Every business has inventory and its cash flow as its lifeline for earning revenue in the longer run. There are different methods and statistics which can be implemented to a balanced inventory cash inflow and productive sales for the business. Inventory turnover methodology is one of them.
Let’s understand how this inventory turnover formula will help in increasing our sales and having a balanced inventory in our warehouses.
What is Inventory Turnover?
Inventory turnover is the ratio, to give an insight into the efficiency a company has, both absolute and relative while converting it’s cash into sales and business revenue. In other words, it is a ratio depicting how many times an organization has sold and replaced inventory during a given period of time. Companies can then divide the no. of days in a given period by the inventory turnover formula to calculate the days it would take to sell inventory in hand.
Calculating inventory turnover helps businesses in making better choices and do futuristic inventory planning on pricing, manufacturing, marketing and purchasing of new stock in demand.
How is Inventory Turnover calculated?
Inventory Turnover = Annual Sales / Average inventory for a period.
Where: Average Inventory=(BI – Ending Inventory) ÷ 2
Point to note here is that some of the companies use cost of goods sold, instead of annual sales while calculating the inventory tracker value. When using the inventory turn ratio to compare companies within an industry, we need to make sure we are using ratios calculated on the same basis. If you assess one company using the cost of sales in the calculation, and the other using total sales, you’ll have an inconsistent and faulty comparison . These improper value of inventory turnover ratio will be of no use for your business management.
Applications of Inventory turnover in business:
A low turnover ratio will point to overstocking, obsolescence, or deficiencies within the marketing effort. If the inventory is popping over slowly, then the prices of warehouse attribution to every unit are higher. A high turnover rate might indicate inadequate levels of inventory, which can result in a loss in business because the inventory is low. The cost of sales is taken into account to be more realistic because the difference in the sales and cost of sales are recorded. Stock inventory turnover also indicates the briskness of the business.
Questions on Inventory Turnover
A lot of people have some basic queries related to inventory turnover and how it will be useful in our business model. Let’s discuss the top four queries to understand inventory turnovers better.
1. Why do you need to measure inventory turnover?
If you’re still not measuring inventory turnover for your business, here are a couple of reasons you should be doing it on a regular basis:-
- Better Financial position
Inventory turnover ratio is one of the key performance indicators (KPI) for a growing business. Often banks consider Inventory turnover ratio as a measure of how easily your inventory can be sold and how quick you can make a profit for your business. Inventory in many business models are kept as collateral for loan sanctions, hence inventory trackers are very important in getting financial support for your firm.
Read More – High Inventory Levels: Overcoming the Challenge
You’ll make smarter business decisions
Understanding your market trends and closely monitoring stock turn helps in making better purchasing decisions, keep a constant merchandise movement in our warehouses and sell smarter to your customers with a complete view of market trends in hand.
This Inventory metrics can inform you of many decisions like:
- What items need to be ordered – Understanding your product market trends can be repeated using these turnover values and help us to decide on which products need a refill and which product is going obsolete in our warehouses.
- What units need to be kept in front of the sale aisle – Dead stock and out of date products can be reshuffled and sold first to avoid any product wastage.
- What has to be ordered in advance to allow ample time for manufacturing/production/shipping – understanding the amount of raw material required in the products production cycle, we can ensure that we don’t run into out of stock or stock-out situations and preorder our required amount of spare parts in advance.
Clearly, when we have a solid handle on inventory turnover, we have better answers to our daily inventory needs which are useful for making futuristic and more efficient stock requirement decisions.
2. What’s a normal Inventory Turnover Ratio?
Inventory turnover ratio varies from one industry to the other. Comparing the inventory turnover rate for our company against our competitors will give us an insight into their inventory management team and help us to generate more sales with our learning curves.
In general scenarios, retail grocery stores and food chains typically have a much higher inventory turn rate as these low cost products are perishable in nature and require more diligent management team.
Heavy machinery and hardware companies have lower turnover ratio due to the high rate of products and longer duration of production and sales cycle.
Use of Inventory Turnover Ratio:
We can use the inventory turnover ratio to investigate how briskly the organization is selling its inventory and compare its efficiency within the industry standards. In most industries, the turnover ratio falls between 5 to 10. The ratio varies from each industry reckoning on their complexity of the business environment and the nature of the products.
Retail organizations have higher turnover ratios because they treat the high-volume and low-margin industry. Low-volume industries like automobile manufacturing, airline manufacturing which care for high margins will report low inventory turnover rates. Analysts use the inventory turnover ratio to check whether the organization is meeting the standards of the industry and clearing the inventories in less time than its competitors.
Another major use of the inventory turnover ratio is that it helps to measure the liquidity of the organization. Liquidity is that the situation that reflects the flexibility of the organization to maintain sufficient cash on hand. An organization that has a high inventory turnover ratio enjoys high liquidity because it receives the money frequently from the customers. The peers who will report a low inventory turnover ratio will suffer high carrying costs. To keep organizations financially healthy, it should maintain a high inventory turnover ratio.
3. How to improve Inventory Turnover ratio?
On analyzing your business inventory requirement and turnover ratio, if you think its needs an improvement to increase your business profit, here are some ways to improve your inventory management.
- Better Forecasting
Forecasting is very important in understanding your inventory trends. If we can understand and forecast our customers demand trends correctly, we can only order the required set of inventory. With the high demand for required stocks in hand, we can definitely improve our business revenue.
- Improve Sales
Improved marketing strategies help in improving overall inventory ratio. With better sales of in-demand products with advertisements, promotional events and offers,the inventory ratio will definitely improve. This in-turn helps in increasing overall revenue for the organization.
- Reduced Product price
Many companies apply the option of reduced prices to an attractive level to increase their product sales. Items with a lower sales rate and with marketing team not able to increase its demand, providing discounted price strategy helps in increasing the sales of the products and overall working capital for the company. In such low profit margin cases, out and outdated inventory stocks can be quickly removed to improve the overall turnover ratio of the products.
- Focus on Top Selling products
Applying the Pareto’s 80:20 principle, we should invest more on the products that get you the maximum profit and at the same time eliminate or reduce the purchases of products which have low sales rate and are incurring losses for your firm. Removing the lower turnover ratio for products in loss, will improve the overall inventory turnover for the company as a whole.
- Better Order Management
Having better inventory management strategies help in avoiding unwanted and unnecessary inventory purchases and improve the overall inventory management ratio.
- Eliminate Safety stocks and old inventory
Many manufacturing invests in safety stocks to be prepared for unseen demands and emergency situation. But with efficient inventory management strategies, proper knowledge of the required inventory can be done to avoid any extra purchases of inventory and bypass unwanted inventory all together. This considerably reduces old and outdated products in warehouses and make way for fast moving products which improve the inventory turnover and overall revenue generation for the company.
- Reduce Purchase Quantity
Extra and unnecessary product purchase is the major cause of low inventory turnover ratio, having a calculated amount of purchase quantity helps in maintaining optimal requirements of inventory and improving the overall turnover ratio.
4. Disadvantages of Inventory Turnover Ratio
Usually, having a high turnover ratio are considered to be a favorable situation for a business, problems can arise if turnover occurs too rapidly or too slowly. Let’s understand some of the disadvantages of inventory turnover ratio.
- Lost Sales
Moving your inventory to a high inventory ratio can have its own negative effects. Merchants man elect to limit the variety and amount of the products they carry to prevent a backlog of inventory and keep goods moving in their warehouses. While merchants are more focused on improving the inventory ratio, products in hand can quickly go out of stock and many customers may find it difficult to get the required quantity. In such scenarios many clients drifts towards many competitive products, to keep their required quantity fulfilled and may never turn back to the current product at all.
- High Expenses
Many merchants order small quantities of inventory to keep their inventory levels high and incur the greater cost for the business. Transportation expenses come to a higher value for repetitive and small orders. Also, merchants who order small quantities often ,miss out on the bulk discounts and special deals on high volume purchases. In some cases, merchants may have to order expensive express delivery methods to prevent out-of-stock situations. Along with these, many taxes and other processing charges get additionally added to multiple and frequently repetitive orders.
Inventory turnover ratio helps in knowing which products to store or reorder and how much to order. These information are the key game-changing insights for any business model. Having a solid knowledge on your inventory turn, allows you to stay on top of your game in making right decisions for carrying the correct amount of inventory at the correct time. SalesBabuCRM is an efficient cloud based inventory management tool to help you with analyzing your product requirements and manage your inventory.