When it comes to working out how much inventory your company is holding and turning over, you’ll need to calculate the inventory turnover ratio. Knowing how much raw materials have been used within the production of goods is an important factor in determining the value of your assets, as well as what your financial buffer is between manufacturing and fulfilling orders.
Inventory can also be seen as a company’s first source of revenue generation. For shareholders, especially, the raw materials at the start of the process contain economic potential, supporting their subsequent earnings and growth. While your balance sheet will display your company’s current assets, this inventory also includes work-in-progress and finished goods. Therefore, your inventory turnover ratio is needed to work out how much money your company has invested in your raw materials. Knowing this figure can help you minimise costs and streamline your production stock.
How To Calculate Inventory Turnover Ratio
The inventory turnover ratio demonstrates how many times a company’s inventory has been sold and replaced over a particular period. It is then possible to calculate the number of days it takes to sell a batch of inventory.
The Inventory Turnover Formula
Inventory Turnover = Cost Of Goods Sold (COGS) / Average Value of Inventory
Using the above formula, it is possible to work out your inventory turnover. By dividing your COGS figure by your average inventory, you can calculate an accurate inventory turnover ratio. It is possible to determine this ratio by dividing sales by the same average inventory. If you use this second method, it is worth being aware that sales include mark up costs, which will reduce the accuracy of your result.
The Importance Of Your Inventory Turnover Ratio
Companies that are aware of their inventory turnover ratio can use this information to improve their business decisions. For example, in knowing how long it takes to utilise your current-size batch of inventory, you are able to change your pricing and organise your manufacturing and purchasing processes accordingly.
Similarly, if you know how fast inventory is used and sold, you can build a picture of your business’s performance. These factors help to assess whether your business is meeting the market demand and how it is competing within its sector. Once these figures have been determined, companies can then go on to evaluate their product’s effectiveness.
Understanding Your Inventory Turnover
To make informed decisions for your inventory turnover, first, you need to understand what the numbers are telling you.
What is A Good Inventory Turnover Ratio?
A low inventory turnover ratio is a suggestion of weak sales and overstocking. In these cases, companies can address this issue by reducing the quantity of inventory they are holding, helping them to stop backing up money within raw materials. By redistributing the company’s finances, it is possible to reduce inventory, freeing up money for marketing to help drive sales.
On the other hand, a high ratio suggests strong turnover and good demand for sales. The rate a company sells its inventory is often seen as an indication of its general business performance, hence why a higher ratio is seen positively.
However, it can be a sign that your inventory supply is insufficient. If customers have to wait a long time until they get their hands on your products, this could encourage them to look elsewhere. Having said this, a low inventory turnover ratio can be a positive. In some circumstances, for example, if a raw material’s price is rising or there are expected shortages, a lower ratio will help your company stay ahead of the competition. To get the most from these figures, it is best to interpret them with the current situation in mind.
Average Inventory
To calculate your inventory turnover ratio you will need to have an understanding of your average inventory. This figure is the average cost of the same goods but between two designated time periods, commonly the balance of an inventory at the beginning and end of the same fiscal year. Then, to work out an average these two account balances are divided by two to provide you with the average cost of your inventory sales.
Average Inventory = (Beginning Inventory + Ending Inventory) / 2
There is no ruling that states these two figures must be a year apart, creating an annual average. For example, it is possible to calculate a monthly or quarterly average, allowing you to carry out specific analysis on your inventory account.
Cost of Goods Sold
The Cost of Goods Sold (COGS) figure quantifies how much it costs to create a product, from the initial raw materials to the labour costs that are needed to manufacture the finished goods. For merchandising businesses, this figure is the same as the product’s final price, plus any shipping costs. In any case, however, the COGS is determined by using an inventory account.
How To Improve Your Inventory Turnover Ratio
If you have deciphered your inventory turnover and are concerned that the ratio is lower than you expected, it is possible to implement strategies to improve this result. There are many factors companies can address to improve their ratio, including:
- Customer Buying Traits – Improve your understanding of each of your product’s selling figures, where can you improve and what products should you push? Make sure your inventory allows you to maximise sales on your most wanted products.
- Inventory Management – Grouping your inventory is a good way to manage each area of your business. By focusing on more specific categories, it will be easier to make analytical decisions that improve your ratio. This approach will also help to improve your forecasting.
- Marketing – By looking to improve your marketing campaigns to include targeted and cost-appropriate marketing outreaches, you will be able to increase the demand for your inventory.
- Pre-Ordering – If you do not already, encourage clients to pre-order their goods, allowing you to plan your inventory levels accordingly.
- Pricing – With money held up in raw materials, readdressing this may allow you to realign your business’s pricing strategy. In doing so you will be able to increase sales value.
- Purchasing – Have you been with the same supplier for a prolonged period? It may be time to negotiate a discount for your loyalty to their services. By reviewing your purchase prices, your company can look to reduce its spending.
- Stagnate Inventory – Is your business left with inventory that takes up valuable space in your warehouse? If so, it may be time to eliminate all stagnant inventory, offering up more space for inventory with higher demand and, consequently, a higher return.
Why Should You Improve Your Inventory Turnover Ratio?
Heeding our advice and improving your inventory turnover, does not only have the benefit of producing a higher ratio; these strategies will also help your business to improve its profitability with better warehouse management. Put simply, an inventory that takes up space in your warehouse, only to be used once a year results in unnecessary holding costs. By managing and reordering your inventory, you can significantly reduce the money you are spending holding obsolete and stagnant raw materials.
Moreover, with additional storage space and more net income, now holding fees have been cut, and you are in a position to hold inventory that sells frequently. In doing so, you will be able to respond to customer demand for popular products faster, receiving more profit from constant sales.
Overhaul Your Inventory Management Today
While inventory management may seem like a huge task, it is extremely beneficial to your company. By using the inventory turnover ratio formula, you will be well on your way to identifying what you can do to get the most profit from your inventory.
If you are looking for a new third-party logistics partner to help you achieve streamlined storage and inventory order fulfilment, look no further than Breakwells. We can take care of your inventory’s logistical needs, taking the pressure off you.
Give us a call today.