What is the inventory turnover ratio, how is it calculated, and how to improve it? Find out in this article.
Are you familiar with the concept of inventory turnover, but would you like to learn more about its calculation and purpose?
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 defines the inventory turnover ratio, how it is calculated, the benefits of paying attention to it, and how to improve it.
Inventory turnover, also known as merchandise turnover, is an indicator of how inventory changes over a given period of time. It is a financial ratio showing how many times a company has sold and replaced inventory during a given period. It can be calculated using cost of sales and average inventory value, calculated from the number of inventory items, and visualized as inventory trends. Inventory turnover is useful as a reference for management strategy and inventory control, assuring that they are aligned with the company's business situation and goals.
The inventory turnover ratio serves the purpose of visualizing the movement of inventory. Generally, high ratios are better than low ones.
As an example, suppose there are two products, A and B. If the inventory turnover per month is calculated as "1 for A" and "3 for B," it can be determined that B is selling better. A product with a low inventory turnover ratio could result in storage and disposal costs, so it is important for a company to take measures to prevent inventory buildup.
Inventory turnover is often thought to be difficult to calculate. However, it can be calculated using simple calculations based on monetary values and the number of items. Below, we will define the most common ways of calculation.
The inventory turnover ratio can be calculated by dividing the annual cost of goods sold (cost of sales) by the average inventory value. The cost of sales for the year is calculated by using the following formula:
"The value of the inventory of goods at the beginning of the year PLUS the purchase value of goods for the year MINUS the value of the inventory of goods at the end of the year”.
The rationale behind using cost of sales instead of sales is rooted in the fact that the average inventory value represents the costs of purchased goods. In contrast, the actual sales amount does not provide an accurate depiction of the situation since it includes the markup of sold goods.
For example, using the formula "Sales/Inventory”, if inventory is 1 million USD and annual sales are 10 million USD, the calculation is "Sales $10 million USD / Inventory $1 million USD = turnover ratio of 10. Indicating that the inventory is approximately replaced every 37 days (365 days / 10 replacements)
In this case, we calculated the inventory turnover period on a daily basis as 365 days, but if you want 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.
it is worth noting that the terms "average inventory value" and "inventory" are sometimes used interchangeably.
The inventory turnover ratio using quantity 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 a year 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.
Calculations using monetary values are for management since they are based on financial statements, however, inventory counts are easier for employees to perform.
By applying the formula, it is additionally possible to determine the amount of average inventory needed to clear the target number of inventory turnover.
By analyzing the inventory turnover ratio and inventory turnover period, it becomes possible to assess whether proper inventory management practices are being implemented.
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.
For example, if the average inventory value is 10 million USD and annual sales are 50 million USD, the inventory turnover rate is 5 times/year, which means that inventory is replaced about once every 2.4 months.
If a company exhibits a high annual inventory turnover, it suggests effective inventory management practices and the maintenance of optimal stock levels.
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”.
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 refers to the number of days required from product order from the manufacturer to delivery to the warehouse. In order to maintain appropriate inventory turnover days, the number of lead time days for replenishment orders must also be taken into account.
When the lead time is 10 days and the inventory turnover days are set at 30 days, it becomes necessary to place a replenishment order when there is still at least 10 days' worth of inventory remaining. Additionally, it is important to note that lead time can vary significantly depending on the specific item being purchased. Therefore, keeping track of the required number of days for each item is crucial.
When dealing with overseas imports, the choice of delivery method between ocean and air transport can result in a substantial difference in lead time. Failing to accurately estimate the lead time can potentially lead to inventory depletion. The appropriate number of inventory turnover days for each product should be set in consideration of the lead time and managed to avoid shortages.
For example, if a product has a short lead time of less than one week and a long inventory turnover of 50 days, it might be not an appropriate inventory quantity. However, the costs for transportation have to be taken into consideration too. Often a longer storage time results in lower costs than more frequent replenishment orders with related transportation costs.
Comprehending and using the inventory turnover ratio can lead to the implementation of management strategies that enhance profitability and decrease costs. Below are some specific benefits of proper management.
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 or expiration and may have to 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.
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.
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 might be beneficial to consider discounting or disposing of them, as they may be causing unnecessary storage costs in addition to putting pressure on storage space.
By increasing your storage capacity, e.g. by using an automated cube storage technology, 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.
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, procuring such products in large amounts can result in costly excess inventory. To reduce costs, it is essential to keep track of the sales of each product.
To enhance the inventory turnover ratio, which in turn reduces costs and boosts customer satisfaction, consider incorporating the following four points into your management strategy.
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 USD and the target average inventory is 3 million USD, 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 industry peers during goal setting.
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. The impact most likely will be a better inventory turnover ratio.
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 your company's brand value. It’s moreover important to note that disposing of the product can also have its own drawbacks and costs.
Therefore, careful consideration is necessary before making any decisions regarding pricing and inventory management.
Warehouse management systems are equipped with functions that aim to improve the efficiency of logistics operations, and their introduction can help improve inventory turnover. To introduce one function, RF tags can be attached to products and read by a mobile RF-terminal to grasp the number of products and their storage locations in real-time. Of course, the use of labels and mobile scanners could be another way of improvement.
It is important to note that inadequate warehouse management, resulting in product quality deterioration or misplaced inventory storage, can lead to increased lead time for product delivery to customers and a decrease in the inventory turnover rate.
The inventory turnover ratio shows the number of times a company turned over its inventory relative to its costs-of-goods-sold in a given time period. It serves as a crucial indicator for maintaining an optimal inventory count, enabling visualization of inventory flow and contributing to cost reduction. This ratio tells you a lot about the company’s efficiency and how it manages its inventory. It also enables the management to compare their company with similar companies in their industry vertical. However, other factors like transportation costs, off-shore or near-shore manufacturing, and seasonal factors might limit these comparisons.
In addition to setting targets, reviewing lead times and selling prices and implementing a modern warehouse management system can be effective in enhancing inventory turnover.
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