Do you know your inventory turnover ratio? Here’s the simple formula to calculate your inventory turns, what it means and why it matters.
This post is by Chinh Nguyen, Co-founder and VP, Marketing and Revenue at Finale Inventory.
As an ecommerce business owner, customers all over the world can view and buy your products in an instant. This allows your inventory to move at a much faster pace than in brick-and-mortar stores.
When your inventory is managed well, it can lead to long-term success for your business, making your inventory turnover ratio an important topic to know and understand. There’s a lot you need to know about inventory turnover for ecommerce, and we’re here to answer all of your most pertinent questions.
What is inventory turnover?
Let’s start at the beginning: what is inventory turnover, exactly?
In the simplest terms, inventory turnover is how many times inventory is repeatedly used or sold in a certain time period. This is usually a year, but it may differ depending on your business timeline and needs.
To put it another way, it’s the ratio between sales made and inventory held in stock. It is calculated based on the cost of inventory, but to keep things simpler here’s an example just based on units.
If you sold 100 units in the year, and had 100 units in stock on average, your inventory turnover ratio was 1:1, usually just stated as 1. You could also say that you:
- “Turned over” your inventory once
- Had one “inventory turn”
If, however, you sold a total of 500 units, and still had 100 units in stock on average, your inventory turnover ratio would be 5. To achieve this, you must have purchased a lot of stock during the year, probably on multiple occasions. Your inventory turnover ratio is just one number, but it gives a good indication of how well stock is flowing through the business during the year.
Once you have your ratio, it can be compared to industry averages to see how your business is measuring up. If you find you have a low inventory turnover ratio, it implies that you have poor sales and excess inventory that you need to get moving.
If, however, you have a high inventory turnover ratio, this indicates strong sales or perhaps large discounts. High inventory turnover suggests that you are selling products quickly, which is an indicator of good business performance overall.
How do you calculate your inventory turnover ratio?
Inventory turnover depends on two key business operations:
- Stock purchasing
Stock purchasing is, of course, how much inventory your business purchases throughout the year. If you are purchasing higher inventory amounts during the year, it means your company will have to sell higher amounts just to match or improve inventory turnover. If your business fails to sell more stock, it will become vulnerable to higher storage costs.
Sales, then, have to match inventory purchases. Otherwise, inventory won’t turn very effectively, spelling out problems for the company at large. So, your sales and purchasing departments have to be in sync with each other.
For smaller ecommerce businesses, this simply means that you have to be in constant communication with the different parts of the company so nothing is missed and everyone is on the same page!
What is the formula for inventory turnover?
Cost of goods sold (COGS)
You can figure the COGS from your inventory software, accounting system or annual income statement. If you have weekly or monthly income statements, you may use these numbers as well, though annual income is most common and useful in the long run.
You can also calculate COGS from your balance sheets at the start and end of the designated time period:
COGS = Beginning Inventory + Net Inventory Purchases – Ending Inventory
If beginning inventory was $100,000, and there were net purchases of $240,000, and ending inventory was $120,000, then COGS will be:
COGS = $100,000 + $240,000 – $120,000 = $220,000
Average inventory (AI)
Here’s the formula for average inventory:
Average inventory = (Beginning Inventory + Ending Inventory) ÷ 2
In other words, average inventory is the average of the beginning inventory and ending inventory for the designated period.
To continue the example above, with beginning inventory of $100,000 and ending inventory of $120,000, average inventory will be:
Average inventory = ($100,000 + $120,000) ÷ 2 = $110,000
Inventory turnover ratio
Now, you can calculate the inventory turnover ratio by dividing the cost of goods sold by average inventory.
Inventory turnover ratio = COGS ÷ Average Inventory
To finish the example, COGS of $220,000 divided by average inventory of $110,000 gives:
Inventory turnover ratio = $220,000 ÷ $110,000 = 2
So the inventory turnover ratio in this example is exactly 2.
Once you have your inventory turnover ratio, you will be able to see how your business is performing. Dig deeper, and you can find where your business is successful and where it may need some work.
Why do inventory turns matter?
So now that you have got the numbers to work with, are you wondering why inventory turns matter in the first place?
The inventory turnover ratio is important for the following reasons:
- It tells you how quickly your company is selling inventory
- It can be used as an accurate comparison to industry averages. This allows you to measure your company’s sales volumes and overall performance against the wider market.
- It provides one of the most critical measurements of your overall business performance.
- It gives you clear and valuable insight into the inner workings of your company, specifically how it manages inventory, sales, and costs.
In addition to these reasons, inventory turns matter in ecommerce because they provide a truly crucial measurement of your business performance.
When you have a brick-and-mortar store, you can often tell how well you’re doing by the number of customers you see and serve during the day, as well as the state of your cash register at the end of the day.
While ecommerce businesses can measure traffic through their analytics, they may not truly know how well their sales, inventory, and costs are going without knowing their inventory turnover ratio.
With this in mind, inventory turns matter because they can assure ecommerce businesses that they are managing both their supply chain and sales well, while also forecasting for the future accurately. They let you know how your business doing, which is valuable information for any business owner in the long run.
What is the best inventory turnover ratio?
For many ecommerce businesses, the ideal inventory turnover ratio is about 4 to 6. All businesses are different, of course, but in general a ratio between 4 and 6 usually means that the rate at which you restock items is well balanced with your sales.
In other words:
- You do not run out of products so are usually able to meet customer demand.
- You do not have a lot of unsold products choking up your warehouse.
In short, if you are able to match the stock coming in with how much is going out, your ecommerce business is golden and poised for natural and steady growth.
What should I do about a low inventory turnover ratio?
A low inventory turnover ratio means that certain products in your store just aren’t selling. You’ve spent money on products that aren’t giving you a return on your investment.
When this happens, it can cause a ton of issues for your business such as:
- High storage costs
- Products becoming obsolete
- Too much capital wrapped up in inventory
In short, low inventory turnover can lose you a lot of money, which is never good for business.
If your inventory turnover is too low, you do have some options on how to fix this problem. First, you need to decrease the average amount of inventory you have. There are a variety of strategies you can use to get this done. Think about:
You can use promotions to help deplete certain inventory items and increase overall sales.
Discounts also help create a better relationship with your customers because who doesn’t love a discount or sale? If it catches on, chances are that word will travel, giving your some free marketing that could lead to business growth in the long run.
Be sure to negotiate discounts with your manufacturer or supplier as well. If you have a strong relationship with your suppliers, negotiations could lead to even lower prices for recurring orders in the future.
Purchasing stock “little and often”
You can simply change how and when you buy stock to address a low inventory turnover ratio. For example, try buying for one month’s demand rather than the demand you expect for a year.
When you buy less stock but more often, you decrease the risk of losing money on products that don’t sell. This also frees up capital and storage space for new products that may lack sales data. In other words, buying less stock, more often, lowers a lot of different risks.
Finally, encourage pre-orders among your customers.
Not every business can do this, but pre-orders are great because they help gauge the demand and excitement a new product will generate. It also lets you raise funds!
Why is a higher inventory ratio better?
If you have a high inventory turnover, this usually indicates that your ecommerce business is selling products in a timely manner. Sales are strong and you aren’t holding too much dead stock. You are able to sell your inventory quickly and repurchase new inventory in a timely manner. Your customers aren’t left waiting because you are out of stock, and you build a good customer relationship.
In summary, when you have an ecommerce business, you want to shoot for a high inventory turnover rate because it indicates that a lot of good things are happening in your business.
Can inventory turnover ever be too high?
A high turnover ratio is certainly important and should be viewed as something positive for your business, but you want to be careful. Really high inventory turnover can actually be a bad thing. If sales are incredibly high, and you are replenishing inventory as quickly as you run out of it, that can lead to stockouts. In the event of a stockout, it may take weeks to replenish certain products, and your customers may just turn to another store.
Further, the longer you have to wait for a product to be replenished, the longer you will go without sales on a popular item. This damages your sales rank on Amazon, and recent sales history on eBay, so your search ranking drops and might take a long time to recover.
Also note that having a high turnover ratio is useless unless you are actually making a profit per sale. There may some limited circumstances such as an introductory offer for a new product where you intentionally don’t make a profit. But in general, losing ten cents for every dollar sold is a bad proposition in the long run regardless of a healthy turnover rate.
Thankfully, it’s pretty simple to avoid an inventory turnover ratio that’s too high. Your business either needs to order more inventory to meet demand or make fewer sales! A good rule of thumb is to buy more inventory of a popular product so that you have backstock ready to go. If this will cost too much money, arranging financing so you can invest in stock or raising prices to make fewer sales might be the right answer.
How else can the inventory turnover ratio be used?
The ideal inventory turnover ratio can be a useful reference point, but while industry averages offer direction, they shouldn’t be rigidly implemented.
Here are some ways you can use inventory turnover to provide more nuanced insights your business.
Look at how your inventory turnover ratio has changed over time to get more insight into the health of your business. A decreasing trend in annual turnover ratios (e.g. from 5.5 in 2015 to 5.1 in 2016 and to 4.8 to 2017) could be a red flag and may require more investigation to understand the decline. Have order volumes crept up ahead of sales for some reason?
Segments and SKUs
Within your operations, it is likely that you have products that sell quickly and some that sell infrequently. In addition to calculating the overall inventory turnover rate, it is also a good practice to calculate the ratio for different product segments to help reveal additional business insights.
Another popular method is calculating the inventory turnover ratio by product category. For example, a seller of auto parts would have different inventory strategies for high-turnover categories such as windshield wipers or brake pads, and low turnover categories such as catalytic converters and strut assemblies.
You can even go down to the SKU level, or segment by supplier, to help align your replenishment strategy with product popularity and supplier ordering requirements.
The 80/20 rule
You can also apply the 80/20 rule (also known as the Pareto principle). This is a convenient rule of thumb, which assumes that 80% of your sales come from 20% of the products in inventory. As a result, you would calculate a separate inventory turnover ratio for the top 20% of best selling products and the bottom 80%.
It’s all about thinking creatively to make the most of your ecommerce data.
Inventory management is the key
Inventory management can be tricky, but it is important to learn because it keeps your ecommerce business alive and working well. There are different software options to help keep track of your ecommerce store’s inventory, orders, sales, and costs, making things a bit easier for busy business owners.
Now that you know all the ins and outs of inventory turnover for ecommerce, you can keep your business going strong for years to come.
This post was by Chinh Nguyen. Chinh has more than 15 years of digital marketing experience and is responsible the marketing and business operations at Finale Inventory, a cloud-based inventory management solution. Prior to joining Finale Inventory, Chinh held marketing, business analytics, and product management leadership roles at a number of high-technology companies.