Some items in your store fly off the shelf, and others collect dust. It’s vital—and not always easy—for retailers to understand what inventory is moving and how quickly. The inventory turnover ratio is a key performance indicator (KPI) that not only helps businesses manage their inventory properly, but also empowers them to price items strategically, build consistent supplier relationships, and make informed decisions about their inventory.
This article is a practical guide to the inventory turnover ratio, why it’s essential, and how to leverage it to manage your business’s inventory. We include an interactive calculator so that you can find and understand your own inventory turnover ratio.
Let’s get started and equip you with the tools to manage your inventory effectively.
What Is Inventory Turnover?
Inventory turnover, sometimes called inventory turn, stock turn, or stock turnover, is an essential inventory management metric that measures how efficiently a company uses and manages its inventory.
More specifically, inventory turnover rates measure the number of times a business sells through its assets in a set time period (a month, a quarter, or, most commonly, a year). One complete turnover of inventory means the company sold the stock that it purchased—and that’s a good thing.
It’s always crucial for retailers to move through their stock, especially if it’s perishable or time-sensitive (e.g., groceries, automobiles, or trending clothing). Measuring inventory turnover helps retailers—especially those with sensitive inventory—prevent deadstock, poor supply chain planning, and much more.
Key Takeaways:
- The inventory turnover ratio measures how efficiently a company turns inventory into sales by calculating how often it is sold and replaced over a period of time.
- Tracking inventory turnover helps businesses improve profitability and reduce dead stock through efficient pricing and inventory management.
- Inventory turnover rates can be calculated using either Cost of Goods Sold (COGS) or net sales.
- The inventory ratio does not account for profit margins, seasonal variations, or supply chain inefficiencies, so companies should use it carefully.
What is the Inventory Turnover Ratio?
The inventory turnover ratio is a quantitative key performance indicator (KPI) that measures how often a company turns over its inventory relative to its sales or costs of goods sold (COGS) in a given period. It’s a handy financial metric that helps companies avoid inefficient inventory management practices that lead to excessive inventory and unsold stock.
The ratio is derived from a mathematical calculation, where either the sales or COGS are divided by the average inventory for the same period. A higher ratio is more desirable than a low ratio because it tends to point to strong sales, with some exceptions.
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Why Is Inventory Turnover Important for Businesses?
Calculating and tracking inventory turnover ratios helps businesses make smarter inventory planning decisions related to purchasing, pricing, manufacturing, marketing, and warehouse management (we’ve written about some of the best inventory management software, too).
Here’s why tracking the inventory turnover ratio is vital for businesses:
Increased Profitability
A high inventory turnover ratio indicates faster sales of inventory and reduced holding costs related to storage, insurance, and spoilage. The inventory turnover ratio KPI is one of the most indicative growth indicators, as increasing inventory turnover drives profit. By tracking turnover, businesses can gain insight into their overall operational performance and make informed decisions.
Avoiding Outdated Stock
Frequent turnover reduces the risk of obsolete or excess inventory, which is especially important in rapidly evolving and trend-dominated industries like fashion or technology. It also helps companies track and manage their slow-moving inventory, improving cash flow and reducing financial strain for businesses.
Enhanced Customer Satisfaction
Maintaining optimal turnover rates helps business align their inventory with customer demand. This means products are available when customers want them, with fewer missed sales opportunities. Efficient inventory turnover also balances inventory levels, reducing the likelihood of stockouts.
The Inventory Turnover Ratio Formula
You know the “what” and “why” of the inventory turnover ratio. Let’s discuss the “how”: How do retailers calculate their inventory turnover?
Whether you’re leveraging a specific inventory management tool or clicking away on a good, old-fashioned calculator, here’s how to calculate your business’s inventory turnover using two formulas:
Calculating Inventory Turnover Using Cost of Goods Sold
Many companies calculate inventory turnover using costs of goods sold (COGS) because it directly measures the cost associated with inventory sold. To calculate inventory turnover using COGS, follow these steps:
- Determine the Costs of Goods Sold (COGS):
COGS is the total cost incurred to produce the goods sold during a specific time period. It’s found on your company’s income statement or balance sheet.
- Calculate Average Inventory:
Calculate the average inventory value by adding together your beginning inventory and ending inventory balances for a set period and dividing by two.
- Apply the Inventory Turnover Formula:
Inventory turnover is calculated as costs of goods sold (COGS) divided by the average inventory value. Plug your numbers into the equation, and you’re set!
Calculating Inventory Turnover Using Sales
Using sales is another approach to calculate inventory turnover, which is most useful when you prefer to analyze inventory efficiency from a sales perspective rather than focusing directly on costs. Here’s how to calculate inventory turnover using sales:
- Determine Net Sales:
Net sales represent the total revenue from goods sold after subtracting returns, allowances, and discounts. It’s found on your company’s income statement or balance sheet.
- Calculate Average Inventory:
Calculate the average inventory value by adding together your beginning inventory and ending inventory balances for a set period and dividing by two.
- Apply the Inventory Turnover Formula:
Inventory turnover is calculated as net sales divided by average inventory value. Plug your numbers into the equation, and you’re set!
An Inventory Turnover Calculation Example
Let’s work through an inventory turnover calculation together:
Rue de Montmartre is a small but growing winery on the central coast of California focused on direct-to-consumer sales. In 2023, the winery had its busiest year to date, with $360,000 in COGS. At the beginning of the year, it had $80,000 in inventory, and by the end of the year, its inventory value was $120,000.
- COGS: $360,000
- Beginning Inventory: $80,000
- Ending Inventory: $120,000
First, we need to find the average inventory for the year. To do this, add the beginning inventory to the ending inventory and divide by two:
- Calculate Average Inventory:
(80,000 + 120,000)/2 = $100,000 average inventory
Next, use the COGS to find the Inventory Turnover Ratio. Divide the COGS by the average inventory:
- Calculate Inventory Turnover:
(360,000/100,000) = 3.6
This result means that, on average, the winery’s inventory was turned over 3.6 times during the year based on the cost of goods sold.
3.6, in this case, is a good ratio because it was the growing winery’s biggest year yet. For other organizations, 3.6 might be a low number. Considering the inventory turnover ratio in the context of a company’s history and goals is always important.
Drawbacks of the Inventory Turnover Ratio
While the inventory turnover ratio is a valuable tool for assessing a company’s inventory management efficiency, it has limitations and drawbacks that can hinder its usefulness. Here’s why:
Does Not Account for Profit Margins
The ratio measures how often inventory is sold and replaced—it does not reflect the profitability of those sales. A high turnover ratio with low profit margins might not benefit a business as a lower turnover ratio with higher profit margins.
Ignores Seasonal Variations
The inventory turnover ratio might not account for seasonal inventory levels and sales fluctuations. For companies with seasonal products, turnover rates can vary significantly throughout the year. If not considered contextually, inventory turnover ratios could mislead business owners and lead to obsolete inventory.
Ignores High-Cost Items
Higher-cost items tend to move off the shelves more slowly. Customers do their research and take their time before investing in big-ticket items like cars, meaning a lower turnover rate is likely. Companies need to research and ensure that these slower-moving, high-ticket items are worth the wait on their warehouse shelves so they can turn inventory into cash.
Excludes Inventory Variability
The inventory turnover ratio does not account for variations in inventory levels, so companies with fluctuating inventory levels might have turnover ratios that do not accurately reflect their inventory management efficiency. A point of sale system with comprehensive inventory management capabilities could fill in any gaps.
Does Not Measure Supply Chain Efficiency
The ratio focuses on sales and inventory management rather than supply chain inefficiencies, such as lead times, supplier performance, production delays, and hiccups, which are all too familiar in a global marketplace. These factors, which are out of the retailer’s control, can impact inventory turnover ratios.
Potential for Misinterpretation
A high turnover ratio might indicate that inventory levels are too low, which could lead to insufficient inventory, stockouts, and lost sales. On the other hand, a meager ratio might suggest overstocking, but it could also be due to slow-moving inventory that could be cleared with promotional strategies. There’s no way to tell what an optimal inventory turnover ratio is just by looking at a number—the proper inventory management software will help you figure these things out.
Limited Insight into Non-Product Costs
The stock turnover ratio only considers direct costs. It does not include other costs associated with retail inventory management, such as carrying costs, storage expenses, or obsolescence costs. These factors will impact a business’s overall inventory management efficiency, yet they are not reflected clearly in the ratio.
Inflexibility Across Industries and Business Models
Different industries and business models have varying standards for inventory turnover measures. A ratio that is considered good in one sector might need to be improved in another. Thus, the inventory turnover ratio might not provide a clear comparison across different sectors. Look at industry averages to understand where your business lies.
This guide has tips to help you become the best manager you can be! Plus, free printable templates and checklists are included for use in your retail store operations.
FAQ About Inventory Turnover Ratio
Businesses can optimize inventory levels by analyzing sales data to ensure stock matches customer demand and minimize overstock or stockouts. Implementing merchandising strategies such as targeted promotions can drive sales and increase inventory turnover. Enhancing operational efficiency through streamlined supply chain management and faster inventory replenishment can boost turnover rates, too.
The ideal inventory turnover ratio varies significantly by industry, although generally, a higher ratio is considered favorable because it indicates solid inventory management and strong sales. A turnover ratio of 6 to 12 is often deemed strong for retail business. However, it’s essential to compare your ratio with industry benchmarks and your business’s historical performance to understand whether it’s “good” or represents weak sales.
A higher inventory turnover ratio typically improves financial performance by reducing holding costs and freeing up cash that can be used elsewhere. Conversely, a low ratio might strain finances due to higher storage costs and potential write-offs for unsold inventory.
A Solution to Stay on Top of Your Inventory Turnover
With the right retail POS system, you can immediately gain control of your inventory turnover and meet customer demand. Consolidate your inventory into one database, whether you have one store or multiple, and keep an eye on what’s moving. With a cloud-based solution, you can also analyze your inventory data anywhere, at any time.
Check out KORONA POS for a robust POS solution. Set up a free trial and demo with one of our great product specialists. We’ll walk you through all the features that can benefit your small business.
