Calculating your inventory turnover ratio and understanding what factors influence this metric are critical to the success of your business.
With this metric, you can identify critical inventory issues, analyze the competition, and ultimately boost profits.
This blog post is a comprehensive guide on inventory turnover ratios for product-based and ecommerce businesses.
After this post, you’ll come away knowing:
- The definition of inventory turnover ratios and why they are important in ecommerce
- How to calculate your company’s inventory turnover ratio
- What a “good” or “bad” inventory turnover ratio is
- How to use the metric to improve your business performance
Let’s jump in.
What inventory turnover ratio is and how to calculate it
Inventory Turnover Ratio is a metric that measures how quickly a product is sold given the amount of stock held by a business.
It’s calculated by taking the cost of goods sold (COGS) divided by the average inventory during an accounting period (usually a year).
It serves as an indicator for businesses on how well they are managing their inventory and emphasizes the importance of having a well-stocked inventory.
Understanding the inventory turnover formula
The inventory turnover calculation is quite simple:
Inventory Turnover Ratio = Cost of Goods Sold ÷ Average Inventory
Cost of Goods Sold (COGS) is the amount a business spends to produce, store and/or promote their products or services. It can be found on your company’s financial statements.
Average Inventory is the average amount of inventory that a company holds during an accounting period (usually a year). It can be calculated by taking the beginning and ending inventory and dividing it by two.
Understanding “good” and “bad” inventory turnover ratios
As mentioned above, the inventory turnover ratio measures how fast you sell your inventory. The higher the ratio, the more often you are selling and restocking your inventory.
In general, an ideal inventory turnover ratio is 4-6 times per year for product-based or ecommerce businesses. These ratios will vary by industry and company, of course.
A inventory turnover ratio measures the efficiency of inventory management and sales generation
So why are inventory turnover ratios such a big deal? What’s the relevance of tracking how often you “refresh” your product stock?
The actual metric itself seems arbitrary, but it’s actually a telltale indicator of the health of your inventory management and sales processes.
The importance of inventory turnover ratios in ecommerce
Inventory turnover ratios have two main uses in understanding the health of your business and inventory management.
The first is to identify and diagnose any inventory control issues, and the second is to help you measure your progress against competitors.
Let’s take a look at each of these in detail.
Inventory turnover ratios help you diagnose internal inventory control issues
A low inventory turnover ratio can be an indication that you are holding too much stock and not selling enough. It could also suggest a few other things:
- You have poor stock management systems in place
- Your product margins are too low
- You’re overstocking slow-moving items
- You’re not pricing your products correctly
- You’re not advertising or marketing your products effectively
Many of these can be improved by implementing a robust inventory management system, including inventory management software like Linnworks.
On the other hand, a high inventory turnover ratio (anywhere between 4-6 per year) is a signal that you’re cycling through your products at a healthy pace.
But a high inventory turnover ratio alone doesn’t mean your business is in perfect condition.
It’s important to remember that these metrics must be considered in context with other inventory control metrics.
For example, a high inventory turnover ratio may not actually be a good thing if it’s associated with a high number of stockouts, meaning that customers are being turned away because you don’t have enough product on hand to meet the demand.
In this case, you may need to invest in better forecasting and inventory planning tools to ensure that your stock levels are always at their optimal level.
Inventory turnover ratios help you measure progress against competitors
Another use of inventory turnover ratios is to measure your performance against competitors or industry benchmarks.
If your competitors are publicly-traded companies (or you know of some publicly-traded companies in your vertical or industry), you can easily calculate the inventory turnover ratio using key figures from their financial statements.
This will give you an insight into how well they are performing and the level of efficiency in their inventory management and sales process.
By comparing your own figures to these industry benchmarks, you can identify areas where you need to improve and get a better understanding of how well you’re doing overall.
An example of calculating a competitor’s inventory turnover ratio
Let’s say you own an ecommerce business in the personal electronics niche. You want to compare your own inventory turnover ratio to that of a competitive publicly-traded company, such as Best Buy.
You can find the following figures in their annual financial report:
Cost of Goods Sold (COGS): $22 billion
Average Inventory Value: $4 billion
Using the formula above, you can calculate Best Buy’s inventory turnover ratio:
Inventory Turnover Ratio = COGS / Average Inventory
Best Buy’s Inventory Turnover Ratio = 22 billion / 4 billion
Best Buy’s Inventory Turnover Ratio = 5.5 times per year
Now that you know their inventory turnover ratio, you can compare it to your own figures and identify any areas where you need to improve.
Common industry benchmarks for inventory turnover ratio
If you can’t be bothered to dig through financial statements, here are some common inventory turnover ratio benchmarks broken down across various industries.
- Supermarkets and Grocery Stores: 14
- Pharmacies: 14
- Fashion Stores: 3 to 4
- Electronics Retailers: 8 to 12
- Furniture Stores: 6 to 8
- Sporting Goods Stores: 4 to 6
- Home Improvement Stores: 8 to 12
- Bookstores: 6 to 8
- Pet Stores: 6 to 8
- Beauty and Personal Care Stores: 8 to 10
- Toy Stores: 4 to 6
- Gift and Specialty Stores: 4 to 6
- Office Supply Stores: 6 to 8
- Automotive Parts Stores: 8 to 10
- Convenience Stores: 20 to 25
Ultimately, while a healthy turnover ratio is generally 4 to 6 times annually, there’s no one magic number: every industry is different. Be careful when comparing yourself to businesses that aren’t in your vertical.
Understanding Cost of Goods Sold (COGS) and Average Inventory
As mentioned throughout this post, the only two metrics you need to understand a company’s inventory turnover ratio are Cost of Goods Sold (COGS) and Average Inventory (at cost).
These metrics get thrown around a lot in accounting, and they’re some of the most important to understand as a business owner.
What is Cost of Goods Sold (COGS)?
Cost of Goods Sold (COGS) is the total cost of all inventory items sold during a given period, such as one month or one year.
It includes the cost of purchasing raw materials, manufacturing costs, and any other associated costs with bringing products to market.
It does not include general overhead expenses like administrative costs, rent, or marketing and advertising expenses.
What is Average Inventory?
Average inventory is the sum of all current inventory at cost, divided by the number of products in that inventory.
It includes both finished goods (products ready to be sold) as well as materials and components used to manufacture those products.
It is important to note that Average Inventory should be taken at cost (not at selling price), and not including any discounts or promotions.
Another easy formula to help you calculate Average Inventory is the following:
Average Inventory = (Beginning Inventory + Ending Inventory) / 2
This formula takes the sum of the inventory at the beginning and end of a period, such as a month or a year, and divides it by two to get an average.
For example, let’s say you have a beginning inventory of $50 and an ending inventory of $60. Your average inventory for that period would be $55 ($50 + $60 = 110, 110 / 2 = 55).
If you wanted to use that to calculate inventory turnover ratio, you’d then plug that $55 into the formula above.
Finally, if you’re using an inventory management system like Linnworks, you can quickly pull reports to get your own inventory turnover ratio and compare it against industry benchmarks.
By understanding the basics of inventory turnover ratio, you can gain valuable insights into how well your business is doing compared to competitors in terms of sales efficiency and inventory management.
Common issues related to low inventory turnover
In almost all cases, a low inventory turnover ratio (relative to your competitors or industry) is not a good thing.
A low ratio is often a symptom of a much bigger problem –– or problems. Let’s go into some common causes of a less-than-ideal inventory ratio.
Excess inventory caused by over-purchasing or underselling
Excess inventory refers to the amount of inventory that a company holds that is not needed to meet the current demand for its products.
Too much inventory ties up valuable resources, such as cash and storage space, and can result in inventory obsolescence and reduced profitability.
A low inventory turnover ratio, which indicates that the company is not selling its inventory quickly, may be a sign that the company is holding too much excess inventory.
This may happen because the company is purchasing more inventory than it can sell in a given period, or because the company is not able to sell its inventory as quickly as it had anticipated.
An all-in-one inventory management system like Linnworks can help you avoid this problem by providing you with accurate sales data and giving you the tools to measure and manage your purchasing decisions.
Stock forecasting features also allow business owners to better understand customer demand and plan their inventory levels accordingly.
Supply chain or inventory replenishment issues
Another common cause of low inventory turnover is a supply chain or inventory replenishment issue.
Poor inventory management processes will almost always lead to either insufficient inventory or inadequate inventory. But, it may also lead to obsolete inventory.
For example, if your suppliers are unreliable, you may over-purchase a particular SKU, not realizing that by the time you receive it, the consumer demand will have already waned.
This leaves you with a warehouse full of unsold inventory, which may in turn become dead stock.
Weak sales due to a lack of strategy or product-market fit
If you’re struggling to sell your products, it could be a sign that there is an underlying problem with your product-market fit.
It could mean that the products you are offering don’t align with customer needs and wants or that you are failing to communicate the value of your offerings in a way that resonates with your target audience.
It could also mean that your pricing is too high or your messaging isn’t engaging enough to draw customers in.
When a company sells fewer products than it should, its inventory turnover ratio will suffer.
It’s important to take a step back and ask yourself why customers aren’t buying your product. Are you offering the right products? Is your pricing competitive? What could you do differently to increase sales?
Analyzing customer feedback and re-evaluating your product offerings, pricing, and marketing strategies can help you understand the underlying causes of a low inventory turnover ratio and take steps to correct them.
With better purchase decisions, an optimized supply chain, and an effective sales strategy, you should see an improvement in your inventory turnover ratio over time.
An inventory turnover ratio is a function of how many times a company completely sells and replenishes its stock over a given time period (usually one year).
A higher inventory turnover ratio is most often a good thing, and it signals that the business has a thriving, vibrant customer base.
On the other hand, a lower inventory turnover ratio can be an indicator of weak sales or inefficient supply chain management.
To ensure that your inventory ratios remain healthy and to identify potential problem areas, it’s important to understand the common causes of low inventory turnover and take steps to address them.
This includes keeping a close eye on customer demand, optimizing inventory replenishment processes, and potentially re-evaluating your pricing strategy.
By understanding the factors that contribute to low inventory turnover ratios, you can work to keep your business profitable and avoid costly inventory problems.
Linnworks is the ultimate companion platform for ecommerce businesses, offering a range of features that can help you to better manage your inventory and achieve a higher turnover rate.
With powerful stock forecasting tools, robust purchasing capabilities, and built-in supply chain solutions, Linnworks can help you organize and streamline your inventory management processes once and for all.