How To Calculate, And Correct, Your Inventory Turnover Ratio

Inventory Turnover Ratio

Last Updated October 8, 2021

A business that understands its inventory turnover ratio makes smarter decisions across the supply chain. With clear inventory insights, you can competitively price your products without cutting into profits, bring efficiency into your manufacturing processes, streamline your warehouse management efforts, and predict when to order more goods more accurately.

In this article, we will break down how your warehouse can accurately determine your inventory turnover. We’ll start off by helping you identify the data you need to carry out this calculation. Once you have your figures, we’ll break down what they mean and how you can use them to re-evaluate your existing processes, including your picking and packing methods, your warehouse picking paths, and more.

Let’s get started.

BONUS: Before you read further, download our Warehouse Management Software Whitepaper to see how Logiwa uses real-time data to help you get up to 100% inventory accuracy and execute advanced fulfillment strategies like wave planning.

What Is Inventory Turnover and Why Is It Important?

Inventory turnover shows how many products a company has sold and replaced over a specific period of time. In other words, it’s how quickly a company transforms its inventory into sales. Most companies express inventory turnover as a ratio.

How To Calculate Inventory Turnover

There are two different methods for calculating inventory turnover:

  1. Divide sales by your average inventory
  2. Divide cost of goods sold (COGS) by your average inventory

Let’s quickly take stock of the data we need to run an inventory turnover formula.

Variable Description
Time period

For the purposes of this exercise, we’ll assume our time period is 1 year.

  • Example variable: 1 year
Sales

This is the dollar figure of all your sales over one year. Keep in mind that this is sales revenue, not cash flow. If you’ve sold an item, but haven’t received payment yet, you would still include the dollar value of the sale in your annual sales figure.

  • Example variable: $1 million
Cost of goods sold

This is exactly what it sounds like: the cost of the goods you sold. Your sales figure is the price of goods sold. In other words, your sales figures include a markup. Some companies prefer to use the cost of goods sold because it provides a number that’s more reflective of reality. Some argue that inventory turnover formula calculated using sales revenue results in an inflated number.

  • Example variable: $625,000
Average inventory

Find your average inventory by adding your starting inventory (at the beginning of the year, in this case) to your finishing inventory (at the end of the year, in this case) and then dividing it by 2.

  • Example variable: 1,000 units / 2

Analysts use inventory turnover to assess your company’s health relative to its industry peers. It shows how quickly your company is selling goods, and analysts can use industry benchmarks to see whether you’re under- or over-performing.

Is Your Inventory Turnover Ratio High or Low?

How do you know whether your inventory turnover rate is low or high? The short answer: It depends on your industry. For instance, a luxury goods business will have a low turnover rate in general, but a high turnover rate in terms of its industry. Why? Because luxury goods retailers sell a lower volume of goods, but at a higher price and with higher mark-ups. For their industry, a low turnover rate is acceptable.

So, keep in mind that there is no “general” inventory turnover rate that you should meet. Rather, you should compare your inventory turnover ratio to industry benchmarks.

What does a low inventory turnover ratio mean?

A low inventory turnover ratio points to two big potential issues:

  • Sluggish sales
  • Excess stock

Low turnover is a sign that your goods aren’t selling quickly enough or that you aren’t marketing them effectively. It could also point to issues in your warehouse management. If your goods aren’t getting to customers on time or in the right quantities, your reverse supply chain (returns) may be having a negative impact on your inventory turnover ratio.

What does a high inventory turnover ratio mean?

Interestingly, a high inventory turnover ratio can be a good or a bad sign, depending on the context.

In most cases, it’s a good sign. It means you’re moving products and bringing in revenue. Your stock isn’t sitting on shelves at the risk of theft, damage, loss, spoilage, or obsolescence.

On the other hand, a high turnover rate may point to insufficient inventory. If you’re burning through inventory at a rapid pace, it could be a sign that you’re missing out on additional sales opportunities.

A high turnover rate also presents the risk of stockouts down the road. Stockout events diminish customer loyalty, potentially jeopardizing your future inventory turnover rates as your customers move to other retailers.

How To Correct Poor Inventory Turnover Ratios

Revisit Your Safety Stock Formula

As described above, what exactly constitutes a “sub-optimal” inventory turnover ratio depends on the context. If you have high inventory turnover levels because of inefficient inventory, it’s a sign that you need to revisit your safety stock replenishment strategy and that means thinking about your safety stock formula.

In fact, thinking about your safety stock formula also addresses excess inventory issues, which leads to a lower inventory ratio down the road.

Business owners often rely on gut feelings to determine inventory reorder points. However, if you want a sustainable, scalable business, you’ll need to take a data-driven approach. There are several variations of the safety stock formula, and you may even have software that has this functionality built-in. If not, use this simple formula as a starting point:

Safety Stock = Z × σLT × D avg

Variable Description
Z Z represents your desired service level. There is no “drag and drop” number you can use–this number depends on your business and, specifically, how many “screw-ups” your customers are willing to put up with before they move on to another vendor. As a starting point, pick somewhere between 90 and 95 percent. Eventually, you should use historical data to pick a more accurate service level. You may also have different service levels for different items within your business. For instance, high-priority items may need a service level of up to 99 percent.
σLT σLT represents your standard deviation of lead time. To determine this, you’ll need historical data on your lead times (i.e., the number of days it’s supposed to take to receive goods) and your actual lead times (i.e., the number of days vendors actually take to deliver your goods). Check out this detailed breakdown of how to calculate your σLT for guidance.
D AVG D AVG is your demand average. To calculate this, first, choose a time period (preferably the interval of time between re-order points). Then, figure out how much inventory you go through during that time frame. For instance, if you reorder a specific type of inventory once a month, break down how much you sell each week within that month. Check out this detailed breakdown of how to calculate your demand average.

Once you’ve set your safety stock formula, make sure you set a reorder point into your inventory management system (IMS). You can either set it up so that you are notified when it’s time to reorder or set it up so that a purchase order is automatically sent to the vendor, eliminating the need for manual intervention.

You may also want to consider reviewing end-of-day reports as you familiarize yourself with your inventory data.

Use Flash Sales to Manage Excess Inventory

If you find yourself faced with excess inventory, a flash sale is one option for reducing the load. This type of sale is designed to sell goods at seriously discounted prices over a short period of time.

However, keep in mind that there are a few drawbacks to a flash sale. Since they are purely transactional, they don’t inspire customer loyalty. They also have very low margins, and you’ll have to hand over control of your brand to the site that’s managing the flash sale. Moreover, you’ll need to have a great inventory management and order management system in place to fulfill the influx of orders.

On the other hand, you can quickly get rid of products that could otherwise sit in your warehouse forever.

You may also like: Here is everything you need to know about the days in inventory formula, how to calculate it, and the ways to improve your inventory days formula to optimum levels.

How Warehouse Management Processes Affect Inventory Turnover

Your warehouse management processes can positively or negatively affect your inventory turnover. Consider this: Inventory turnover is all about converting your goods from stock to revenue, and your warehouse plays a pivotal role in the distribution of your goods.

If your warehouse is struggling to move goods efficiently, analyze the following areas.

Use the Right Picking Method

You can get away with single order picking (also known as discrete order picking) in the early days of your business. But, as your warehouse gets bigger, you’ll need to select a more strategic, and efficient, order picking method.

Method Description
Batch picking

With this method, workers pick items for multiple orders at once. Rather than picking one order at a time, they’ll pick all of the separate items (apples, oranges, pears) for several customers, and then sort them by the customer at a separate location within the warehouse.

 

This method makes sense for warehouses managing a high volume of multi-item orders.

Wave picking

The wave picking method takes a schedule-based approach. The day’s “picks” are organized in waves based on  criteria like “orders that need to be on the 2:00 P.M. outbound trucks,” or “orders that require specialized packaging.” This allows the warehouse to allocate its labor resources efficiently and meet customer delivery deadlines.

 

This method makes sense for warehouses managing several types of orders going to multiple locations and with varying customer deadlines (e.g., expedited delivery).

Zone picking (also known as pick and pass)

Zone picking is an enhanced version of batch picking. Workers are dedicated to specific zones where they are responsible for a certain set of SKUs. Multi-order cartons move through the warehouse while workers pick the items needed from their zones. The cartons then move on to the next zone and the next until everything for each order has been picked.

 

This is great for warehouses with a large volume of orders or warehouses that require specialized training and equipment (e.g., forklifts) for specific sections.

Pick Path and Putaway Path Optimization Through Algorithms

Motion waste can seriously limit your ability to fulfill orders quickly enough. You can keep motion waste at a minimum by improving the layout of your warehouse and by using algorithms to optimize the path your workers take when picking goods or putting them away.

An efficient putaway path gets your goods on the shelves quickly, while an efficient pick path gets your goods out the door fast.

Seek out a WMS that uses algorithms to optimize your pick path. While the word “algorithm” can sound scary, once you take the time to break down warehouse algorithms, you can discover huge applications in your warehouse processes.

Flow-Through Order Management

Businesses process about 7 EDI documents per purchasing cycle. These kinds of manual processes increase the probability of errors and stretch out the time it takes to process a customer order, send an invoice, and ultimately, get paid! Adopting a flow-through order management system helps eliminate some manual processes and improve overall performance.

It may be worth investing in integrated systems—ones that can “speak” to each other and also “speak” to your vendor’s systems and your customer-facing systems. Your inventory turnover ratio will be higher if an online customer order instantly triggers an action in your WMS, instead of your system waiting for you to manually input information.

Inventory Turnover Ratio is a Sign Of A Business’s Health, So Be Mindful!

Your inventory turnover ratio is worth your attention. It serves as a barometer of your business’s health. Much like your cash flow statements keep you aware of how much money is coming in, your inventory turnover ratio helps you pay attention to how quickly goods are moving out. It’s also something that investors will take a look at if you ever seek additional financing or want to sell your business. Understand the importance of inventory turnover, take time to calculate your ratio, use a data-driven safety stock formula, and invest in efficient warehouse management processes.

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