Calculating inventory turnover
Inventory turnover is how quickly you sell your inventory. Understanding your inventory turnover can help you decide how much inventory to order. This can help you manage your inventory costs and the cash flow of your business.
Inventory turnover = Cost of goods sold / (0.5 x Opening inventory + 0.5 x Closing inventory)
If you have an inventory turnover of two, for example, then you sell all your inventory twice per year.
Inventory turnover ratio examples
Sam has a business that sells pens and wants to calculate his inventory turnover to check if he stocks enough pens.
Sam knows his cost of goods sold is $50,000. At the start of the financial year, he had $6000 of inventory. At the end of the financial year, he had $14,000 of inventory.
Using the inventory turnover formula, he calculates his inventory ratio as 4.5, which means he turns over his inventory 4.5 times per year. He thinks this is neither too high or low, so decides not to increase the number of pens than he currently stocks.
Tips when calculating your inventory turnover ratio
- Perishable products should have a higher turnover ratio than non-perishables. You shouldn’t sell perishable products, such as milk, after they go out-of-date. Because of this, they should have a higher inventory turnover ratio than non-perishable products such as bricks.
- Low inventory turnover ratios can indicate you’re stocking too much inventory. Stocking too much inventory can mean you’re spending too much on storage costs. Consider stocking less inventory if you have a very low inventory turnover ratio.
Inventory turnover ratio benchmarks
Benchmarking your inventory turnover ratio is evaluating your inventory turnover ratio by comparing it with a standard.
You can use benchmarking to compare your inventory turnover ratio with the inventory turnover ratios of your competitors. You can also use it to compare the inventory turnover ratios of different products you sell to work out if you are stocking enough or too much of the right products.
Check out these examples:
- Jane sells smartphones and has an inventory turnover ratio of two. She finds out her competitors have an inventory turnover ratio of four, so hers is only 50% of her competitors. She thinks this is too low, since her competitors may be stocking more popular, up-to-date smartphones than she does.
- Jim sells four kinds of dolls. His average inventory turnover ratio is 0.5. One type of doll he sells only has an inventory 0.1 though, which is five times less than his average. He thinks this means this doll is less popular, so he should stock less of it.