What is the Ideal Inventory Turnover Ratio For a Company?
Inventory turnover ratios provide useful metrics for measuring stock and sales performance. Learn how to calculate this figure in just 3 simple steps.
Trying to find the sweet spot of having just enough inventory on hand to satisfy current demand levels without having too much or too little of one product is at the heart of inventory tracking and management.
One of the easiest ways of determining adequate inventory levels is by calculating the inventory turnover ratio. This figure expresses the number of times the inventory has been sold over a specific time period and can reveal if the level of stock being held is appropriate, given the volume of sales.
A low ratio can indicate overstocking, which would result in excessive inventory-related costs, while a high ratio can signal understocking, which could lead to lost sales due to missed opportunities.
In this article, well discuss how to calculate the ideal inventory turnover ratio for a company.
Benefits of Monitoring Inventory Turnover Ratios
There are many advantages to regularly calculating and tracking inventory turnover
ratios. This figure can be a helpful metric when analyzing efficiency in inventory tracking abilities.
- The ratio itself provides a quick snapshot as to how effective the business is in selling inventory.
- From a business standpoint, it provides a very valuable indicator of how certain products are performing and whether they should be kept or discontinued.
- If the inventory isn't selling as it should, it quickly highlights issues in inventory tracking and control.
- It's a useful and quantifiable metric business owners can use to compare their performance with that of industry averages.
3 Steps for Calculating the Turnover Ratio
While it may seem tedious for business leaders to learn yet another mathematical formula, turnover ratios only require a handful of information and can be completed in three simple steps.
For businesses utilizing inventory management software, this information, as well as other inventory tracking metrics, may already be available in their systems.
The first step to calculating the ideal inventory ratio for a company is finding the cost of goods sold (COGS). The COGS is an important figure to calculate as it refers to the total costs incurred by the company to produce the goods being sold.
To calculate the COGS, its important to take a look at income statements and find three key pieces of information- the starting inventory, the net inventory purchases, and the ending inventory.
Starting Inventory + Net Inventory Purchases - Ending Inventory = COGS
If Company ABC runs a clothing store where the most popular product is a blue t-shirt, they can determine the inventory turnover ratio for this product to see if they are storing the appropriate level of stock to meet consumer demands.
The income statement states that they had a starting inventory of $300,000 and a net purchase of $640,000 worth of blue t-shirts over the year, but only had $120,000 worth of inventory by the end of the year. These figures can then be plugged into the formula to determine the COGS.
$300,000 + $640,000 - $120,000 = $820,000
The next step involves figuring out the average inventory (AI) on hand. The formula for this figure can be expressed as the following-
(Starting Inventory + Ending Inventory) / 2 = AI
Since the starting and ending inventory figures have already been established, the AI is-
($300,000 + $120,000) / 2 = $210,000
Now that the heavy lifting is out of the way, the inventory turnover ratio can be easily calculated. As a formula, this ratio is expressed as-
COGS / AI = Inventory Turnover Ratio
Since we have already completed both formulas, we can simply plug in the figures to determine our inventory turnover ratio.
$820,000 / $210,000 = 3.90
What Is Considered to Be an Ideal Inventory Turnover Ratio?
The ideal inventory turnover ratio for a company is anywhere between 4 and 6, although this can fluctuate depending on the industry. Businesses with an inventory turnover ratio in this range are likely able to meet customer demand appropriately without the burden of excess stock.
In the above example, the store selling blue t-shirts falls just below this 4-6 range and while it does not deviate significantly from the recommended range, it reveals some key information.
Lower ratios (anything under 4) tends to imply that businesses probably have products in stock that arent selling as efficiently as they should. So, while the popularity of these shirts was initially very high, the business is starting to see that the demand for the shirts has tapered off quite a bit since then. When demand begins to dwindle, businesses can be left with excess inventory, which leads to high storage costs and obsolete stock.
On the other hand, higher ratios (anything over 6) could indicate that the business is at risk of stocking out on popular products and may need to order more safety stock.
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