The answer to the question, "What is a good inventory turnover ratio?" is the midpoint between two extremes. You don't want your merchandise gathering dust; however, you don't want to have to restock inventory too often or risk having inadequate inventory to meet demand. The golden ratio is somewhere in between and varies from industry to industry—and often from product to product.
In this article, we'll discuss finding the ideal turnover ratio considering your industry and size, help you calculate and interpret your inventory turnover ratio, and share practical tactics for reaching your optimal inventory level.
What is a good inventory turnover ratio?
For most industries, a good inventory turnover ratio is between 5 and 10, which indicates that you sell and restock your inventory every 1-2 months. This ratio strikes a good balance between having enough inventory on hand and not having to reorder too frequently.
Some organizations, such as Ready Ratios, track the median ITR across various industries. But while those numbers are good to know, your industry's average ITR isn't necessarily a good inventory turnover ratio for your business. Optimizing your company's inventory turnover is one of the most critical parts of inventory control. You'll want to examine inventory turnover differences based on your industry, business size, and other factors.
You may be wondering, “Can an inventory ratio be too high?” Generally, a high inventory turnover ratio is a good thing. However, contrary to some inventory management myths, an extremely high turnover ratio can be a bad thing, hurt your balance sheet, and affect your business performance. The good news is that there's usually a simple fix: adjust your ordering cycle to better match demand.
If you continually restock inventory right as you're running out of it, your inventory levels could get dangerously low. The slightest hitch in your supply chain can lead to a shortage, which means you might not be able to meet customer demand. Additionally, you likely are not maximizing your buying power with your manufacturers. Higher-volume inventory purchase orders with your suppliers often lead to better pricing and better profits for you.
Also, a company might have an ultra-high ITR (in other words, strong sales) while going bankrupt because the company isn't making enough profit on each sale. Although it's usually not a good idea to sacrifice profit for turnover, it's sometimes necessary—for example, when it's more costly to store dead stock in your warehouse than sell it off quickly.
How to Improve Your Inventory Turnover Ratio
The ideal ITR for your business depends on the size of your operation, your cash flow, how quickly you can liquidate your assets, and which products you're selling. When you're just getting your feet wet, you can use the average ITR in your industry as a benchmark.
Over time, though, you'll want to move past industry averages to maximize your company's profits. Sorry, there's no silver bullet for this—you’ll need to dive into your data and income statements to find out what's best for your profitability and growth. The old-fashioned approach involves running calculations in spreadsheets (like Excel). What many businesses have found, though, is that spreadsheets are better for displaying data than harvesting insights.
Today, you can use software to track your inventory and automate the calculation of your ITR and other vital metrics. Using inventory management software (IMS) allows you to track your ITR against your profits and discover the healthiest ratio for your business. With the right software, you can also find cost-saving opportunities that would otherwise lie dormant in your data.
If you've found that you have low turnover, below are several tried-and-true strategies to improve your inventory turnover ratio:
Categorize Your Inventory
Establishing one universal turnover ratio for all the products you sell may not be the best way to evaluate your stock turns. For example, products with best-before dates must sell well before the item expires, or with fashion, a core product offered all year around doesn’t need to sell by a certain date compared to seasonal items like a winter parka with a shorter selling season.
Segmenting your inventory into a few categories based on the ideal selling window (e.g., fast turn vs. slow turn or seasonal vs non-seasonal) might allow you to order core or non-seasonal products at a greater volume than average, reducing your cost per piece and allowing for greater attention to quick-turn products your business needs to sell quickly.
Forecast Your Inventory Turnover
To properly predict (and improve) inventory turnover, reviewing historical and current sales velocity in addition to forecasting future demand is important. For example, you likely will want to build inventory volumes going into peak seasonal demand periods like Black Friday for weeks going into the event. As a result, when reviewing your turnover, there will likely be a period leading up to the event when your inventory turn will look slower than usual.
Maximize Seasonal Inventory
When the optimal selling window for a specific item is limited because of seasonality, many tactics should be considered to maximize profit margins while also impacting stock turn. For example, the perceived value of a snow shovel is very different depending on the weather outside.
A promotional discount offered at the end of the season to clear inventory is often the first go-to for many businesses to recapture working capital. Alternatively, offering the item(s) for sale in a counter-seasonal market like Australia or South America for businesses in the Northern Hemisphere can create a new selling window for these items.
Another option is to temporarily remove seasonal items from your working inventory and available-to-sell inventory and reintroduce them when they are back in season. When you do this, it is essential to review your inventory on order and consider the costs of warehousing the non-selling items over an extended period of time.
Implement Marketing and Promotions
Promotions and discounts are a quick way to turn specific items and increase sales overall. Customers love them, and you can also use discounts to incentivize referrals. A well-executed marketing campaign can also help increase inventory turnover. For example, while promoting new products is an obvious way to test market demand for a new item, another tactic is to promote when you intend to discontinue an item. This will often incentivize loyalists to stock up on their favorite items before they are no longer available.
Infusing seasonality into your marketing strategy is another way to increase your inventory turnover rate. We recommend observing customers' existing purchasing patterns to determine natural seasonality. Include the relative seasonal performance of different sales channels as you examine these trends. That way, you can drive quicker sales with targeted promotions that ride your existing waves.
Fortunately, there are also many software tools available that can help automate your promotional and marketing efforts—for instance, modules that get more products in front of customers through upselling and cross-selling on your product listings—and provide essential insights into your inventory data. Extensiv offers a broad range of reporting and analytics capabilities into all your sales channels while enabling you to track performance down to the SKU level. We give you the ability to evaluate the impact of your marketing and sales campaigns, especially as you grow and diversify your channel strategy.
Adjust Your Pricing
Ecommerce has made it easy to compare prices from multiple sellers, and shoppers take advantage of that opportunity before they buy. Fortunately, the web has also made it easier for sellers to adjust their prices in real-time to undercut competitors by a small margin.
More broadly, it can be smart to review your pricing strategy. This doesn't necessarily mean reducing prices across the board; lower prices don't always increase turnover. Instead, explore the well-established pricing strategies that you may not have considered, such as tiered pricing, premium pricing, seasonal pricing, rush delivery, cost-plus pricing, etc.
Bundle Products
Product bundles are a way to capitalize on a (fairly obvious) sales opportunity: people often buy related products together. Amazon’s virtual bundles were a pioneer in this area. It seems like such a basic idea, but it's powerful—and suitable for most industries. Almost every ecommerce business has opportunities to bundle products. That means every company can offer a pathway for consumers to help them clear out a chunk of the inventory at once.
While bundling can be pretty intuitive, it's best to take a quantitative, data-driven approach to a product bundling strategy. For example, the data suggests that it's not a good idea to offer a product bundle without also offering the option to buy each product individually.
Order management systems (OMS), including Extensiv's platform, equip brands to develop and offer the right product bundles at the right price to increase both turnover and profit.
Optimize Inventory Replenishment
Sometimes, your ordering cycle—the length of time needed before you use up supply to meet your supplier’s target order requirement—is the culprit. Fortunately, if you have your historical data and the right software, this is a simple problem to fix.
There are automated tools that will reorder a company's inventory based on sales data, preventing both overstocking and under-ordering. This process limits excess inventory that's hard to turn over. Extensiv’s Order Management platform includes a feature that creates purchase orders automatically and recommends when and how many units of a product to order for real-time inventory upkeep based on sales velocity data.
Review Your Product Portfolio Frequently
Above all, to improve inventory turn, you want to stock what sells—determining profitability by SKU is critical. Many companies get so caught up in increasing revenue that they compromise profits. If the time for a single SKU to turn over is too long, then it's draining your resources, even if it eventually sells.
It's amazing how many business owners don't know which SKUs are generating profit. The first step is to calculate your inventory turnover by individual SKU. Don't do this manually, especially if you have thousands of SKUs; instead, you can automate this process with inventory optimization software.
Inventory Turnover Formula
Let’s dig into the inventory turnover ratio formula. To find your ITR for the year, divide your total cost of goods sold by your average inventory value. You can determine the average inventory value by adding together the beginning inventory and ending inventory balances for a single month and dividing by two.
Inventory Turnover Ratio = COGS ÷ Average Inventory Value
So, let’s say your sales for the year totaled $500,000, and your average inventory value on any given day was $100,000. By applying the turnover ratio formula, you’ll find that your ITR was 5. That means you sold and replaced your inventory five times.
If you divide the number of days in the year (365) by your ITR, you’ll get your days sales of inventory (DSI), in other words, the average number of days it took you to turn over your inventory.
Days Sales of Inventory = 365 ÷ Inventory Turnover Ratio
In the above scenario, your days sales of inventory would be 73.
While software is the most accurate way to calculate inventory turnover at a high level of detail, all the information you need for a quick inventory turnover calculation is available on your financial statements.
Optimize Your Inventory Turnover with Extensiv
Now that you have the basic formula and you know how different factors affect turnover, it's time to find the ideal inventory turnover ratio for your business. When determining your goal ITR, consider your profit margins; the lower the margin, the faster you need to turn your stock. Also, consider the seasonality of your products and examine the profitability of each SKU.
If you're off target, the right technology (i.e., software) can be a game changer. Consider incorporating supply chain and customer-facing tools in addition to inventory management software like Extensiv’s solutions for brands. While you won't reach your ideal ratio overnight, with reliable processes in place and a robust, long-term inventory management strategy, you'll be able to strike that balance sooner than you think.
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