Don’t be alarmed if the phrase inventory turnover makes you want to scratch your head.
After all, most small business owners don’t have formal inventory or accounting training. But this is one of those times where diving into the technical could prove to be immensely beneficial (and profitable) for your business. Let’s take a closer look at inventory turnover together — what it means, what it does, and how to use it.
What is inventory turnover ratio?
Simply put, inventory turnover ratio calculates the number of times that a company cycles through (or replaces) its inventory in any given time period. While calculating it is a matter of applying a simple formula which we will examine shortly, the way it applies to and affects a company’s operations can be extensive.
Measuring how fast a business (particularly a retail business) goes through the products it has in stock can reveal many important performance indicators that would otherwise go unnoticed. Some of the areas directly affected by inventory turnover include, but are not limited to purchasing, ordering, cost-management, storing and moving supplies, packaging, shipping, marketing, invoicing, and cash flow management.
It’s easy to see that ultimately, inventory is at the core of a retail operation. Cash flow is often said to be the blood of a business, and if that’s true, then inventory is most certainly the heart — responsible for generating both the cash flow and profit.
Let’s Take a Look at the Basics of Inventory Management
Most commonly, inventory is thought of as something that is completed by setting aside a large block of time to determine what is and isn’t on your shelves — separating the projected stock from what’s actually on hand after breakage, theft, mismanaged tracking, and other losses. It may surprise you to find out, however, that in the end, the result is little more than a single data point, and that there are many more steps that can be taken afterward.
Inventory is often viewed as static, but in fact, it has a rhythm of its own. As a whole, inventory management refers to how a company’s leadership and management controls the flow of goods and merchandise through a business. It also includes the systems and software used to assist in this process. Ultimately, it’s a combination of steps and procedures applied during daily operations that can speak volumes about how well a company operates as a whole.
Because inventory usually represents a substantial percentage of a company’s operating assets (or assets directly involved in generating profit), the way it moves into, through, and out of the business can predict how the company will do in the long run.
There are a number of commonly accepted systems, such as last-in-first-out (LIFO), first-in-first-out (FIFO), highest-in-first-out (HIFO) and JIT (Just-in-time), and dozens of programs and tools that can aid you in your quest for management efficiency. Now let’s look at the barest necessities of inventory management skills.
The process by which we do inventory, or take a physical accounting of what’s in stock, consists of three primary steps.
1. Pull stock items report or equivalent (your POS system reporting should allow you to do this in a few easy steps)
2. Compare the stock items list to physical stock to account for any discrepancies between the two data points
3. Make adjustments to the stock item list to reflect the final, accurate totals
With this accurate, real-time data, we can now begin to track the inventory’s progress and follow its movement through your business. We do this by first mapping inventory data (the stock on hand) at predetermined times throughout the business cycle (for example, monthly).
With a minimum three months of data (though 12 is ideal), one can begin to draw parallels between the business cycle (ordering, marketing, and distribution), and the way inventory behaves on the shelves. Certain times will reveal higher demand (and hence lower inventory), while slow sales will correspond with overstock.
So if taking an initial inventory of stock is point A, mapping that stock at certain time intervals and putting those numbers on a graph is point B, then point C is the analysis work that must follow in order to draw conclusions.
Now let’s look at calculating your inventory turnover ratio.
Calculating your inventory turnover ratio can be done in a number of different ways. Here are a couple of options:
1. Sales divided by ending inventory. As a practical example, a retail business that does 100,000 in sales and has 10,000 in ending inventory has a stock turnover ratio of roughly 10. This means that the inventory turns over or exchanges approximately 10 times over that period.
2. Cost of Goods Sold (COGS) divided by inventory. This requires tracking inventory over a period of time to get an average, so it may be more accurate to do it this way: Annual COGS / Average Annual Inventory.
So let’s pretend that in the example above, the 100,000 sale figure was for the month of January. The figure fluctuated slightly, and over a 12-month period we ended up with 1,400,000 in sales (due to a busy holiday season). If the COGS was 1,050,000, and the inventory monthly average was 12,000, then 1,050,000/12,000 = 87.5. This figure suggests that this business turned its inventory 87.5 times during that calendar year.
3. Days Sales of Inventory (DSI) is sometimes a useful representation of turnover that shows the same figure as above in days. To achieve it, take the final product of B and divide it into 365 to receive the stock turnover period in days. So 365 / 87.5 = 4.17, so about once every four days. This represents a very high turnover ratio.
One thing to note is that regardless of how you choose to calculate your turnover, the important thing is to remain consistent.
A Few Additional Things to Know
Now that you know how to calculate your inventory turnover, there are a few additional terms related to inventory turnover, that if you become familiar with, will be helpful for your business in the long run.
To begin with, your carrying cost of inventory is the cost associated with the storage and maintenance of your inventory. Since the faster the inventory moves, the less time it spends on the shelf (and hence the less it costs), the carrying cost is also affected by the turnover ratio. Another important thing to keep in mind is that increasing sales often means increasing the total cost of inventory, either in terms of volume on hand or the carrying costs.
The operating leverage of a company is the ratio of its fixed and variable costs as compared to its total costs. If fixed costs are higher, then so is the operating leverage since the costs remain the same as more profit is made. If variable costs are higher, the operating leverage is lower. Since the opposite is now true, more profit means higher costs. The degree of operating leverage matters because of its impact on profits and losses. Since inventory is used to generate sales (and therefore profits), having a clear understanding of which costs are fixed/variable can help with dialing in your optimal inventory turnover ratio.
Having the carrying cost and operating leverage numbers along with industry averages can form a solid basis for analyzing a company’s performance or predicting the potential return on investment (ROI) in purchasing, either the business as a whole, or in part (stock shares of a prospective investment).
Bottom line: The productivity of your inventory (as measured by the ratio of inventory turnover) will determine your company’s flexibility and overall pace in generating profit. Drive your business towards the next level of growth in the coming year by finding ways to make adjustments to your inventory turnover and to push the envelope of cash flow and profitability.