All about Inventory Turnover Ratio and Formula to calculate

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The flow of content:

What is Inventory turnover ratio? Its importance
Inventory Turnover Ratio Formula with Example
Significance of inventory turnover ratio
Ideal inventory turnover ratio for a company

 

What is the inventory turnover ratio? And its importance

Inventory Turnover Ratio is a key to efficient stock replenishment. It is essential to calculate the turnover of inventory for efficient warehouse management.

However, the practice of calculating the inventory turnover is not just limited to the warehouse but is also done by retailers running the small shops. The ratio helps in knowing how much inventory is utilized within a period of time and therefore, new inventory requirements can be estimated on the basis of this.

To better understand the concept, let us first understand its meaning and definition.

According to Wikipedia

“The Inventory turnover is a measure of the number of times inventory is sold or used in a time period, such as a year. It is calculated to see if a business has an excessive inventory in comparison to its sales level.”

However, in a layman’s term,

 Inventory turnover is the number of times the products are replenished by the retailer or businessperson to keep his/her business running smoothly without going out-of-stock or over-stocking the products. 

But how to determine as to how many times you need to restock the items you’re selling? Luckily, there’s a way to calculate it.

If you’re having trouble understanding all the weird formulas floating around for calculating the inventory turnover ratio, then this is a must-read for you. 

I will show you exactly how to calculate the inventory turnover in the easiest and yet accurate way possible in this article. 

“If you have lower than a ten percent turnover, there is a problem. And if you have higher than, say 20%, there is a problem.” William Mcgovern

So keeping this in mind, the key is to strike a balance! But how exactly does one do that? 

By calculating the inventory turnover using a formula. 

Before, we get on with how the calculation of inventory turnover ratio formula works, you need to understand that the formula is based on two main activities of any business: 

  • Purchases of the goods to be sold
  • Selling of the goods

These two are determining factors in the success of any business and therefore, their performance can be judged only by calculating the inventory turnover ratio. 

 

Inventory Turnover Ratio Formula with Example

There are multiple formulas to calculate inventory turnover ratio but the most commonly used formula that is effective enough in predicting the turnover is –

Inventory Turnover Ratio Formula

Inventory turnover = Cost of goods sold / average inventory

Now don’t let this formula boggle your mind. We will split it up so that you can understand it better. 

Firstly, we will need the Cost of goods sold. For getting this detail we will need the stock count of the inventory at the beginning and at the end of the month. So let’s learn how to calculate the Cost of Goods Sold (COGS) first of all,

Calculating the Cost of goods becomes easy when we use the given formula:

Beginning inventory cost + purchases – Ending inventory cost = Cost of Goods Sold (COGS) 

COGS Formula

 

To understand this formula better, let’s take a look at a practical example, 

For instance, a retailer named Exotic Perfumeries is selling premium perfume for $100, and he has 90 such packs at the starting of September, 

so the total cost of our goods is 100 x 90 = $9000

Let’s call this ‘Beginning Inventory of the month’.

Now, it is a good business practice to take a stock count at the end of every month. During the stocktake at the end of that very month, Exotic Perfumeries has 92 packs of premium perfumes.

so the total cost of our goods is 100 x 92 = $9200

Let’s call this the ‘Ending inventory of the month’.

How to calculate COGS

Technically, this is not possible without buying new stock in the middle of the month…right? So, let’s take a look at our invoices and check how many purchases we did in September. By looking at the invoices, we get to know that 77 packs of premium perfumes were purchased at the cost of $100 each. 

Therefore, 77 x 100 = $ 7700

Let’s call this as ‘Purchases.’ 

Now that we have got the required values, let’s put our COGS formula to work:

Beginning inventory cost + purchases – Ending inventory cost = COGS

Therefore, as per our above example,

$9000 (beginning inventory cost) + $7700 (Purchases) – $9200 (ending inventory cost) = $ 7500 (COGS)

Hence, our Cost of the Goods Sold (COGS) value is $ 7500. Which indicates we have already halfway up to getting to our inventory turnover. 

Now, coming on to the second part of our inventory turnover formula. 

We need to get a particular number for the average inventory. For this, we will again use an easy formula. 

Average Inventory Formula

Simply add the inventory stock at the beginning and end of the month and then divide it by 2. 

Don’t want to calculate the average inventory manually? Use our automated average inventory calculator. Just fill in the required information and you will get the result instantly.

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Start by adding your data above

Average Inventory Turnover Calculation

Now that we have got values for both COGS and average inventory, 

let’s apply our inventory turnover formula,

Inventory turnover = Cost of goods sold / average inventory

7500/9100= 1.213

This means that the retailer is turning over the inventory once every month.

 

Significance of inventory turnover ratio

All businesses can flourish successfully if they have proper in-flow and out-go of cash and inventory. It is like the more goods you sell, the better profits you make and therefore, not going out-of-stock is very important, but at the same time, you can’t overstock your products as well, as that would mean blocking your funds.

Hence, it is essential to maintain a certain amount of stock for running a business smoothly, 

The inventory turnover ratio helps in determining how much stock you should keep for running your business smoothly.

The higher the turnover ratio, the higher the risks of overstocking the inventory. The lower the turnover ratio, the higher the risk of going out-of-stock. 

Low inventory turnover ratio also indicates that there is inefficiency in managing the business and thus the retailer can channelize his/her energies in improving the supply chain management as per the customer’s demand. 

A retailer can increase his/her business profitability by improving its inventory turnover.

Ideal inventory turnover ratio for a company

To conclude, all businesses are different, and hence they all have different inventory turnover, but it is ideal for a business to replenish their stores 12-13 times in a year. That is just how many times our illustrated company, Exotic Perfumeries, will replenish their product in the store. 

I hope this helps you in replenishing your inventory successfully!

 

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