While there are plenty of factors influencing the profitability of your online business, a healthy inventory turnover is fundamental to long-term success.
But what does inventory turnover actually mean? And how do you calculate it?
Also known as stock turnover and inventory turns, inventory turnover refers to stock rotation.
More specifically, it is a measure of the number of times inventory is sold and replaced in any given time period, usually annually.
Now before we jump into calculating inventory turnover, it’s important to really understand its purpose.
Why does inventory turnover matter to your eCommerce business?
Sure, inventory turnover might just be another metric that you need to measure, but it’s a pretty crucial one at that.
In fact, regardless of how large or small your business is, having a clear understanding of what inventory turnover is, how to calculate it, and perhaps more importantly, what it’s telling you, could be the difference between growth and failure.
Let’s start by giving some context to the two components of business performance that influence total turnover; stock purchasing and sales.
Since the speed in which stock is sold influences how long you physically have it sat in the warehouse, making sure you’re purchasing the right amount of stock is imperative.
Too much and you risk unnecessary storage charges, not to mention the additional costs incurred such as insurance, obsolescence and so on.
Failing to stock enough inventory to meet customer demand, however, can equate to missed sales opportunities. In other words, lack of potential profits.
And that’s assuming you have the right inventory management controls in place to start with, to avoid overselling stock you don’t have, leading to further costs, disappointed customers and the risk of marketplace suspension. But that's another article...
Ultimately, you need to have the right balance between sales and stock purchasing.
More importantly, you should be striving to improve on the speed in which you rotate this stock.
To do this, you need to understand just how efficient your business is at converting the money you’ve invested in your stock into sales and profits.
Let’s assume you have £10 million worth of inventory.
If you were to sell your entire inventory in 30 days, you are going to have a far better cash flow than if you were to sell this inventory in 90 days.
The bottom line is, the faster your inventory turnover occurs, the more efficient your business will be operating and the higher return you can expect.
A higher inventory turnover, the more profitable your business stands to become.
Which leads us to the question you’re wanting answered…
How to calculate inventory turnover
Before we jump straight into how you can calculate inventory turnover, it’s important to understand the two monetary amounts you will need for this calculation – the Cost of Goods Sold (COGS) and your average inventory.
How to calculate Cost of Goods Sold
While ‘Sales’ refers to the cost of the sale, ‘Cost of Goods Sold’ is a calculation of all of the costs involved in selling a product. In other words, it considers the total cost of producing the products; materials, labour and any other related costs.
So, what is the exact Cost of Goods Sold Formula?
While this measure can be found on your company’s income statement, the calculation is:
Cost of inventory at the beginning of the year + Additional inventory costs (purchased during the year) – Cost of inventory at the end of the year = Cost of Goods Sold
Let’s assume you have £90,000 worth of inventory at the start of 2018, but during the year you purchased £175,000 worth of additional inventory.
At the end of 2018, however, you were left with £120,000 worth of inventory.
Your Cost of Goods Sold calculation would therefore be:
£90,000 + £175,000 – £85,000 = £180,000
How to calculate average inventory
Now that you know the Cost of Goods Sold, you will need to calculate your average inventory.
Given that you will likely have more stock at certain times of the year – for example around Black Friday and the Christmas Period – it’s recommended that you take your average inventory value for the time period, as opposed to the ending inventory for the year.
After all, your ending balance will not accurately reflect your total inventory during that year.
In order to calculate your average inventory, you will need to add your beginning and ending inventory for the year (or time period) and divide this number by two.
Your average inventory formula would therefore be:
(Cost of inventory at the beginning of the year + Cost of inventory at the end of the year) ÷ 2 = Average Inventory
Using the same example as before, the calculation would be:
£180,000 ÷ £87,500 = 2.05
Once you have calculated the cost of goods sold and your average inventory, you will be able to calculate your inventory turnover.
Your inventory turns ratio is therefore the Cost of Goods Sold (COGs) divided by the average inventory value for the same time period – in this case a year.
Cost of Goods Sold ÷ Average Inventory = Inventory Turnover
Using the same examples as before, your inventory turnover calculation would be:
£180,000 ÷ £87,500 = 2.05
This would mean that your inventory turns ratio is two. In other words, your stock rotates twice a year.
Keep in mind that you can also run this calculation using Sales ÷ Inventory.
Once you have your inventory turn ratio you should go one step further and calculate your inventory turnover period, otherwise known as Days Sales in Inventory (DSI).
DSI specifically measure how many days it takes for inventory to turn into sales, by using the following calculation:
(Average Inventory ÷ Cost of Goods Sold) x 365
So, what does this all look like in practice?
Once again, using the same numbers, your inventory days calculation would be:
(£87,500 ÷ £180,000) x 365 = 177.4
This means that it would take the company approximately 177 days to sell its stock.
What is a good inventory turnover rate?
In other words, what is the average inventory turnover that you should be benchmarking against?
The honest answer is that it depends entirely on which industry you operate in.
If you sell fast-moving consumer goods (FMCG), then your inventory turnover should be a lot higher than if you sell slow-moving consumer goods (SMCG), such as cars.
As an example, according to benchmarks from The Retail Owner’s Institute, the industry average inventory turnover rate for supermarkets and grocery stores was 55.3 in 2017, compared with 4.3 for auto parts & accessories in the same year.
What does your inventory turnover ratio and DSI tell you?
With all of this in mind, what exactly do the numbers tell you? Do you want a high or low inventory turnover?
In short, a higher turn rate is a good indication of efficiency, suggesting that you’re not buying more inventory than is needed.
That said, if your inventory turnover rate is too high, it could lead to stock shortages, which is why you should ideally have an automated system in place to prevent against stock-outs.
A low inventory turn rate, however, could be a result of overstocking and/or an inefficient sales and marketing process.
While you should look at inventory reduction strategies for ideas on how to increase inventory turns, it’s also important that you’re managing your inventory as efficiently as possible
How to improve inventory turnover
One of the most effective ways to improve your inventory turn rate is by increasing the demand for your stock.
While there are a number of ways you can achieve this, you should start by thinking about your eCommerce marketing strategy.
Could you realistically be generating more sales? Are you promoting your brand and products well enough? Are you selling on multiple marketplaces and subsequently expanding your reach?
While I’m sure it’s safe to say that all businesses could be doing more, it really is worth you answering these questions as honestly as possible.
Ultimately, the more visibility you’re getting, the more sales you stand to make which helps to increase your inventory turnover ratio.
Aside from promotional tactics, it's important to consider how else you could you be lowering your costs?
With the right reporting structure in place, the better equipped you are to understand your inventory performance.
In fact, once you know what your best-sellers are, you could see if you could negotiate a better price with your suppliers by purchasing more in bulk. Alternatively, could look at other ways to lower costs, for example by negotiating extended credit options.
The bottom line is, regardless of which tactics you use to improve your inventory turnover ratio, it’s just not possible without a streamlined process.