Inventory turnover ratio - Improve it now to gain efficiency

Inventory Turnover

What is Inventory turnover and why is it important

Inventory turnover, also known as inventory turns, or inventory turnover ratio is a key financial kpi that measures how many times a company’s inventory is sold and replaced over a specific time period, typically a calendar year but can also be over a financial year.

It is calculated by dividing the cost of goods sold (COGS) by the average inventory during that period. This ratio provides insights into the efficiency of production planning, inventory control and production management as well as overall operational effectiveness of the organization.

The inventory turnover rate can vary widely between industries or even between different companies in the same industry. This is largely due to the nature of the business, shelf life of inventory/merchandise, brand perception and sales behavior or patterns for the product being made and sold.

Companies very commonly work on finding solutions to optimize or improve their inventory turnover to gain financial benefits, optimize inventory of raw materials and finished goods, reduce working capital or reduce business risk.

Calculating inventory turnover ratio correctly

Formula for Inventory Turnover Ratio

The inventory turnover can be calculated with the following formula:

Cost of goods sold (COGS)

Inventory turnover= ——————————-

Average Inventory

Cost of Goods Sold (COGS):

The Cost of Goods Sold or COGS is typically found on the income statement (profit and loss statement). It includes the direct costs attributable to the production or acquisition of the goods sold by the company during a specific period. In a manufacturing business, these can include the raw materials, energy, labor and manufacturing overhead costs that are incurred in manufacturing the goods sold. It does not include indirect costs of selling or administration of the business.

Average Inventory

The average Inventory is usually calculated by taking the sum of the beginning inventory and ending inventory for a specific time or accounting period and dividing by two. The figures for both the beginning and ending inventory figures can be found on the balance sheet.

Note: The time period or accounting period used for both the COGS and average inventory in the formulation to calculate the Inventory turnover should be the same. Usually this is one financial year in the financial statements of the company.

Interpreting the Inventory turnover ratio

Interpreting the Inventory turnover ratio is important in gaining further understanding of how well the business is investing in raw materials and inputs and converting them to sales of finish products.

To help interpret this ratio we will use an example of a Manufacturing business with the following data:

COGS: US$ 1,200,000

Average inventory: US$200,000

Therefor, Inventory turnover = 6

As an example, if a business has an inventory turnover ratio of 6 means the company sells and replaces its inventory six times a year or every two months.

A higher ratio can indicates efficient inventory management, less requirement for warehouse space, lower working capital needs and strong sales.

A lower ratio can indicate overstocking, obsolete inventory in the warehouse, or weaker/slower sales. These issues can lead to loss in profitability and requirements for more financing required to keep operations going.

To interpret the ratio correctly and then formulate decision a wide range of factors must be considered. These are further explained below.

Factors that impact inventory turnover

In calculating and interpreting the inventory turnover ratio, we must be careful to understand the business and the industry it operates in to better guage if the calculated ratio is in fact good or not.

Structural or External factors that can affect the ratio include:

Seasonal Variations that might affect inventory levels and turnover rates. For example, the Christmas or religious holiday periods for a restaurant or bakery.

Inventory Type which can be perishable or non-perishable as it influences turnover rates and how quickly the business must move to sell the products. For example, could be a fresh food supermarket will have a different turnover rate than a quarry.t

Changes in consumer Preferences and tastes can affect demand for certain products, impacting turnover rates. Thes could be seasonal or structural shift over time. An example being the preference of SUV vehicles vs sedans.

Market Conditions such as economic downturns or upturns influence consumer spending and demand for goods which can lead to faster or slower sales affecting the ratio.

Industry-wide trends and technological advancements can shift demand patterns, preferences and influence turnover rates. For example, the trend for factories to not keep big quantities of certain machine spare parts and having the supplier’s stock these for them instead.

Increased Market Competition can affect market share and sales volume, impacting sales volumes leading to slower inventory turnover.

Compliance Requirements to regulations requiring specific inventory controls or safety stocks can impact inventory levels and turnover rates. An example can be a pharmaceutical company having to keep a minimum stock of a certain vaccine or medicine as part of their license to sell these.

Internal or company specific factor which can affect the ratio:

Inventory Management Practices such as employing well planned Just-in-Time (JIT) Inventory can greatly increase turnover by reducing inventory levels and meeting demand as it arises.

Inventory Control Technology or Systems can help optimize stock levels and avoid overstocking or stockouts. A business using a MRP and real-time data driven accounting system may be able to optimize its inventory holding of each SKU more efficiently, thus increasing the inventory turnover ratio.

Accuracy of demand Forecasting can have a substantial impact on inventory holding levels, reducing excess inventory, and increasing turnover. Alternatively inaccurate forecasting can lead to shortages, then ramping up production to catchup resulting in overstocking.

Marketing and Sales Strategies that are well planned and carried out effectively can boost sales, thereby increasing the turnover ratio, as log as production is well planned and clear communication between the sales and manufacturing department exists.

How to improve inventory turnover

Usually, most businesses look to improve their inventory turnover ratio to optimize their inventory holding levels, minimize stock spoilage and reduce the need for working capital.

To understand what to focus on to achieve this we must look at the formula composition first. Given the formula:

Cost of goods sold (COGS)

Inventory turnover= ——————————-

Average Inventory

As the COGS is divided between the average inventories. We could:

Increase the COGS by increasing the Sales of the business and keeping the average inventory the same, meaning no new requirement for further inventory. This can be achieved through reviewing our Marketing and sales strategy or adding new sales resources. These resources could be in the form of staff or a third-party distributor for example.

For some businesses, a more viable route to increase the inventory turnover ratio would be to decrease the average inventory while the sales and COGS remain the same. This can be done by addressing some of the factors discussed above, and:

– Sometimes a simple stock take and writing off redundant inventory can boost the ratio.

– Improving inventory management practices, like ABC warehousing or implement newer inventory management technology.

– Collecting better or more market intelligence from customers and stakeholders to better understand market trends, improve demand planning and forecasting to better balance production with market demand can yield very good results.

The actions taken will vary much on what type of business and inventory you need to carry, the current economic climate and market. Review the factors that can affect your inventory turnover rate above and explore these areas to seek opportunities for improvement.

Inventory turnover ratios in different industries

In a recent study to understand the different Inventory turnover ratios between companies in different industries leanmanufacture.net has conducted the following analysis below based on data from the Australian and UK markets (2023).

As you can see, different companies carry different forms of inventory: perishable, nonperishable, low value, or high value per item which, seasonal, stable/unstable market demand. These differences in inventory together with overall industry structure and competition and the market which its supplied to have an impact on the inventory turnover ratio.

Supermarkets

Woolworths Group Ltd (WOW.AX): 12.7

Coles Group Ltd (COL.AX): 12.9

Tesco PLC (TSCO.L): 24.7

Sainsbury PLC (SBRY.L): 15.52

Minerals Mining

BHP Group Ltd (BHP.AX): 3.0

Rio Tinto Ltd (RIO.AX): 3.2

South32 Limited (S32.AX): 3.6

Anglo American plc (AAL.L): 2.4

Pharmaceuticals

GSK plc (GSK.L): 1.6

AstraZeneca plc (AZN.L): 1.5

Mayne Pharma Group Ltd (MYX.AX): 1.2

Hikma Pharmaceuticals (HIK.L): 1.7

From the analysis done in three different industries we can see that Supermarkets turn over their inventory quicker than mining and pharmaceutical companies. This could be due to the short shelf life of their products like fresh produce. Also, food staples are an item the general population would purchase several types a week. Within the companies analyzed we see that Tesco in the UK turns over inventory much quicker than its peers.

Mining companies generally turnover their inventory 3-4 times a year which could be due to the way their product is mined, stockpiled, and awaiting bulk shipment to overseas buyers. Their industry and how the inventory is planned, handled, and sold influences the turnover ratio.

Pharmaceuticals had the lowest inventory turnover of the three industries analyzed above. This could be due to many factors including longer shelf life of medicines, seasonality of demand, the type of medicine and pharmaceuticals (product mix among peer companies).

When computing and comparing the inventory turnover ratio for your company or business, take into account the different factors that impact the ratio we have covered above to make an informed decision on whether the current turnover rate is efficient or not and also what areas of the business to look at for further improvement.

The data in this analysis was based on data from Yahoo Finance