How to calculate inventory turnover

Managing your stock levels is an important thing to get right for any product based business. This article will look at how to calculate inventory turnover, so you can understand your stock performance, by looking at the following areas:

• What is inventory turnover?
• Why is it important to measure inventory turnover?
• What are the benefits of good inventory management?
• How do I calculate inventory turnover?
• What should I do with the measurements?

Inventory turnover is a calculation that shows the rate at which your stock is sold and replaced over a period of time. This rate of turnover shows if you are keeping stock for a long time before it sells or if you perhaps don’t have enough stock because it is flying off the shelves and being replaced often.

It’s important to understand your inventory turnover from a business perspective. It can be an indication of business performance and how well your business is meeting demand in the industry.

Each industry will have different stock turnover standards. For example, less expensive items like household items might shift faster than more expensive stock, such as TVs. By comparing your inventory turnover ratio to the industry average, you can assess your stock level efficiency.

If you sell several types of products, you will also be able to gauge which is the most popular, giving yourself the chance to find out where your best sources of revenue come from.

Generally, high stock turnover is preferable because it shows that your business is performing well in the current market. It may also mean reduced costs on rent, insurance and holding costs associated with storing stock. Too high, however, can mean that you are not holding enough stock for the customer demand you have. That’s why working out the turnover rate can help you make more informed business decisions.

Understanding your inventory can pay your business back in several ways:

• Save money – your inventory might be your largest business asset (assets are valuable items that your business owns). Overstocking can lead to monetary losses for the company because you have spent a lot up front and not sold it to make the money back. So understanding your stock levels will allow you to order stock at exactly the right levels and reduce money risks.
• Better customer service – people expect items to be in stock and if they find they aren’t then they may look for a different supplier. Customers consistently having to backorder a product may lead to an unprofitable business if customers can’t use your services.
• Better storage facility organisation – an inefficient storage space could cost you money if you are finding that stock is wasted or damaged. Understanding what your more profitable items are allows you to group them together and find ways to store your stock better. 
• Improve cash flow – by understanding what you can spend on stock levels, you are able to spend in a more stable way. This eliminates the need to spend large chunks of cash on bringing in more stock suddenly and therefore doesn’t affect your cash flow as much.

The calculation of inventory turnover looks like this:

Cost of goods sold ÷ average inventory = inventory turnover ratio

Let’s break down the terms.

Cost of goods sold (COGS) is the cost associated with creating a product. This could be for the raw materials needed to make the product or the cost of buying the product plus the shipping expense to get it to you. Add up the total cost over a specific time period (e.g. the cost of making or purchasing products for the entire year) and this is your COGS figure.

Average inventory is the average of the value of goods you are storing. To work this out you will need to take the same time period you used in your COGS number. 

Let’s use the annual costs as an example. You need to note down the cash value of the inventory products at the beginning of the year (i.e. the total amount you would sell every piece of stock for). You also need to take down the cash value at the end of the year. Then you add these two numbers together and divide by two. This gives you the average inventory value for the year. 

You might want to break this up by month so you have more visibility over the months when you are selling more or less stock. You could calculate monthly averages and at the end of the year add them all up and divide by 12, if you want to have a more detailed view of the average yearly value. You could also do this every quarter, or every two months, however you choose.

Now to calculate your inventory turnover rate, you divide the COGS figure with the average inventory value total. This figure indicates how many times you have ‘turned over’ (sold and replaced) the stock in the chosen time period. 

A good inventory turnover figure is between 4 and 6. This obviously will differ from sector to sector and depends on the type and cost of products you sell. A number between 4 and 6 indicates that you are balancing having enough stock that you don’t run out, but not so much that it is taking up storage space or costing too much. This will differ slightly for each industry so do your research to understand how you compare.

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