What is Inventory Turnover?

Inventory turnover can be calculated by value or quantity and is used to visualize the flow of inventory. Knowing the inventory turnover ratio helps to visualize the sales of products, thus avoiding unnecessary inventory and reducing costs.

This article explains what inventory turnover ratio is, how it is calculated, its benefits, and how to improve it.

What is inventory turnover?

Inventory turnover is an indicator of how inventory changes over a given period of time. It can be calculated using the cost of sales, average inventory value and the number of inventory items. This can then be visualized as inventory trends.

A high inventory turnover indicates that the product sells well. However, when consumer needs for certain products change seasonally, the average inventory turnover ratio may not be helpful. By understanding what inventory turnover is, how it is calculated, and the benefits of utilizing it, inventory turnover can become an important source of information influencing a company's management strategy.

Purpose of inventory turnover ratio

The purpose of inventory turnover ratio is to visualize the flow of inventory, and it tells business owners and warehouse management how efficiently their company moves products.

For example, suppose there are two products, A and B. If the inventory turnover per month is calculated as "1 for Product A" and "3 for Product B," it can be determined that Product B is selling better. A product with a low inventory turnover ratio could result in storage and disposal costs, so to prevent inventory buildup, it is important for a company to take measures.

How to calculate inventory turnover ratio

Inventory turnover is often thought to be difficult to calculate, but it can be calculated using simple calculations based on monetary values and number of items.

Calculation method using amounts

The inventory turnover ratio can be calculated by dividing the annual sales amount (cost) by the average inventory amount. The sales amount (cost) for the year is calculated by using the following formula: "the inventory of goods at the beginning of the year + the purchase amount of goods for the year - the inventory of goods at the end of the year”.

The reason for using the sales amount (cost) is that the average inventory amount is a purchase amount, meaning it must be calculated at cost, and the actual sales amount is not a correct figure.

Calculation using quantity

The inventory turnover ratio is calculated by using the "number of deliveries (total)/average number of inventory" for a certain period of time.

Assuming that the total number of inventory items dispatched in 2021 was 500, the number of inventory items at the beginning of the period was 100, and the number of inventory items at the end of the period was 100, the calculation can be made as follows.

• Total number of inventory released = (100 pieces of inventory at the beginning of the period + 100 pieces of inventory at the end of the period)/2 = 100 pieces.
• Inventory turnover = Total number of inventory 500 pieces/Total number of inventory released 100 pieces = 5.

Calculations using monetary values are for management since they are based on financial statements, however, inventory counts are easier for employees to perform.

Points for calculating average inventory amount and average inventory count

The key to calculating "average amount of inventory" and "average number of inventory" is that they are both calculated based on the average of the beginning and the end of the period.

First, the "average amount of inventory," which is used to calculate the inventory turnover ratio, is calculated using the formula "beginning inventory amount + ending inventory amount x ½”.

As an additional point, the term "average inventory value" is sometimes used interchangeably with "inventory," but both terms are calculated in the same way.

The "average inventory quantity" used in the quantity-based calculation method can be calculated as "beginning inventory + ending inventory x ½”.  By applying the formula, it is additionally possible to determine the amount of average inventory needed to clear the target number of inventory turnover.

Estimated inventory turnover ratio by industry

When determining a guideline or target for inventory turnover ratio, it is recommended to refer to the average of other companies in the same industry.

How to calculate inventory turnover

Inventory turnover refers to the turnover of inventory over a given period of time, and can be calculated using the formula "Inventories/Sales”.

For example, if inventory is 5 million dollars and annual sales are 10 million dollars, the calculation is "Inventory 1 million dollars / (Sales 1000 / 365 days) = 37," indicating that inventory is replaced every 37 days out of 365 days.

In this case, we calculated the inventory turnover period on a daily basis as 365 days, but if you would like to calculate it on a monthly basis, you can divide it by 12 to calculate the inventory turnover period, depending on the period you want to know.

Relationship between inventory turnover and proper inventory

To confirm whether inventory management is being conducted properly, inventory turnover ratio and inventory turnover period can be a good indicator.

Since proper inventory refers to the number of inventory items without excesses or deficiencies, if the inventory turnover ratio can be visualized, it is possible to ascertain whether the current inventory management is being carried out properly.

If the average inventory value is 10 million dollars and annual sales are 50 million dollars, the inventory turnover rate is 5 times/year, which means that inventory is replaced about once every 2.4 months.

If a company has a high annual inventory turnover, it indicates that it is effectively managing its inventory and maintaining appropriate stock levels.

How to calculate and set the appropriate number of inventory days

Inventory days represent the number of days of sales that would occur if all currently stored inventory were sold, and can be calculated as "inventory value (selling price)/average daily sales”.

If the number of days in inventory is long, the number of days the goods are stored is also long; if the number of days in inventory is short, the number of days the goods are stored is short as well.

According to Inventory Management 110, which sells inventory management systems, the typical inventory days by industry are listed as "Manufacturing: 30-50 days”, "Wholesale: 20-30 days”, and "Retail: 15-20 days”.

Since the number of inventory days varies by industry and product, it is recommended to set the appropriate number of inventory days while also taking into account the company's sales situation.

Lead time is key to maintaining appropriate inventory turnover days

Inventory turnover can be calculated as "days/inventory turnover ratio" and refers to the number of days of inventory turnover. Lead time refers to the number of days required from product order to delivery, and in order to maintain appropriate inventory turnover days, the number of lead time days must also be taken into account.

If the lead time is 10 days and the inventory turnover days are 30 days, then the product must be ordered while 10 days of inventory is available.

Also, lead time varies greatly depending on what you are purchasing, which is why it is important to keep track of how many days are needed for each item.

In the case of overseas imports, the difference in delivery method between ship and plane can be as much as a lap or more, and if you do not know the correct lead time, you may run out of inventory.

For example, if a product has a short lead time of less than one week and a long inventory turnover of 50 days, it is not an appropriate inventory quantity. The appropriate number of inventory turnover days for each product should be set in consideration of the lead time and managed to avoid shortages.

Four benefits of understanding inventory turnover ratio

Comprehending the inventory turnover ratio can lead to the implementation of management strategies that enhance profitability and decrease costs. Below are some specific benefits.

Visualization of inventory flow

Inventory turnover visualizes the flow of inventory and allows for appropriate quality control. If inventory is stored for a long period of time, some products may become unsaleable due to deterioration and may be discarded.

To understand which products are selling at what pace, it is important to know the inventory turnover rate for each product as a numerical value, not as a feeling.

Preventing opportunity losses

Inventory with a high inventory turnover ratio is a hot-selling product, so if you can purchase appropriately while taking lead time into consideration, it becomes possible to prevent opportunity losses.

Opportunity loss is a missed opportunity to increase profits, and it has a significant impact on the business situation. In order to improve profits, it is important to utilize the inventory turnover ratio as an indicator of when to make purchases and implement a management strategy.

Know what customers are looking for

Inventory turnover rates fluctuate according to sales conditions, allowing you to know what products your customers are looking for. Some products sell well only at certain times of the year, and determining how many to stock at any given time is important for earning more profit.

In addition, products with high inventory turnover can be judged to be in demand by many customers, which can lead to higher sales if they can be stocked without running out of stock. Conversely, if products with low inventory turnover are stored for a long period of time, it is recommended to consider disposing of them, as they may be wasting money in addition to putting pressure on storage space.

By increasing your storage capacity, you can store more high-turnover products and effectively fulfill your customers' demands. Identifying your customers' needs can help you devise a business strategy to boost sales and cut costs.

Reduce costs without excess inventory

By understanding inventory turnover, you will be able to visualize appropriate inventory, thus avoiding the problem of overstocking. Furthermore, by comparing several years of inventory turnover data, it becomes possible to more accurately determine the proper amount of inventory and purchase the number of inventory needed.

Excess inventory is often composed of products with poor sales. Therefore, purchasing such products can result in costly excess inventory. This not only incurs storage costs but also disposal costs. To reduce costs, it is essential to keep track of the sales of each product and avoid buying products that are not selling well.

Four points to increase inventory turnover ratio

Since improving the inventory turnover ratio will lead to lower costs and higher customer satisfaction, please refer to the following four points to develop your management strategy.

Set a target for inventory turnover ratio

The target inventory turnover ratio can be calculated by dividing the annual sales target by the target average inventory amount.

If the annual sales target is 30 million yen and the target average inventory is 3 million yen, the target for inventory turnover ratio is 10, which means that inventory will be replaced every 1.2 months.

To enhance employee motivation and determine your yearly operating policy, it is advisable to establish a specific goal for inventory turnover ratio while taking into account the inventory turnover rates of your peers during goal setting.

Review lead times

To increase the likelihood of repeat business, enhancing customer satisfaction is key. One effective way to achieve this is by reducing lead time from order receipt to package delivery, thereby shortening the time it takes for products to reach customers.

Review your lead time to see if there are any operations that can be shortened, as this will allow you to meet customers' delivery timing requirements, such as same-day delivery.

Change selling prices

To avoid incurring storage costs, it's important to increase the inventory turnover of products with low turnover rates. One effective way to achieve this is by reviewing the selling prices of these products and potentially lowering them. 

However, it's crucial to be mindful when changing the selling price as a significant price reduction could have negative effects on the company's brand value. It's also important to note that disposing of the product can also come with its own drawbacks and costs.

Therefore, careful consideration is necessary before making any decisions regarding pricing and inventory management.

Implement a warehouse management system

Warehouse management systems are equipped with functions that aim to improve the efficiency of logistics operations, and their introduction can help improve inventory turnover. For example, IC tags can be attached to products and read by a terminal to identify the number of products and their storage locations in real time.

Note that if warehouse management is not done correctly and product quality deteriorates or the storage location of inventory is lost, the lead time until the product reaches the customer may increase and the inventory turnover rate may decrease.

Conclusion

This article has introduced the inventory turnover ratio, its calculation method, benefits, and ways to improve it.

Inventory turnover ratio is an important indicator for maintaining an optimal inventory count as it allows visualization of inventory flow, while also being useful as a cost reduction.

In addition to setting targets, reviewing lead times and selling prices can also be effective in improving inventory turnover. If you are considering improving the efficiency of your overall logistics operations, we recommend implementing a warehouse management system.