Last Updated On October 18, 2019 / Written By Michelle Jaco

How to Increase Profits with Inventory Turnover Ratio Calculations

Cutting down on costs is a great way of increasing your profit margins. This article will help you understand how accurate inventory calculations can allow you to manage your budget and why you need an inventory turnover ratio calculation software.

What is ITR?

Inventory turnover ratio (ITR) is used to define the amount of times you replenished your stocked resources in a fixed period - which is a great way of determining how many sales you made at that time. This can help you understand how your inventory practices are affecting your profits (more on that later).

Not just this, but restaurant managers and owners can use this metric to decide future menu prices, food costing and purchase decisions.

In fact, not taking regular inventory can put you in the group of 75% restaurants that struggle to generate high revenues.

Despite this, around 46% of SMBs either don’t keep track of their inventory or use outdated methods to do so.

Hence, to promote best practices for inventory management, a number of new tools have been introduced that allow businesses to calculate ITR easily and efficiently.

How Is Inventory Turnover Ratio Calculated?

Before we get into how ITR can lead to better resource management and increased profits, we must first understand the measurements.

Inventory turnover is a ratio of your cost of goods sold (COGS) and your average inventory (AI). Here’s how you can define these values

1. Calculating COGS
Since the cost of sold items is the carrying value of resources used up for sales in a specific amount of time, it can be calculated weekly, monthly or even yearly.

As these costs fall between 20% and 40% for the restaurant industry, regular - such as weekly - calculations can help solve over-spending on unnecessary items, thereby increasing profit margins.

After setting your time period, you can use the following formula
Cost of sold goods = (beginning inventory + purchases) - (ending inventory)

2. Calculating AI
Your average inventory is an estimate of the mean value of your stock throughout a term and can be calculated using
Average Inventory = (beginning inventory + ending inventory) / 2

For those making bi-annual inventory calculations, the stock values can be more than one and the formula can be adjusted to
AI = (inventory of month 1 + 2 + 3 + 4 + 5 + 6) / 6

3. Calculating ITR
After these values are calculated, they can be simply plugged in to find the inventory turnover ratio.
ITR = COGS / Average Inventory

To better help you understand this, here’s an example

Say that your initial inventory for August 2019 was worth $15,000 and after making a purchase of about $10,000, your ending inventory was $5,000.

Now using the formulas mentioned above, you can calculate your ITR for the month of August as [(15,000 + 10,000) - 5,000] / [(15,000 + 5,000)/2], or 2

This means that your restaurant emptied its entire pantry twice in August.

How Do You Calculate Average Days in Inventory?

One of the most important applications of the inventory turnover ratio in the foodservice industry is to determine the average days for your inventory on hand.

This can help restaurateurs give more accurate answers to three key questions

  • How long does it take for my inventory to turn over?
  • Is there a risk of spoilage?
  • Am I over-stocking?
Not only this, but you can even use this value to determine how your business fairs against your competitors.

Consider this, based on average sales, inventory on hand has increased by 8.3% in the last five years, which means that restaurants are stockpiling without even realizing it.

To calculate your inventory period, simply divide the number of days in the year (365) by your ITR and you’ll know where you stand.

The Relationship Between Inventory and Profit

The first rule of business is to keep your costs low so you can maximize profits, and this common rule of thumb is basically the relationship between your inventory and profit.

Your inventory cost for a term (COGS) is an important variable when calculating both ITR and profit - the net profit is calculated by subtracting your initial costs from the total generated revenue.

This means that by keeping track of your inventory, you can control your stocks to keep COGS low and attain a higher profit.

How and Why Should You Lower Your COGS

Restaurants have always largely relied on consumer spending to generate revenue, but with the recent economic recession, the average profit margins in the industry have fallen below 4%.

This has led foodservice providers to cut costs in various ways to make up for lost profits, lowering COGS.

Business owners now focus on conserving ingredients so there’s less need for restocking and keep food levels in check to avoid spoilage and other such problems. This is only made possible when they establish reliable inventory management practices.

In other words, keeping an eye on each item that sits in your pantry allows you to allocate a specific budget for different items - for example, fixing $200 for buying avocados each month.

This removes any factor of surprise costs and caps overspending so you can minimize capital expense without compromising on quality and brand image.

And this tactic works, regardless of the size of your business, whether you own a small cafe or a fancy upscale bistro.

Tips to Optimize Your Inventory Turnover Ratio

A good ITR for food is between 4 and 6 and if your ratio falls under or above this range, it is wise to explore new ways to achieve an optimal value.

Here are three actionable ways you can optimize your ITR

Forecast
Analyze past resource spending methods to establish a pattern of how much of each product you require. This will help you predict order amounts for every month and tailor them, if need be.

Also, there are tools available in the market that can help you do this - we’ll get into that in a bit.

Ensure Best Practices
Push your employees to adopt the FIFO - first-in, first-out - inventory method - items that are bought first should be used first.

This can be achieved by stocking your pantry in a way that makes it easy to access older products, so there are minimal items in your inventory that expire.

Negotiate Raw Materials Costs
Here’s a tip. No matter how great your vendor is and regardless of how long you have been in business with them, always look for better prices.

Cheaper products don’t necessarily mean poor quality; if you research enough, compare prices between different vendors and change your buying practices, you can end up paying less for more items.

Why Conventional Inventory Tracking Does Not Work

1. The Pen And Paper Approach
Gone are the days when you sat down with a pen and paper to do much of anything, let alone keep stock; but many small-scale businesses to-date keep physical inventory spreadsheets - shocker, right?

This method of data-keeping doesn’t only make it difficult to adjust records, but it also makes it tough to discern patterns and make decisions based on them. In addition, physical data is extremely easy to lose as well.

Imagine having to go through a pile of record books, page by page, every time you want to see your sales trend or establish inventory variance.

Even a slight change in one number could potentially mess up your entire sheet - and for those of us who don’t have an A-game in math, this could be a nightmare for our inventory, especially since accounting errors cause 15.3% of inventory loss.

Here’s a scenario, to calculate only one week’s inventory turnover ratio you first have to write down all the items in your pantry that you bought at the beginning of the week and their per piece product cost. Next, you have to multiply the cost per piece with the amount of that item in stock.

Sounds like a lot of work? You’re not even halfway done.

You now have to

  • Find the gross total
  • Repeat the process from scratch for ending inventory
  • Calculate the total purchases made in between
And finally, put them in multiple formulas just to get one week’s ITR.

2. Computer Inventory Spreadsheet
For those of you who use computer-based bookkeeping for inventory, we have good news and bad news.

The good news is that you are less prone to errors and time waste than paper-based inventory keepers - you have to make fewer calculations, it’s easier to make changes and you can keep track of trends.

But the bad news is that you are still messing up those calculations.

This is because even though digital spreadsheets like Excel may be crunching the numbers for you, those numbers are still entered manually - and manual data entry has an error rate of at least 1%.

Put simply, this means that for every 100 numbers you enter, one of them is incorrect; as a result, this can yield a drastically different ITR from the real value.

Inventory Automation

With so many disadvantages of conventional methods, it’s only natural that people are turning to automated methods of inventory.

In fact, more than 80% of restaurants that practice stock keeping are now turning to technology.

Such software-based management systems help owners monitor available stock levels, analyze usage trends, keep track of product expiration dates and deal with unexpected situations.

Benefits of Using a Tool for Inventory Management

1. Reduce Your Food Costs - Food prices have increased by 3% in 2019; adding this to the 8.7% hike between 2011 and 2015, we are looking at a pattern of inflation.

Reducing food costs not only requires you to work on your order frequency, but it is also largely dependent on keeping an eye on costing trends.

A good inventory management tool gives you access to inventory variance and COGS reports so you can identify, predict and avoid over-paying.

2. Manage All Data In One Place - With all your data - spreadsheets, prices, sales - on one app, managing information becomes more convenient than ever. Instead of having to make each change manually everywhere, one alteration will be enough to update all your synced data.

Not to mention how easy it makes calculating your inventory turnover ratio.

3. Track And Reduce Waste - Around 16% of restaurant food in stock ends up in the trash due to spoilage and expiration.

This means that all the costs that went into buying those products will never translate to sales and profit.

A good tool can help you determine the reason behind this and lead you to better stock management to reduce inventory wastage.

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