Small Business Accounting Guide

18. Accounting 101: How to Calculate Inventory Turnover Ratio

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Business Finance

Accounting 101: How to Calculate Inventory Turnover Ratio

Apr 27, 2023 • 6 min read
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      The inventory turnover ratio is a financial metric that reflects the efficiency of your inventory management. As a business owner, analyzing it can provide valuable insights that help you improve related processes.

      Let’s explore what you should know about the inventory turnover ratio, including how to calculate it, why it matters, and how to improve it.

      What is the inventory turnover ratio?

      The inventory turnover ratio is a financial metric that measures how many times your business sells and replaces its inventory in a given period, usually a calendar year. Dividing the ratio by the number of days in the period lets you determine how long it takes to sell your inventory, on average.

      You can use the turnover ratio to help inform your business decisions regarding purchasing and producing inventory. For example, a low ratio indicates you’re struggling to sell your product, which might lead you to reduce production and keep fewer products on hand.

      Conversely, a high ratio indicates that you’re selling your product quickly, which might lead you to increase your production or purchases to better keep up with demand.

      Inventory turnover ratio formula.

      Here’s the formula for the inventory turnover ratio:

      Inventory Turnover Ratio = Cost of Goods Sold ÷ Average Inventory

      The cost of goods sold refers to the expenses directly necessary for making your products ready for sale. Typically, that includes the following:

      • Direct materials This is the cost of the materials used to make your inventory. For example, the direct materials for a company that manufactures and sells wooden chairs might include wood, screws, and paint.
      • Direct labor This is the cost of the workers directly responsible for making your product ready for sale. At the same wooden chair company, that would include wages paid to employees who put the chairs together and paint them.
      • Manufacturing overhead – These are the indirect manufacturing costs you incur during production. For example, it might include depreciation on your manufacturing equipment and the electricity used to run them.

      Meanwhile, your average inventory refers to the sum of your inventory values at the beginning and end of the period divided by two.

      How to calculate inventory turnover ratio.

      The inventory turnover ratio can be surprisingly complex to calculate in practice. Let’s go over an example to help demonstrate how it works.

      Say you own a small business that produces and sells candles. You have the following financial data for the latest calendar year:

      • Direct materials: $75,000
      • Direct labor: $100,000
      • Manufacturing overhead: $25,000
      • Beginning inventory: $30,000
      • Ending inventory: $50,000

      Here’s how you’d calculate your inventory turnover ratio for the period:

      $75,000 direct materials + $100,000 direct labor + $25,000 manufacturing overhead = $200,000 cost of goods sold

      ($30,000 beginning inventory + $50,000 ending inventory) ÷ 2 = $40,000 average inventory

      $200,000 cost of goods sold ÷ $40,000 average inventory = inventory turnover ratio of 5

      That means your business sells and replaces its inventory five times per year. You can also divide the 365 days in the period by your inventory turnover ratio of five to deduce that you turn your inventory over every 73 days, on average.

      What is a good inventory turnover ratio?

      Good inventory turnover ratios tend to be between roughly five and 10. However, the ideal ratio can vary significantly depending on the nature of your business’ industry and products. For example, businesses that sell products with a short shelf life (Ex: food) may require a higher inventory turnover ratio to prevent spoilage and waste.

      Conversely, businesses that sell expensive and highly-specialized products without expiration dates may have a lower inventory turnover ratio due to the longer sales cycles and higher customer acquisition costs associated with those products.One of the best ways to get an idea of your target inventory turnover ratio is to look at your top competitors’ results or the average for your industry. If yours is roughly that number or higher, then your inventory management is probably reasonably efficient.

      How to improve your inventory turnover ratio.

      Since your inventory turnover ratio represents the efficiency of your inventory management, looking for ways to improve it can help you improve your overall profitability. Here are some of the best options to consider pursuing:

      1. Refine target inventory levels 

      Overstocking ties up working capital, inflates storage costs, and increases the risk of spoiled or damaged inventory. Conversely, understocking can result in delays that upset customers and cost you sales. Avoid these issues and improve your turnover ratio by adjusting your inventory levels to more closely match demand. Consider using additional software to refine your inventory tracking and demand forecasting.

      2. Increase sales volume

      By increasing the number of units you sell, you can significantly improve your inventory turnover ratio, even without adjusting your inventory levels. You can achieve this in many ways, including expanding your sales team, updating your marketing strategy, and exploring new sales channels. Just know that most of these strategies require a capital investment.

      3. Monitor and reduce waste

      Inadvertent damage to the goods and materials you keep on hand erodes the value of your inventory. Looking for ways to minimize spoilage and accidental damage can help you improve your turnover ratio. For example, you can refine your product packaging and update your quality controls to help reduce waste.

      Optimizing your inventory turnover ratio requires a multi-pronged approach, but don’t overextend yourself. Some of these strategies can be capital-intensive, so consider investing in one at a time and assessing your results before continuing.

      About the author
      Nick Gallo, CPA

      Nick Gallo is a Certified Public Accountant and content marketer for the financial industry. He has been an auditor of international companies and a tax strategist for real estate investors. He now writes articles on personal and corporate finance, accounting and tax matters, and entrepreneurship.

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