover rate is highly subjective to your business industry. It’s up to you to figure out if your products are doing well in the market or are set up to fail.

Rapid Fire Questions

Q#1: What is Inventory Turnover Rate?

Ans:  Inventory turnover rate refers to the ratio that indicates how frequently a company has sold its physical products.  It helps businesses identify how quickly or slowly their products are being sold.

Q#2: What is the formula to calculate Inventory Turnover Rate?

Ans: Inventory Turnover = (Net Sales) / (Average Inventory at Selling Price)

Q#3: What is considered a good Inventory Turnover Ratio?

Ans: Having an Inventory turnover ratio of 5 to 10 is generally considered good. However, it’s highly subjective and depends on your business industries.

Q#4: Is having a very high turnover rate good?

Ans: Not necessarily.  High turnover rates might also indicate that your products are underpriced when compared to your competitors. This can lead to other problems such as product shortage.

Q#5: How to fix a low turnover rate?

Ans: You can fix a low turnover rate by :

  • Offering underselling products in bundles
  • Increasing marketing and promotional activities
  • Adjusting the price of your underselling products
  • Adjusting your order cycle to match the product’s demand and avoid issues like over-stocking
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