Ecommerce success is all about finding the perfect balance between inventory levels and sales. One of the most important factors to track is your inventory turnover ratio. In order to increase sales and boost profits all while managing your warehousing and inventory capacity, it is absolutely vital to get your stock orders just right. Too much stock means wasted space and skyrocketing holding costs. Too little stock means lost sales and customers left empty-handed and disappointed. It’s not a stretch to say that, for most companies, the movement of inventory through the supply chain is your business. How good your operation is at that is the strongest indicator of future success.
So, what can be done about this? We will explore the ins and outs of inventory turnover, an essential inventory management metric that is key to getting that balance just right, and maintaining it. We will walk you through everything you need to know about inventory turnover, and how to calculate your own inventory turnover ratio. From increased profitability to optimizing efficiency, a rigorous understanding of your inventory turnover is key to a streamlined inventory management operation. This allows you to make better decisions for your business. The inventory turnover calculation informs everything from pricing strategy and supplier relationships to promotions and the product life cycle.
What is Inventory Turnover Ratio?
In simple terms, the inventory turnover ratio is the number of times a company has sold and replenished its inventory over a specific amount of time. The formula can also be used to calculate the number of days it will take to sell the inventory on hand. The turnover ratio comes from an equation, where the cost of goods sold is divided by the average inventory for the same period. A higher ratio is more desirable than a low one as a high ratio tends to indicate strong sales. Knowing your turnover ratio depends on effective inventory control, also known as stock control, where you have good insight into what you have on hand.
Calculating and tracking inventory turnover helps ecommerce businesses make smarter decisions, including pricing structure, manufacturing, marketing, purchasing and warehouse management. The inventory turnover ratio measures how well the company generates sales from its stock. It is one of a number of KPIs that can provide insights into how to increase sales or improve the marketability of certain stock or the overall inventory mix.
How Inventory Ratio Works
Average inventory is typically used to even out spikes and dips from outlier events that can occur and represent one segment of time, such as a day or month. Average inventory renders a more stable and reliable measure.
For example, in the case of seasonal sales, inventories of certain items—like those that are holiday specific or weather dependent—are pushed abnormally high just ahead of the season and are seriously depleted at the end of it. However, turnover ratio may also be calculated using ending inventory numbers for the same period that the cost of goods sold (COGS) number is taken. The cost of goods sold by a company can be found on the company’s income statement.
The formula can also be used to calculate how much time it will take to sell all the inventory currently on hand. Days sales of inventory (DSI) it is calculated like this for a daily context:
(Average inventory / cost of goods sold) x 365
How do you Calculate Inventory Turnover Ratio (ITR)?
The standard method includes either market sales information or the cost of goods sold (COGS) divided by the inventory.
Start by calculating the average inventory in a period by dividing the sum of the beginning and ending inventory by two:
Average inventory = (beginning inventory + ending inventory) / 2
You can use ending stock in place of average inventory if the business does not have seasonal fluctuations. More data points are better, though, so divide the monthly inventory by 12 and use the annual average inventory. Then apply the formula for inventory turnover:
Inventory Turnover Ratio = Cost of Goods Sold / Avg. Inventory
Inventory Turnover Formula and Calculations
Whatever inventory turnover formula works best for your company, you will need to draw data from the balance sheet, so it’s important to understand what these terms and numbers represent.
- Cost of Goods Sold (COGS): Cost of goods sold, aka COGS, is the direct costs of producing goods (including raw materials) to be sold by the company.
- Average Inventory (AI): Average inventory smooths out the amount of inventory on hand over two or more specified time periods.
Beginning Inventory + ending inventory / number of months in the accounting period
- Inventory Turnover Ratio: The inventory turnover ratio is a measure of how many times the inventory is sold and replaced over a given period.
Inventory Turnover Ratio = Cost of Goods Sold / Avg. Inventory
What is a Good Inventory Turnover Ratio?
When analysing your stock turnover ratio, remember it will be relative to the stock you sell and the industry you trade in. For example, an ideal stock turnover ratio for a fast-moving consumer goods retailer will be much higher than a company that sells high-end furniture.
Usually, businesses with low gross margins need to turn their inventory more often, so they can offset their low per unit profit with higher sales volumes.
Ideally you’d look to benchmark your turnover against similar businesses in your industry, but if this proves challenging, then look internally at your trends and seek to better them.
However, there is a fine line between having a high inventory turnover ratio and winding up with stockouts. Having insufficient inventory levels can lead to lost sales opportunities, unhappy customers and a damaged reputation over time.
What is a Low Inventory Turnover Ratio?
An inventory turnover ratio any lower than two could indicate that sales are weak and product demand is waning. This could result in excess inventory, also known as overstocking, on the warehouse shelves and wasted space and resources. On the other hand, an inventory turnover ratio any higher than six is an indication that the consumer exceeds supply. That means your inventory purchase levels might actually be too low, leading to lost sales opportunities as a result—or negative customer experiences from delayed deliveries. A low turnover implies weak sales and possibly excess inventory, also known as overstocking.
How to Increase Inventory Turnover for your Ecommerce Business
Adjust Your Purchasing Plans
Compare the turnover ratio of various categories to their sales figures and see where you could start ordering less. If sales of a particular product or category have started to drop off, you could combine ordering less of them with bringing in new products that are more in line with your best sellers. It is better for retailers to reduce their carrying costs by resisting the urge to buy in bulk, even where there are economies of scale or discounts to be had. If those products aren’t going to sell, those potential savings from the manufacturer could be meaningless.
Review Your Pricing Strategies
Pricing can drive customers away, even if the quality of the products and their experiences land. If your sales aren’t strong, you could consider implementing some of the following pricing strategies:
- Bulk Pricing: this is where customers save money based on how many units they buy (2 for $10, 3 for $12, 4 for $15, etc).
- Seasonal Discounts: if your ecommerce business has a seasonal edge—apparel seasons, for example—start discounting incrementally earlier in the season. Instead of having blowout end of season sales where you try to move a lot of inventory at steep discounts, start with much smaller discounts about halfway through the season and increase the discount from there.
- Bundle Pricing: like bulk pricing, customers get more while paying less. Here, though, you bundle different items together to move stock. It’s much like upselling, but with some of the sales legwork already done if you make the product bundles yourself.
Plan for Seasonality
Capitalizing on seasonality is another way to craft a marketing strategy to increase your inventory turnover rate. We recommend observing customers’ existing purchasing patterns to determine natural seasonality. Include the relative seasonal performance of different sales channels as you examine these trends. That way, you can drive quicker sales with targeted promotions that ride your existing waves.
Limitations of Inventory Turnover Ratio
The time it takes a company to sell through its supply can vary greatly by industry. If you don’t know the average inventory turns for the industry in question, then the formula won’t help you very much. For instance, retail chains and grocery stores typically have a much higher ITR. That’s because they sell lower-cost products that spoil quickly. As a result, these businesses require far greater managerial diligence. On the other hand, a company that makes heavy equipment, such as airplanes, will have a much lower turnover rate. It takes a long time to manufacture and sell an airplane, but once the sale closes, it often brings in millions of dollars for the company.
Improving Inventory Turnover with Inventory Management Software
Inventory management software comes with many features that will help you modernize and optimize your inventory management processes and policies. For example, such software enables your company to switch to the perpetual inventory method in accounting with a continuous real-time record of inventory. Computerized point-of-sale systems and enterprise asset management software immediately reflect changes in inventory by tracking sales and inventory depletion or restocking.
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. 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. 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.