What is inventory turnover?
Inventory turnover is defined as the number of times inventory is sold or used in a given period, usually a month, quarter, or year. The formula for calculating your inventory turnover rate is the following:
Inventory turnover rate = (Cost of goods sold / Average inventory value)
For example, if a company’s cost of goods sold for the year is $1 million and its average inventory is $100,000, then its inventory turnover rate would be:
Inventory turnover rate = ($1 million / $100,000) = 10 times per year
In other words, in a typical year, this company’s inventory can be sold and replenished ten times.
Why is it important to know your inventory turnover rate?
If you’re an eCommerce or product-based business, it’s essential to know your inventory turnover rate for a few key reasons:
1. It’s a good way to measure how efficient your company is at selling its products or services. A high turnover rate generally means that your company is doing a good job of selling what it has in stock.
A low turnover rate could indicate that your company is having trouble selling its products or services, which could be a sign of poor customer demand or poor pricing. Holding onto inventory for longer also is generally more expensive because you have to pay to store that inventory until it’s sold.
2. It can help you forecast future sales. If you know your inventory turnover rate, you can use it to estimate how much inventory you’ll need to have on hand to meet future sales demands.
This is especially helpful if you’re planning to grow your business, as you’ll need to make sure you have enough inventory in stock to meet increased demand.
3. It can help you manage your cash flow. Knowing your inventory turnover rate can help you better forecast your future cash needs.
This is because when you have a high turnover rate, you’re selling and replenishing your inventory more frequently, which means you’ll need to have more cash on hand to pay for a new product.
Conversely, if you have a low turnover rate, you won’t need as much cash on hand to pay for inventory, as you’ll be selling and replenishing it less frequently.
What is a good inventory turnover rate?
Some sources will tell you to shoot for a yearly turnover rate between four and six, but there is no magic number when it comes to what constitutes a “good” inventory turnover rate.
It all depends on your industry, your business model, and a variety of other factors (many of which we’ll explain in the next section).
In general, a higher turnover rate is better than a lower one, as it indicates that your company is selling its products or services at a good clip. However, there are some exceptions to this rule, which we’ll discuss in the next section.
A good starting point is to compare your company’s inventory turnover rate to that of other companies in your industry. This will give you a benchmark to measure yourself against and can help you see where you need to improve.
How do you find these numbers? Well, if your competitors (or at least similar businesses in your industry) are publicly-traded, this information is freely available on their quarterly and annual financial statements.
For example, electronics retailer Best Buy ended its Q2 with a 5.22x quarterly inventory turnover ratio. Right now, their annual inventory turnover rate is 7.2x.
What factors affect your inventory turnover rate?
There are a number of factors that can affect your company’s inventory turnover rate. Here are some of the most common ones:
1. The type of business you’re in: Some businesses, by their very nature, have higher inventory turnover rates than others.
For example, businesses that sell perishable goods (such as food) or seasonal goods (such as clothing) will typically have higher turnover rates than businesses that sell non-perishable or non-seasonal goods.
Businesses that sell high-ticket items with longer sales cycles will also have lower turnover rates than businesses that sell lots of low-ticket items.
2. Your business model: The way you do business can also affect your inventory turnover rate.
For example, if you sell products that are made to order, you won’t have any inventory on hand until a customer places an order.
This means your turnover rate will be lower than a company that sells products that are already in stock.
3. The state of the economy: The overall state of the economy can also affect your inventory turnover rate.
For example, during an economic downturn, people may be less likely to make big purchases, such as furniture or electronics. This could lead to a decrease in sales and a lower inventory turnover rate.
4. Your pricing: The price you charge for your products or services can also affect your inventory turnover rate.
If you charge too much, potential customers may be turned off and decide to buy from a competitor. On the other hand, if you charge too little, you may make less profit per sale, which could lead to a lower turnover rate.
5. Your marketing: If potential customers don’t know about your business or what you have to offer, they’re not going to buy from you. This could lead to a decrease in sales and a lower inventory turnover rate.
6. The competition: If there are a lot of other businesses selling similar products or services, it may be harder to stand out from the crowd and attract customers. This could lead to a decrease in sales and a lower inventory turnover rate.
7. Your location: If you’re in a high-traffic area, such as a busy shopping mall, you’re likely to get more foot traffic and potential customers than if you’re in a less convenient location. This could lead to a higher turnover rate.
8. The time of year: Businesses that sell seasonal goods (such as Christmas trees or Halloween costumes) will typically see a spike in sales during the relevant season. This could lead to a higher turnover rate.
9. Your product mix: If you sell a lot of high-end products that have a longer shelf life, such as diamonds or artwork, your turnover rate is likely to be lower than a business that sells lower-priced items with a shorter shelf life, such as clothes or food.
10. Your inventory management: Finally, how well you manage your inventory can also affect your inventory turnover rate.
If you have solid inventory management software in place to track your inventory and keep it well-stocked, you’re likely to have a higher turnover rate than a business that doesn’t manage its inventory as well.
The calculation for inventory turnover rate
As mentioned in the introduction, the calculation for inventory turnover rate is the following:
Inventory turnover rate = (Cost of goods sold / Average inventory value)
To calculate your company’s inventory turnover rate, you will need the following information:
1. The cost of goods sold: This is the total cost of the merchandise that you have sold during a certain period of time, such as a month, quarter, or year.
You can find this information on your income statement or check out our guide on calculating COGs.
2. The average inventory value: This is the average value of your inventory during a certain period of time, such as a month, quarter, or year. To calculate this, you will need to take the beginning inventory value and add it to the ending inventory value, then divide it by two.
For example, let’s say that your company’s cost of goods sold for the year was $100,000, and your average inventory value was $20,000. This would give you an inventory turnover rate of 5 ($100,000 / $20,000).
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How to improve inventory turnover rate
There are a few different ways that you can improve your inventory turnover rate:
Review your product mix
Take a look at the mix of products that you’re selling and see if there’s anything that you can do to change it.
For example, if you sell a lot of high-end products with a longer shelf life, you may want to consider adding some lower-priced items with a shorter shelf life. This could help to increase your turnover rate.
Review your pricing
Another way to improve your inventory turnover rate is to review your pricing.
If you find that your prices are too high, you may want to consider lowering them. This could help to increase sales and, as a result, your turnover rate.
Improve your inventory management
Finally, you may want to consider improving your inventory management.
If you have a good system in place to track your inventory and keep it well-stocked, you’re likely to have a higher turnover rate than a business that doesn’t manage its inventory as well.
There are a few different ways that you can improve your inventory management, such as:
Automating your inventory management: There are a number of software programs that can help you to automate your inventory management. This can make it easier to keep track of your inventory and reorder items when necessary.
Hiring a dedicated inventory manager: If you don’t have the time or resources to manage your inventory yourself, you may want to consider hiring a dedicated inventory manager. This person will be responsible for keeping track of your inventory and making sure that it stays well-stocked.
Implementing just-in-time inventory: Just-in-time inventory is a system where you only order the amount of inventory that you need at a given time. This can help to reduce waste and keep your costs down.
Examples of businesses with high, medium, and low inventory turnovers
Retail businesses: Retail businesses tend to have high inventory turnovers because they sell a lot of products that have short shelf lives.
Boutique online businesses: Smaller, more specialized online businesses (not huge marketplaces like Amazon or Wal-Mart) also tend to have high inventory turnovers because they can sell their products quickly and easily without having to worry about storing them.
Manufacturing businesses: Manufacturing businesses usually have medium inventory turnovers because they often produce products that have longer shelf lives.
Wholesale businesses: Wholesale businesses tend to have low inventory turnovers because they sell products in bulk and often have to store them for long periods of time before they can sell them.
FAQs about inventory turnover
Why is a higher inventory turnover ratio better?
A higher inventory turnover ratio is often seen as being better because it indicates that a company is selling its products quickly and efficiently. This can lead to lower storage costs and less waste.
This also eliminates costly “dead stock” or inventory that doesn’t sell (or cannot be sold due to expiration or lack of demand).
What is a good inventory turnover ratio?
The answer to this question depends on the industry that you’re in. For example, retail businesses tend to have higher inventory turnover ratios than manufacturing businesses.
Generally speaking, a higher inventory turnover ratio is more favorable than a lower one.
Can inventory turnover ever be too high?
In some cases, yes. If a company’s inventory turnover ratio is too high, it may mean that the company is not stocking enough products to meet customer demand. This could lead to lost sales and frustrated customers.
It’s important to strike a balance between having too much and too little inventory on hand.
Exorbitantly high inventory turnover rates, when combined with other inventory management benchmarks (like frequent stock-outs), may be a sign that businesses need to either raise their prices, improve their inventory management, or both.
Final thoughts
Inventory turnover is a critical metric for all businesses to track, especially eCommerce and product-based businesses.
Generally speaking, a higher turnover rate is better than a lower one, but this is contingent on your business model and several other factors.
Inventory turnover is just one metric among many that organizations can use to determine the health of their product sales pipeline.
For more actionable advice for improving your inventory management processes (and therefore your cashflow), read this post next:
19 Top Effective Inventory Management Techniques and Best Practices.
