How to Calculate and Analyze Inventory Turnover Ratio
September 16, 2019
Managing inventory effectively and efficiently is vital to the success ecommerce brands. Whether you store your products yourself or partner with a 3PL, understanding the data around your inventory and operations can help you reduce shipping costs, increase efficiency, and maximize cash flow.
What is inventory turnover ratio?
Inventory turnover is measured by a ratio that shows how many times inventory is sold and then replaced in a specific time period. Understanding the average inventory turnover is a critical measure of business performance, cost management, and sales, and can be benchmarked against other companies in a given industry.
How to calculate inventory turnover ratio
To calculate inventory turnover, complete the following 3 steps:
- Identify cost of goods sold (COGS) over the accounting period
- Find average inventory value [ beginning inventory + ending inventory / 2 ]
- Divide the cost of goods sold by your average inventory
Here’s the simple inventory turnover formula:
Inventory turnover = COGS / Average Inventory Value
For example, if your COGS was $200,000 in goods last year, and your average inventory value was $50,000, your inventory turnover ratio would be 4.
You can also calculate your inventory turnover ratio by looking at units, rather than costs:
Inventory turnover = number of units sold / average number of units on-hand
If you sell 1,000 units over a year while having an average of 200 units on-hand at any given time during that year, your inventory turnover rate would be 5.
How analyze inventory turnover ratio
Fully understanding inventory turnover can provide invaluable insight into how your ecommerce business manages costs, how sales initiatives are performing, and how you can further optimize inbound and outbound logistics workflows.
Once you know how to calculate inventory turnover ratio, the next step is understanding what a high turnover rate versus a low turnover rate means, and what the ideal inventory ratio is so you can create an action plan on how to improve the higher inventory turnover ratio.
What is an ideal inventory turnover rate?
For most retailers, an inventory turnover ratio of 2 to 4 is ideal; however, this can vary between industries, so make sure to research your specific industry. A ratio between 2 and 4 means that your inventory restocking matches your sale cycle; you receive the new inventory before you need it and are able to move it relatively quickly.
Low inventory turnover
A rate of 1 or less means you have excess inventory. For example, if you sell 20 units over a year, and always have 20 units on-hand (a rate of 1), you invested too much in inventory since it is way more than what’s needed to meet demand. It’s important to maintain inventory levels by calculating how much the company sells and avoid dead stock which cogs your entire cash flow.
High inventory turnover
High inventory turnover can indicate that you are selling your product in a timely manner, which typically means that sales are good in a given period. Ecommerce retailers should strive for a high inventory turnover rate, which means they sell the inventory they have on hand quickly and repurchase fresh inventory often. This also helps save on inventory carrying costs.
While a high turnover rate is generally considered an indication of success, too high of an inventory turnover rate can actually be problematic. An influx of sales can cause you to constantly have to replenish inventory, and if you can’t keep up with demand, you may experience stockouts.
This is especially true if it takes weeks to replenish the stock for a specific SKU; that can mean weeks of lost sales on what is clearly a popular item.
How to maximize your inventory turnover rate
Whether your inventory turnover is too high or too low, learn the measures you can take to try and combat or regulate the issue.
To solve for (very) high inventory turnover
High inventory turnover is easier to solve than low inventory turnover; you either need to order more inventory or make fewer sales. Typically, this boils down to needing more stock on average to meet your customer demand. Proper demand forecasting can help.
For products with a high inventory turnover ratio, make sure to keep a back stock. Using inventory management software can help you analyze your inventory.
To solve for low inventory turnover
If your inventory turnover ratio is too low, you need to decrease the average amount of inventory on hand. There are several strategies you can use, but the bottom line is that you need to order less and/or sell more. Here are some great ways to make your inventory turnover more efficient:
- Offer promotions to deplete inventory by increasing sales. Beyond clearing inventory, discounts can be an effective way to drive customer loyalty, boost word-of-mouth marketing, and help your business grow.
- Buy less stock, more often. By purchasing inventory to meet a month’s demand, rather than the whole year’s, you take on less risk and invest less capital in products that may not necessarily sell. This can be especially prudent when stocking a new product for which you don’t have prior sales data.
- Negotiate discounts with your manufacturer or supplier. If you’ve built a strong rapport with your supplier, you may be able to negotiate a lower price for recurring orders.
- Encourage pre-orders. Pre-orders can be a beneficial tool for businesses looking to gauge demand, generate excitement, and raise funds.
Keep in mind that inventory turnover ratio is just one metric, and is focused at the SKU level. It’s important to consider additional numbers, such as manufacturing and logistics costs and lead times, to get a full picture of your business’s efficiency.
Partner with a 3PL
If you are looking for a 3PL that will help you manage your inventory in real time, check out ShipBob. With ShipBob’s technology combined with nationwide fulfillment, you can gain a holistic view of your operations with just a few clicks. ShipBob’s built-in inventory reports let you view a trend analysis of your products and give you more control over the key metrics that drive business growth.
“Off the bat, I liked that I would be able to control multiple warehouses through one page with ShipBob. With my old 3PL, I could never just open a page and get the info I wanted. I had to click several times, then export it, and try to make sense of it. ShipBob lets you manage your inventory while providing important data in a very digestible way.”
Wes Brown, Head of Operations at Black Claw LLC
ShipBob also allows you to set automatic reorder point notifications to remind you when it’s time to replenish each item at each ecommerce fulfillment center. Choosing the right reorder notification point will ensure that there is time to send and restock more inventory before orders are put on hold for lack of inventory.
Inventory management is a vital part of ecommerce operations. You need to track your ecommerce store’s orders closely to ensure that you can manage your inventory in a cost-efficient way that maximizes your business’s cash flow while meeting customer demands.
“So many 3PLs have either bad or no front-facing software, making it impossible to keep track of what’s leaving or entering the warehouse.
On the supply chain side, I just throw in what we placed at the factory into a WRO in the ShipBob dashboard, and I can see how many units we have on-hand, what’s incoming, what’s at docks, and so on. I can see all of those numbers in a few seconds, and it makes life so much easier.”
Harley Abrams, Operations Manager of SuperSpeed Golf, LLC
Calculating inventory turnover ratio is a great way to determine if you need to increase or decrease your inventory supply while also helping you understand your company’s inventory for future financial decisions. Gone are the days of using spreadsheets and inventory sheets. You need the right technology to manage it.
“Another ShipBob integration I love is Inventory Planner. It saves me hours every week in Excel spreadsheets, and I can raise a PO in minutes when it used to take me hours. For every order I placed for years, I was ordering too much or not enough. Between inventory forecasting tools and the ability to auto-create WROs, we don’t have stockouts much anymore. I sleep better at night.”
Wes Brown, Head of Operations at Black Claw LLC
Like any metric, it’s not a one-time measurement, but rather a continuous evaluation. Your inventory turnover ratio can fluctuate over time, and you’ll want to make sure you respond accordingly.