Inventory turnover ratio (IT) measures how many times a company turns its inventory during a certain period of time. It gives an idea about how efficiently a company is managing its inventory.
How To Calculate Inventory Turnover?
Inventory Turnover Formula:
Inventory Turnover (IT) = COGS ÷ Average Inventory
Average inventory is used because typically the level of inventory varies throughout the year, depending on seasonality and events.
How to Calculate Average Inventory?
To calculate the average inventory use the below formula
Average Inventory = (Beginning Inventory + Ending Inventory ) ÷ 2
The beginning and ending inventory is taken at cost value.
COGS Not Sales
When you calculate the inventory turnover you do not use sales in the formula, but rather the COGS (cost of goods sold).
Using the sales value instead will give a misleading result, because the average inventory in the same formula is taken at cost value, and not at retail value.
How to Interpret an Inventory Turnover Figure?
To answer this question let’s use an example:
Sales for the last year = 125,000 $ at 45% margin
Beginning Inventory (at the beginning of the year) = 50,000 $
Ending Inventory (at the end of the year) = 60,000 $
Average Inventory = (50,000 $ + 60,000 $) ÷ 2 = 55,000 $
COGS = 125,000 $ x (1-0.45) = 68,750 $
IT = COGS ÷ Average Inventory = 68,750 $ ÷ 55,000 $ = 1.25
This means that the company has turned its inventory 1.25 times in a year. “Turned” here means sold and replaced its inventory.
For example if the turnover ratio is 2, it means the company has sold its inventory and bought new one and sold it again within this period, i.e sold it 2 times.
Interpreting Inventory Turnover Ratio
High Inventory Turnover
A high IT ratio means that you are either getting very high sales and efficiently turning your inventory many times throughout the year or it could also mean that you are understocked.
Because being understocked is actually an issue and might mean that you are missing sales, you can combine inventory turnover ratio with other inventory ratios such as forward stock cover to judge the situation.
Low Inventory Turnover
On the other hand, a low turnover ratio means you are having low sales or you are being overstocked. This signals trouble in both cases, so you will need to dig deeper and see if the problem is in your sales and marketing efforts or your stock levels are high and holding back excess cash that you can utilize it in a better way.
Here you can check your OTB budget and see if you are overstocked and can also combine it with forward stock cover for a full picture.
The Problem with a Low Inventory Turnover Ratio
- Trapped cash
- Low Open to Buy budget
- No freshness or newness
- High storage costs
- Higher stock obsolescence
- Lower profits due to the need to discount & clear
What Is a Good Inventory Turnover Ratio for Retail?
Deciding whether your Inventory Turnover is high or low depends on which retail category you are in. Below is a list of benchmarks by retail category.
|Retail Category||Inventory Turnover|
|Family Clothing Stores||3.2|
|Office Supplies Stores||8.3|
|Household Appliances Stores||4.7|
For example, supermarkets and convenience stores tend to turn their inventory many times during the year (15 to 20). This is because they carry perishable goods that they can not stock for long time and have to sell and replace them faster.
On the other hand, fashion stores tend to have lower inventory turns (2 to 4) and usually carry stocks that cover 3-6 months forward.
Check also our annually updated list of retail benchmarks.
Having an Inventory Turnover of 12 simply means that you replace your entire inventory every month (12 times per year). This is important to know because it dictates how much you invest in inventory to start such a business and also will dictate how much cash will be kept in inventory throughout the business life.
Convenience stores for example have a turnover ratio of 23.5. This means that if I am to open a convenience store tomorrow, I will only need to buy 2-3 weeks worth of inventory.
On the other hand, due to manufacturing cycle and high order lead time of fashion suppliers, you will find that a typical fashion business carries 3-6 months worth of inventory at any given time, and hence the lower IT ratio of 2-3.
This is why as a retailer you should be comparing your inventory turnover ratio to retailers from the same category. Based on your result you then take decisions to manage your inventory in a better way.
Inventory Turnover is one of several measures and KPIs that guide us on the performance of our business and the efficiency of our inventory management process, as well as our purchasing decisions.
Retailer & Founder of Retail Dogma, Inc.
Rasha has 14 years of retail & ecommerce experience. She has started an ecommerce business in 2008, and later worked at H&M, Bath & Body Works, Victoria’s Secret and Landmark Group. She’s lived in 4 different countries, speaks 3 different languages and holds an MBA in Strategic Management & Marketing.
You can connect with her on Linkedin.