Inventory velocity, also referred to as inventory turnover, refers to the speed at which inventory is cycled—aka stocked and sold. Inventory turns is calculated as the cost of goods sold(COGS) divided by the average inventory on hand. It’s the number of times inventory is purchased and sold during the entire fiscal year and thus how much stock is also left sitting in the warehouse. This number essentially states how much of your inventory you were able to go through and how quickly.
Why is it Important to Improve Inventory Velocity?
Consumers have fluctuating demands where companies can use demand forecasting to reduce the risk of overstocking and understocking. Similarly, demand forecasting will also improve inventory velocity. A low inventory velocity ratio indicates that the company is mismanaging goods or can’t sell through their inventory, both of which don’t point to overall successful business. Low turnover implies that a company’s sales are poor, it is carrying too much inventory, or experiencing poor inventory management. Unsold inventory can face significant risks from fluctuating market prices and obsolescence. That’s why companies are often looking for higher inventory velocity. They want a more efficient inventory operation where products are sold quickly and inventory isn’t sitting in fulfillment centers for too long. With strong forecasting and sales processes, a higher inventory velocity means more revenue with fewer expenses and losses.
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Problems with Inventory Velocity
It is possible to focus too much on a high inventory velocity level. If a company keeps little stock on hand, it may find that it cannot fill unexpected customer demand, and so must forgo these sales. This is a particular concern when serving a market niche in which customers expect fast fulfillment times. Thus, it may be necessary to maintain a certain minimum investment in inventory that places an upper cap on inventory velocity.
How to Calculate Inventory Velocity?
Inventory velocity is also referred to as the inventory turnover. The ratio shows you how quickly it takes for a company to turn its inventory into sales.
Formula 1
Therefore, to calculate inventory velocity, a company will need to divide the cost of goods sold by the average inventory for a given period. Thus, the inventory turnover formula will look like this:
Inventory Velocity Rates = COGS\Average Inventory
To also get the average inventory value, You will use this formula:
Average inventory = Total inventory (Final inventory + Beginning Inventory)/ 2
Formula 2
The other option for calculating inventory velocity is dividing the sale by the average inventory. The formula should look like this:
Inventory Velocity= Sales/ Average Inventory
Typically, many companies use the cost of goods sold, the first formula, instead of the sales to get the most accurate results. It would not be advised to use the sales in calculating the inventory velocity because the sales include the mark over cost figures, which causes inflation in the final results. Unfortunately, companies cannot use these formulas to calculate inventory velocity for specific items. We only use the formula in the final inventory.
However, you can calculate inventory velocities for each type of product you are looking to analyze. Cost of goods sold entails all expenses directly linked to the production of the goods. It is exclusive of overhead and marketing expenses. To calculate the sold cost of goods, use the following formula:
Starting inventory + purchases – ending inventory= Cost of goods sold.
This is helpful to a business in determining their gross profits and margin.
How Inventory Velocity Can Help Your Ecommerce Business
Keeping records and performing consistent inventory velocity calculations will help a company make strategic decisions. Some of these strategic decisions include:
Manufacturing
The inventory velocity will indicate which goods a company should increase manufacturing. Besides, the company will also know which stocks they should stop manufacturing and replace with other items.
Purchasing New Inventory
Similar to manufacturing, the inventory velocity will tell a company whether they should purchase a new inventory. A company can buy new inventory if its current goods have a slow inventory velocity.
Marketing Strategies
When the inventory velocity is low, a retailer will know whether the current marketing strategies are working or not. They will also need to know which department they should focus on, sales or marketing.
Perishable Goods or Obsolete Inventory
Inventory velocity will indicate and keep track of seasonal and perishable goods. They will show which goods slowly become absolute and have an expiration date. These goods include vegetables, fashion trends, seasonal clothes, and vehicles.
High inventory velocity indicates there is a low risk of inventory becoming obsolete. For instance, there will be high inventory velocity for bathing suits and sandals during the warm or summer season. Towards the end of the season, having a high stock of sweaters and winter boots indicates a loss of profits. These unsold inventories are referred to as absolute inventories or deadstock. The company could face an understock or overstock situation because they are not focusing on consumer demand but on their set timeline.
Auditing
For a company to conduct auditing, they will need consistent and organized data like the ones we use in inventory velocity. Therefore, auditors, especially external auditors, will find it easy to carry out their tasks.
Keeping Track of Holding Costs
Inventory velocity will help a retailer track the holding costs and other expenses incurred from purchasing raw materials to selling the goods.
People spend more money storing the inventory by paying for the warehouses, insurance, shelving, staff, security, tracking arrangements, and fridge space or electricity for perishable goods. Therefore, inventory velocity will let you know which goods are moving. For example, a high inventory indicates low holding costs, which increases the profit margin.
Inventory Day Sales
The inventory velocity helps to keep track of the day’s sales inventory. These two are different in that inventory velocity is the number of times a company sells inventory in a year. On the other hand, day sales inventory is a company’s time to turn the inventory into sales.
Automated Systems
Some companies purchase automated systems to help them with their inventory control. Using automation in your inventory management practices you may have better intel on how inventory is performing, how much inventory they need to purchase, and which inventory incurs a loss.
Integrating the automated software into the company’s inventory and financial processes will also help estimate the company’s future sales. Automated software can work for some industries more than others. For example, automated software will not work in fast-selling sectors like fast food companies. However, it will perform better with a company selling seasonal clothes.
Bottom Line
One way to assess business performance is to know how fast inventory sells, how effectively it meets the market demand, and how its sales stack up to other products in its class category. Businesses rely on inventory velocity to evaluate product effectiveness, as this is the business’s primary source of revenue. Higher stock turns are favorable because they imply product marketability and reduced holding costs, such as rent, utilities, insurance, theft, and other costs of maintaining goods in inventory.
Another purpose of examining inventory velocity is to compare a business with other businesses in the same industry. Companies gauge their operational efficiency based upon whether their inventory velocity is at par with, or surpasses, the average benchmark set per industry standards.
Help with inventory management is one of the many benefits to working with a 3PL. If you are seeking logistics support we’d love to hear from you. You can read DCL’s list of services to learn more, or check out the many companies we work with to ensure great logistics support. Send us a note to connect about how we can help your company grow.
Tags: KPIs & Metrics
