How to Calculate the Inventory Turnover Ratio (With Example)
By Indeed Editorial Team
Published November 24, 2021
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
It's vital for companies to monitor various aspects of their processes to evaluate their performance accurately. One of the most popular metrics for evaluating performance is the company's inventory turnover ratio. Understanding how to calculate the inventory turnover ratio can help you gain valuable insights into the operations of a business. In this article, we explain what the ratio involves, explore steps for how to calculate the inventory turnover ratio, address its implications, discuss how companies can manage inventory turnover, and provide examples to help you with your own calculations.
What is the inventory turnover ratio?
A company's inventory turnover ratio refers to the rate at which it may sell and replenish its inventory within a specific period. Companies also use this ratio to determine how fast they can sell products that are currently in inventory. A higher turnover ratio can show the company has a high sales volume, while a low inventory turnover ratio shows the company may take a relatively long time to sell all its products. To calculate the ratio accurately, it's important for the company to manage its stock efficiently so it can monitor the number of products in its inventory.
How to calculate the inventory turnover ratio
Here's an overview of how to calculate the inventory turnover ratio:
1. Select a period
To calculate a company's inventory turnover ratio, you may first select a period over which you intend to calculate. You can use whichever length of time is most relevant to the company's operation schedule, ensuring the relevant details for that period are available in the company records. For example, large companies may prefer to calculate annually to view their inventory turnover comprehensively. In contrast, smaller companies with fast-moving goods may calculate the inventory turnover ratio quarterly or monthly.
2. Calculate the cost of goods sold
The cost of goods sold (COGS) is a requirement for calculating a company's inventory turnover ratio. A company's COGS refers to the direct cost of products it intends to sell over a specified period, including raw materials for making more products. Usually, the COGS comprises the cost of materials, labour, and other utility or miscellaneous expenses. To calculate COGS, you may add the starting inventory for a specific period to any additional expenses while subtracting the ending inventory from the sum, represented in this formula:
COGS = starting inventory + additional expenses - ending inventory
For example, if a company has a starting inventory of $10,000, $2,000 of additional inventory expenses, and an ending inventory of $4,000, you can use the formula to calculate its cost of goods sold:
COGS is 10,000 + 2,000 - 4,000 = $8,000
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3. Determine the average inventory
The company's average inventory value is another requirement for finding the inventory turnover ratio. It refers to the average amount of inventory a company had over a specific period. You can calculate the average inventory by adding its starting inventory to its ending inventory and dividing the results by two, as shown in this formula:
(Starting inventory + ending inventory) / 2 = average inventory
For example, if a company had a starting inventory of $10,000 and an ending inventory of $4,000, here's how you can calculate its average inventory:
(10,000 + 4,000) / 2 = $7,000
4. Apply the inventory turnover ratio formula
The formula for calculating a company's inventory turnover ratio is the cost of goods sold divided by the average inventory. After determining both values, you can use the formula to find a company's ratio. The result shows how many times the company has sold and replaced its product inventory over the specified period.
The implication of inventory turnover rate
A higher turnover ratio is typically a good sign for a company. This means they have a high volume of sales and finish their inventory quickly. As a result, companies with a high inventory turnover rate are usually more profitable. A low inventory turnover rate can indicate that a company is selling its products less quickly, but there are some exceptions to this general rule. For example, luxury goods often take longer to produce, which can increase their rarity and cost.
While such products may have a low turnover rate, this doesn't necessarily mean the business is facing challenges. Similarly, while a high turnover ratio is generally a good sign, very high ratios may indicate that the current demand for a company's products has exceeded their ability to supply them. The company may operate at full capacity and increase its profits by developing a strategy to supply products more quickly, such as by upgrading its equipment or adjusting production processes.
How to manage inventory turnover
Here are some methods a company can use to improve its inventory turnover ratio:
1. Increase marketing efforts
The demand for a company's products can affect its inventory turnover ratio significantly, so one common solution is to increase their marketing efforts to improve visibility and encourage people to buy their products. One effective marketing strategy to increase a product's popularity is to offer customers an extra incentive to purchase more products. For example, a company can announce a sale on specific products to help increase demand, or use advertisements and commercials to make their products seem more desirable. There are various other marketing channels companies can exploit, including social media, email campaigns, and websites.
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2. Review product prices
Another factor that can impact a company's turnover rate is its pricing strategy. Pricing differences can make competitors' products more desirable to purchasers. To manage inventory turnover, the company can research recent market trends and adopt more effective pricing strategies to promote sales, including using a lower price than the market average to attract more consumers to their products. Companies can also offer discounts or include price-matching options, which may increase sales within the period.
3. Focus on popular products
If a company offers multiple products, some may have a higher turnover rate than others. This can indicate that those products are currently more popular in the market. To manage the inventory turnover rate, the company can focus on its most popular products, either temporarily or as a broader strategy. By increasing its stock of the products in the highest demand, the company can sell its inventory faster. To use this method, it's vital you have an effective inventory control system to determine the difference in sales between products accurately.
Related: Top Product Management Skills
4. Discontinue less popular products
Just as some products are popular, there are typically others that experience less demand. Whatever the reason, it's important for companies to determine which products may impact their inventory turnover ratio. To manage its inventory, the company can replace these products or modify them to help increase demand. This inventory change can also give the company more space to sell its currently popular products.
5. Take preorders
Preordering is a tactic where companies allow customers to buy products before they're in stock. This strategy is common when companies are releasing a new product. The advantage of preordering is that it can allow a company to estimate demand for the product more accurately and adjust production accordingly. Preordering can also give the company access to more capital, which they can use to develop their other products. It's important for companies to use this strategy sparingly and ensure delivery of the preordered products to avoid affecting customer loyalty.
6. Use data analytics
Data analysis can provide valuable insights which can help inform a company's business strategies. For example, analyzing past inventory data can help the company determine which products were most successful and why that was the case. The company can also gain insights on when its products sell the most, what demographic has the highest patronage, and which marketing strategies are typically most effective. With this information, the company can manage its activities to maintain a better turnover rate.
Examples of calculating inventory turnover ratio
Here's an example of calculating an inventory turnover ratio for you to consider:
Incredibly Snappy Juice is a juice manufacturing company looking to determine its annual inventory turnover ratio. They started with an inventory of $100,000, used $20,000 on additional inventory expenses, and closed the year with an inventory of $60,000. To calculate the inventory turnover ratio, calculate the COGS first, then the average inventory cost:
COGS = 100,000 + 20,000 - 60,000 = $60,000
Average inventory = (100,000 + 60,000) / 2 = $80,000
Once these values are found, calculate the inventory turnover rate:
Inventory turnover ratio = 60,000 / 80,000 = 0.75
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