Retail is in the details. Creating the perfect balance between inventory levels and sales is crucial to the success of any retail business. This post will explore the concept of Inventory turnover ratio, a vital inventory management metric essential to any company involved in buying and selling.
Inventory turnover is the pace at which an inventory stock is sold, utilized, or replaced. The Inventory turnover ratio is calculated by dividing the cost of goods sold by the average inventory for the same period.
For example, if a retailer purchases 6 boxes of shoes and sells all of them in 30 days. The number of times this retailer had to buy these amount of shoes and sell out is 30 days.
The inventory turnover ratio is the amount of time the retailer had to make this purchase within a month. A higher percentage means more sales of that particular item. So basically, an inventory turnover ratio is the value depicting how much sales and replenishment a company has made within a stipulated period. Calculating your inventory turnover ratio can help you make better decisions on pricing, marketing, and buying new stock for your business.
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We have established that the inventory turnover ratio is the amount of time a business takes to sell and replenish goods. It works by simply providing insight into how well your business is doing in terms of inventory management, which is critical to the success of any retail company.
A high ratio usually indicates high sales and may also mean that your stock levels are low and you cannot meet demands. A low ratio suggests poor sales and may also imply that you have too much inventory, are stocking goods nobody wants, or not putting in enough effort in marketing.
The inventory turnover ratio is calculated by dividing the cost of goods sold by the average inventory available. The cost of goods here is how much is expended to produce or purchase a product sold within a particular time, for example, a month.
The cost of goods sold is calculated by summing up the cost of goods you had at the beginning of the month with any other inventory costs you made within that same month. After this, you subtract your inventory at the end of the month from the total sum to determine your cost of goods sold.
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The average inventory, in this case, is the value of all the goods you have in stock. However, since the value can vary over a year, it is essential to use an average sum, not the exact value at the end of that year or whatever period.
It is important to note that the average inventory does not have to be calculated every year. It could be quarterly or monthly, for whatever period is needed for analysis.
For example, if your goods or inventory value were $1000 at the beginning of a year and $3000 at the end, your average inventory value would be $2000. If the cost of goods sold were $3000, your inventory turnover ratio would be 1.5.
A higher inventory ratio means you were able to make more sales and you understood the varying demands of consumers. On the other hand, a low ratio shows poor sales and a decline in the need for your products.
The inventory turnover ratio can show how well your sales and buyers are in sync. If their relationship is seamless, it would improve sales and increase turnover.
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The formula for inventory turnover is ;
Cost of goods sold divided by your average inventory. I.e., Cost of goods sold / Avg Inventory.
The cost of goods sold is the total sales you realized within a specific time frame.
Average Inventory is your total inventory at the beginning of the month, plus your inventory at the end of the month divided by 2.
Inventory can lock down a considerable amount of capital. If money is tied up, it will affect your cash flow or liquidity as a business. Asides from cash flow issues, the longer a stock sits unsold, the more its value begins to decline, resulting in a total loss of investments.
The best way to check that this is not happening is to check with inventory turnover ratio. Especially as optimizing your inventory volume according to your consumer’s demand is crucial to your business profitability and operational efficiency.
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As a business owner, you would not want to tie your funds down on long storage of goods, and at the same time, you do not wish to stock below consumer demand. So rather than leave inventory volumes to chance, you might want to optimize your inventory turnover ratio as the benefits are numerous.
1. Increase In Profits: Analyzing your inventory turnover ratio is a sure way to push your profits. Understanding your inventory turnover ratio can help drive up your earnings, reduce excess stock, and allow you to apply a just-in-time approach to meet your consumer’s demands for products.
2. Better Business Decisions: Analyzing your organization’s inventory turnover will create intelligent and well-informed business decisions. This is so because you would know exactly what your business needs to thrive regarding inventory and stock management.
Most importantly, you would be able to plan your business budget more effectively as you can predict the volume of stock accurately you would require to meet business goals.
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The ideal inventory ratio for most organizations is between 5 and 10. This implies that sales and stock replenishment is made every 1 to 2 months.
This ratio is a good balance between having enough stock to sell and not having to replenish stock often. However, it is essential to note that what is regarded as the best turnover ratio varies based on the business niche
Grocery businesses and discount stores usually sell their goods with low margins, So they would need a high turnover in order to make a profit. Quick sales that move inventory fast are the best path for low-margin organizations to succeed.
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Luxury businesses usually operate with a high-profit margin but low inventory ratio turnover.
This model is peculiar to luxury businesses because of their niche in the industry. Their products are aspirational, and their value appreciates over time or is simply priceless, so there is no need to push out goods quickly for fear of shrinkage.
Businesses with high holding costs like consumer electronics and automobile companies require a high turnover ratio to thrive. This is so because the cost of holding such products is huge and very competitive, and quite costly.
Low inventory turnover is when sales are poor, and stock items stay longer in your inventory than they should. The result is poor cash flow and increased holding costs.
Here are 5 steps companies can adopt to combat a low turnover ratio.
1. Data-Driven Forecasting: Putting structures in place to gather data on your top-selling items would make you better at forecasting. Based on these results, you can then make stock purchases based on accurate figures, which would impact your inventory turnover ratio positively.
Purchases made on customer demands would improve sales, and the stock would move rapidly.
2. Marketing Campaigns: Adopting innovative marketing strategies can create demand for products and increase sales.
3. Remove Old Stock: Old stock can be eliminated through sales and discount events. Revenue realized from this can be used to purchase top-selling products.
4. Resell Old Inventory: Excess inventory after the sales and discounts can be resold back to suppliers at a discounted rate, as they have the market to resell to other retailers. This would free up cash and eliminate the burden of excess stock.
5. Product Diversification: Creating a new product line can help improve your product mix and excite customers and drive better sales.
High inventory turnover indicates that you are making sales frequently. This is good and helps save on stock carrying costs. Generally, a high stock turn can improve profit margins for the following reasons.
However, a business can be said to be expressing a very high inventory turnover when there is a need to restock frequently. Sometimes delays in delivery of new orders may lead to a long stockout period, which simply means a loss of sales opportunities.
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Holding a considerable inventory balance would hold up your working capital, which would negatively impact your liquidity and profitability.
Optimizing your inventory can speed things up and transform your investments into profits.
Here are some techniques businesses can implement to optimize their inventory turnover ratio;
The inventory turnover ratio measures how often sales are made and replaced within a specific period in a business. Low turnover indicates poor sales and leads to excess inventory with enormous holding costs.
This affects liquidity as it ties down the working capital of the business. On the other hand, a high stock turn means that the company makes good sales and replenishes stock on time to meet demand. The ideal scenario for any business is to strike a balance to avoid lengthy and constant supply out periods that could lead to loss of sales.
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