Inventory management involves calculating the inflow and outflow of goods to manage sales. Sometimes, a product flies off the shelf and other times you are unaware of the stock stored in the warehouse. Store managers use inventory turnover ratios to balance pricing strategy, product lifecycle, and supplier relationships to avoid last-minute hassles.
Let’s understand the critical inventory calculation technique.
Inventory Turnover – Explained
Plenty of tools and techniques are implemented to calculate the cost of goods sold in a period. Inventory turnover estimates the number of times a company sells and replaces stock in a particular period.
This offers an upfront view of the inventory sold to indicate a company’s market position. Measuring the stock is critical to maintaining optimum marketing, manufacturing, and warehouse capacity.
What is the Inventory Turnover Formula?
It is a useful financial metric to determine the supply chain management of your company. Let’s understand the formula basics.
Cost of goods sold(COGS) = This is the direct cost related to the production of goods by a company. Adding the cost of raw materials, labour, and manufacturing overhead expenses gives COGS.
Inventory Turnover = Cost of Goods Sold(COGS)/Average Inventory Value
Where average inventory value is the estimated inventory regardless of seasonality effects.
Inventory Turnover Ratio Example
Let’s deconstruct the inventory technique by taking a fictional example.
Company: XYZ Premium Ltd
XYZ Ltd produces eco-friendly packaging materials. For the year 2022, here is a sample of their balance sheet.
Inventory value at the beginning = 50000
Inventory value at the end = 30000
Average inventory value = 50000 + 30000/2 = 40000
Cost of goods sold = 200000
The calculation of inventory for the year 2023:
Cost of Goods Sold/Average Inventory Value
200000/40000 = 5
The stock turnover ratio for XYZ Limited in 2023 was 5. This means they sold and replaced their inventory 5 times throughout the entire year. By analysing the formula and benchmarking it to historical ratios and industry standards, XYZ Limited can gain insights into market demand and enhance operational efficiency.
Next, what is a good inventory turnover ratio? Let’s explore.
How Much is a Good Ratio?
How much should an inventory be replaced in a particular period? That depends on the industry average. For example, perishable items have higher turnover ratios due to their limited shelf life. However, luxury items and heavy machinery have lower ratios due to their longer sales cycle.
Several factors like seasonality, customer satisfaction, and company strategies play a vital role in the inventory cycle. Here is a basic guideline to decide the effectiveness of the ratio.
- Very High Turnover – Any value above 10 indicates a risk of stockouts due to raid sales. Ineffective inventory cycles can create distribution issues. This is common in fast-moving industries like perishable goods and FMCG sectors.
- Moderate to High – Anything between 5 – 10 is considered a healthy financial metric. This indicates good sales performance and efficient inventory management without the risk of an inventory glut.
- Moderate – Ratios between 3 and 5 indicate balance meaning there is enough inventory to meet customer demand while minimising storage cost. Applicable in industries like automotive, manufacturing, and furniture.
- Low Ratio – Values between 1-3 falls under this category. It indicates poor inventory management due to overstocking, poor sales, and slow-moving inventory.
- Very Low Ratio – Anything less than 1 signals serious inventory damage causing massive write-offs, and holding costs. High-value items and specialised products have significantly lesser inventory turnover rates.
This is a general guideline and different industries have different turnover standards. A ratio of 8 is considered optimal for the retail industry, whereas a ratio of 3 is healthy for an automobile manufacturer. Next, let’s explore the best tips to maintain a healthy inventory turnover count.
Best Tips for Inventory Management
Maintaining an optimal inventory turnover ratio is crucial for the efficiency and profitability of any business. Here are some of the best tips to achieve this balance:
1. Accurate Demand Forecasting
Understanding customer demand is essential. Utilise historical sales data, market trends, and predictive analytics to forecast future demand accurately. This helps in ordering the right amount of inventory, avoiding both overstocking and stockouts.
2. Implement Just-In-Time (JIT) Inventory System
A Just-In-Time inventory system ensures that products arrive as they are needed, reducing holding costs and minimising excess inventory. This approach requires a reliable supply chain and close coordination with suppliers to be effective.
3. Regular Inventory Audits
Conduct regular audits to verify the accuracy of inventory records. This can be done through cycle counting, which involves counting a portion of the inventory regularly rather than doing a full inventory count once a year. Accurate records help in making informed purchasing decisions and identifying discrepancies early.
4. Use Inventory Management Software
Invest in robust inventory management software to automate and streamline inventory tracking, ordering, and forecasting. Modern software solutions offer real-time insights, helping to manage inventory levels more efficiently and reduce human error.
5. Optimise Order Quantity
Use economic order quantity (EOQ) models to determine the most cost-effective quantity to order. EOQ helps balance ordering costs with holding costs, ensuring that inventory is replenished at the right time and in the right amounts.
6. Supplier Relationship Management
Develop strong relationships with reliable suppliers to ensure timely deliveries and favourable terms. Good supplier relationships can provide more flexibility in inventory management and help negotiate better prices and faster restocking options.
7. Improve Sales and Marketing Strategies
Align your sales and marketing strategies with your inventory management. Effective marketing can help in moving slow-selling items, while promotional campaigns can be used to clear out excess inventory.
8. Implement a First-In, First-Out (FIFO) System
Use a FIFO inventory system to ensure that older stock is sold before new stock, reducing the risk of obsolescence. This is particularly important for perishable goods; however, it is also beneficial for all types of inventory to maintain freshness and relevance.
9. Monitor Inventory Turnover Ratios Regularly
Regularly review inventory turnover ratios to identify trends and areas for improvement. Compare your ratios against industry benchmarks to ensure competitiveness and make adjustments as necessary to improve efficiency.
10. Reduce Lead Times
Work on reducing lead times with your suppliers to increase responsiveness and reduce the inventory needed on hand. Shorter lead times mean quicker replenishment, allowing for lower safety stock levels.
FAQs: Inventory Turnover: Everything You Need to Know
Is inventory turnover high good?
High turnover is a positive sign indicating your products are clear in a timely manner and sales are good in a particular period. However, an extremely high ratio means your inventory is sold quickly, risking stockouts.
What is the formula for COGS?
Cost of goods sold = Beginning Inventory + Purchases during the year – Ending Inventory.
What is the starting inventory?
The total value of items in stock or ready to use at the beginning of the accounting period. It matches the value of the previous year’s closing inventory.
Conclusion
Effective management strategies utilise the inventory turnover count to keep a watchful eye on their supply chain operations. In every successive cycle, the formula aids store managers in tracking product lifecycle, sales, and traceability, thus ensuring business continuity without hampering customer satisfaction and profitability. For logistical solutions, trust Qodenext and watch your supply chain operations skyrocket to newer heights.
