How to calculate inventory turnover rate
A common formula used to calculate inventory turnover rate is:
Here is an example — in the 2021 fiscal year, Company A’s books reflect the following:
- Cost of goods sold of $500,000
- Inventory value of $200,000 at the start of an accounting period
- Inventory value of $300,000 at the end of an accounting period
From here, average inventory = ($200,000 + $300,000) ÷ 2 = $250,000
Thus, inventory turnover rate = $500,000 ÷ $250,000 = 2
This means that Company A will have to restock their inventory approximately 2 times in a year. In other words, it takes an estimate of 182.5 days (½ a year) to clear their product inventory.
What is the Cost of Goods Sold?
Cost of Goods Sold (COGS) measures the cost of the production of goods or services. This includes:
- Variable costs such as raw materials and labor
- Fixed costs such as storage costs and factory overheads
What is average inventory?
Average inventory refers to the average value of inventory across two (or more) accounting periods. This is an indication of the value of inventory that a company has over a stated amount of time, and is computed by averaging the inventory values at the start and end of a specified period.
The reason why the average is taken is to even out any fluctuations in inventory balances that may be caused by bulk shipments and peak seasons.
Why inventory turnover is important for businesses
The inventory turnover rate is an indicator of how fast a company sells. Generally, a low turnover reveals low sales volume and excess inventory, while a high turnover suggests high sales volume and potentially insufficient inventory.
Why do I have a low turnover rate?
- The products are not priced properly
- There is not much demand for the product
- There is a lack of marketing
This usually results in overstocking and excess inventory, causing a low turnover rate.
Having excess inventory is not ideal for businesses as you may run into the issue of perishable goods expiring and higher warehouse storage costs.
Low inventory turnover is not always a bad thing. In situations when costs are predicted to rise, companies may choose to stock up beforehand. This may naturally result in a low turnover as there is excess inventory to meet future demand.
In this case, the low turnover may not be a cause for concern as the excess inventory can be used to meet future demand at a lower cost to retailers.
Why do I have a high turnover rate?
A high turnover is usually a good sign of strong sales. However, it could also indicate that:
- The products are priced too low
- There is not enough inventory to meet the demand
In such cases, businesses are advised to revisit their pricing strategy and do demand forecasting.
Which is better: high or low turnover rate?
So, which is better? In general, a high turnover rate may imply strong sales and insufficient inventory while a low turnover rate implies weak sales and excess inventory. The former is usually better except in cases when inventory is insufficient and sales are lost.
For a more accurate analysis of turnover rate, it is best for companies to compare it with their past turnover rates and against competitors within the same industry.
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Impact of inventory turnover on Profit and Loss (P&L)
A profit and loss statement is a documentation of the revenue and expenses incurred by a business in a specific period. This is also referred to as P&L or an income statement.
Typically, a high turnover may lead to high profits as goods are moving faster whereas a low turnover may lead to lower profits since goods are moving slower.
Perishable and trendy products
When it comes to perishable and trendy items, the inventory turnover rate is crucial. Examples include fresh produce which has an expiration date, and fashion items which may go out of trend after some time.
Any unsold goods may lead to expiration and a decrease in demand, which can cause financial loss.
Having excess inventory due to weak sales may also increase storage costs as the goods are stored in a warehouse. This poses a potential financial liability for a company.
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A low turnover usually indicates excess inventory. In such cases, companies may resort to putting items on clearance to encourage buyers to buy at a lower price, which results in lower profit margins.
How to achieve an optimal inventory turnover rate: Demand Forecasting
Having an optimal inventory turnover rate can bring about benefits including cost savings from bulk purchases and increased profitability.
To achieve this, businesses are encouraged to use demand forecasting. Not all products sell at the same rate, so forecasting helps to identify the best-selling items and those that are not selling as well.
By tapping on past sales data, businesses can make more informed decisions when stocking inventory for each individual product. This potentially reduces the issue of excess inventory while ensuring there is sufficient stock to meet the fluctuations in demand.
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. This includes data such as units ordered in a standard calendar year.
From here, you can analyze your product sales and forecast the demand for specific items.
How to increase inventory turnover rate
If your business is facing a low inventory turnover rate, here are 5 ways you can try to increase sales!
1. Have a pre-order system
Setting up a pre-order system allows your business to have an immediate and confirmed sale of your products. This means that you can take in orders with a lower risk of excess inventory, potentially preventing inventory turnover problems.
2. Shorten order fulfillment time
Shortening the order fulfillment time is one of the key factors to moving your inventory efficiently. A 2021 research has shown that over 50% of shoppers cited the speed of delivery as an influencing factor of their purchase decision
. This means that same day delivery may give businesses an advantage over their competitors.
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3. Expand globally
In 2021, global e-commerce sales reached USD$4.9 trillion
and is estimated to grow by 50% to reach USD$7.4 trillion by 2025.
Cross-border e-commerce can expose your business to a larger audience and may help to increase sales and turnover rate.
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4. Smart pricing strategy
If you are experiencing a low turnover rate, it might have something to do with pricing. Ensuring that the price is right is a challenge for most businesses.
You can consider implementing multiple pricing strategies, for example, bulk prices, seasonal rates and free shipping. These may incentivize customers to buy, potentially improving sales and turnover rate.
Offer deals with Amazon Promotions
Customers are always looking for the best deals and prices. Amazon sellers can leverage Promotions
to boost sales by offering flash sales and vouchers. This can help businesses free up storage and reduce overstock.
5. Effective marketing strategies
Through marketing, your products can be positioned in an appealing way that attracts customers. Social media, search engine optimization, content marketing and email marketing are some great ways to attract customers.
By capturing the attention of customers through different marketing channels, it can potentially increase sales and improve inventory turnover rate.
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Limitations of inventory turnover rate
The inventory turnover rate reveals the speed at which a company sells its inventory in a year. From there, steps can be taken to move inventory more quickly. However, this metric does have some limitations.
Differences between industries
One of the limitations of the inventory turnover rate is that it does not take into account the difference in movement of goods between industries.
For example, it is normal for a luxury goods store to have a lower turnover rate due to the higher price points as compared to one that sells t-shirts. However, the former generates a higher profit margin while the latter’s inventory can devalue more quickly.
Other factors such as the nature of the product and profit margin should also be considered when analyzing sales figures. When interpreting your inventory turnover rate, it may be more accurate to benchmark against industry competitors rather than across other industries.
Unable to determine slow moving items
The inventory turnover rate is derived from the cost of goods sold divided by the average value of inventory. Hence, this only reflects the overall performance of all the goods when in actual fact, certain goods may move faster than others.
This means that the turnover rate does not reflect which specific items are moving slower and which are performing better. Without this information, businesses may not know which products to stock more or less of.
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Features like Forecast and Inventory Planning allow you to forecast the demand of products and determine how much inventory of a particular item to stock.
Amazon answers FAQs about inventory turnover
What is a good inventory turnover rate?
What is considered good is highly dependent on the industry.
Generally, industries that sell higher priced items will have a lower inventory turnover as customers tend to take more time before purchasing, whereas industries that sell lower priced items are likely to see higher turnover.
Typically, the ideal inventory turnover rate is somewhere between 5 to 10, which means that inventory is stocked about every 1 to 2 months. For perishable goods, the ideal rate would be a lot higher to prevent inventory losses due to spoilage.
Is a high inventory turnover good?
Businesses will almost always aim for a high inventory turnover as it indicates that sales are strong and goods are moving. Additionally, this reduces the risk of inventory becoming obsolete due to spoilage, damage or a decrease in demand.
However, in some cases, a high turnover may be caused by insufficient inventory which could mean losses in potential sales.
What are inventory turnover days?
Days in inventory (DSI) refers to the average number of days it takes for inventory to be sold. To calculate this, take the average value of inventory divided by the cost of goods sold and multiply that by 365 days.
The DSI indicates whether a company is operating efficiently.
What is the difference between inventory turnover and inventory turnover days?
Inventory turnover shows how quickly a company can sell its inventory, whereas DSI shows the average number of days a company can sell its inventory.