Inventory Turnover Ratio: What It Means and How to Use It

Running an effective supply chain is challenging. Thankfully, it gets easier when businesses understand how to calculate and respond to helpful management formulas. One of the most important of these formulas is the business’s inventory turnover ratio.

Inventory turnover is a widely used yet still underutilized way to measure a company’s efficiency. When you know how to refine its formula and interpret the results, it can be one of your strongest assets for supply chain optimization.

What Is Inventory Turnover Ratio?

At its simplest, an inventory turnover ratio reveals how much of a business’s inventory it sold or used over a fixed period. The most common way to calculate it is to divide the cost of goods sold (COGS) in a given period by the average inventory value in the same period.

Generally speaking, a higher ratio is preferable, as it suggests higher sales and less dead inventory. However, what constitutes a high ratio varies widely between industries. The financial sector has an average inventory turnover of 48.76, while retail averages just 10.86.

Keep in mind that high turnover doesn’t always indicate large sales volumes. While more sales will result in a higher ratio, insufficient inventory levels will do the same. If a business is selling through its inventory well above the industry average, it could mean it’s not keeping enough on hand to satisfy demand. In that case, the higher figure actually indicates missed sales.

How to Use Inventory Turnover Ratios

Because you can interpret inventory turnover ratios and adjust their formula a few different ways, they’re a versatile tool. Here are a few of the most helpful ways to use this ratio.

Reveal Inefficiencies

The most straightforward way to apply an inventory turnover ratio is to reveal supply chain inefficiencies. A ratio falling below competitors’ averages can tell a business it needs to rethink its stocking or sales strategy. Conversely, one that’s too high can help identify stock-outs, like the ongoing chip shortage many electronics manufacturers face.

Businesses can start this process by calculating the COGS and inventory value for their entire company. This broad, overall ratio won’t reveal where the inefficiencies lie but will offer a solid look at the organization’s performance.

If the overall inventory turnover figures warrant a closer look, businesses can calculate more specific ratios. Using shorter periods, a more specific section of the inventory and targeting specific stores or departments are all good ways to get more detailed.

Identify High and Low Performers

Getting more granular with inventory turnover ratios is also a helpful way to gauge product performance. This process starts with calculating the turnover for a specific stock-keeping unit (SKU). Businesses can then find the ratio for all other SKUs over the same period for comparison.

With all SKUs’ inventory turnover in hand, companies can find their average and compare specific products accordingly. Those that fall above the average are likely the company’s top performers in terms of sales efficiency, and below-average SKUs deserve further attention.

Identifying high and low performers is important because it informs better supply chain management and sales strategies. Some businesses may find they’re ordering too much of low-volume products, leading to wasted warehouse spending. Others may find opportunities to move more inventory by pairing low performers with best sellers.

Monitor Shifting Trends

Businesses can also use their inventory turnover ratio to track changes in customer demand. Measuring this ratio at regular intervals will reveal when different SKUs’ sales rise and fall and by how much.

Consistently rising turnover rates suggest demand for a certain product is growing, so companies should consider ordering more to prevent stock-outs. Similarly, consistent falls indicate waning demand, warranting a slowdown in manufacturing.

In either case, it’s important to look for consistency, not sudden changes, as fast shifts could only be momentary trends. The holiday season accounts for more than a third of some industries’ annual sales, so some rise and fall is normal at peak seasons. Over-ordering without accounting for seasonality will result in losses.

How to Improve Your Inventory Turnover Ratio

If an inventory turnover for a company or specific SKU is too high or too low, there are several potential fixes. While the necessary course of action varies between situations, here are some general best practices to optimize inventory turnover ratios.

Adjust Ordering Practices

One of the easiest ways to improve inventory turnover is to rethink how much of each SKU the business orders. A low ratio often — though not always — means a SKU’s ordering volumes are too high given its sales. The opposite effect can also happen, but 8% of global stock ends up as waste, so surpluses are more common than under-ordering.

Companies should identify which of their SKUs have the lowest turnover ratios, paying special attention to the highest-cost of these items. The most expensive but slowest-sold products should not have high order volumes. Businesses can refer to sales records to determine a better rate at which to order them to prevent taking up valuable warehouse space with under-selling items.

Adjust Prices

Customer-facing strategies can have a similar effect. Sometimes, it’s easier to adjust prices to encourage higher sales than to restructure product orders to lower inventory levels. Items with high profit margins or that would be considerably more expensive to order in smaller volumes are often good fits for this strategy.

A business may sell through a product too quickly, and it’d be too expensive to scale up inventory at the moment. In those cases, raising prices to boost margins in the meantime can make up for the potential lost sales. Decreasing prices on some items while increasing others can balance discrepancies in inventory turnover between different SKUs.

Use Real-Time Technology

Regardless of the specific approach a business takes, real-time inventory records are essential for effective decision-making. Consequently, real-time technologies like the Internet of Things (IoT) and warehouse management systems (WMS) are an important part of optimizing inventory turnover ratios.

Implementing a WMS has helped some companies increase inventory accuracy by 70% and boost throughput by 80%. Having more accessible and accurate data on inventory levels and trends makes it easier to see where turnover ratio problems arise. As a result, the most effective changes become easier to identify.

Optimize Your Inventory Turnover Today

Calculating your inventory turnover ratio is a crucial part of running a successful business. When you know how and why to apply this formula, you can increase your efficiency, minimize losses and strengthen the supply chain. It all starts with learning what this ratio indicates and how you can respond to it.