What is Inventory Turnover Ratio? Everything you need to know!

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For many small businesses, the margin of error is small. Extraneous costs each month can be the difference between success and failure, which is why every small business owner should know about inventory turnover and how this commonly overlooked ratio can be efficiently managed to turn a loss into a gain or a small profit into a large one.

Inventory turnover ratio is one of five key inventory metrics for small businesses. But what does that term mean? Simple: Your inventory turnover is the cost of goods sold — meaning how much you paid for the materials needed to make your product, rather than the amount your product sold for — divided by your average inventory on site. If your turnover rate is too low or too high, you may have issues with overstocking or with inadequate inventory levels.


Inventory Turnover Formula =

Cost of Good Sold


Average Inventory


Impact of Inventory Turnover

If your cost of goods is low but your average inventory is high, you’ll have a low inventory turnover ratio which indicates you spend too much on holding costs (rent, insurance, theft, etc.) that can drag your business down. Additionally, a low turnover ratio is a bad sign for business because those items sitting on a shelf will deteriorate over time, meaning it will be much more difficult to sell and may, in fact, mean you’ll have to write-down the cost in order to sell those items at all.  On the other hand, if your cost of goods is higher but average inventory remains low, you may not have enough inventory in stock to meet the demand created by your business, thus losing valuable sales.
Inventory Ratios – Industry Comparisons

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Knowing how much inventory you have on hand — and the cost it takes to maintain that inventory — is crucial to running an efficient and profitable business. Unfortunately, according to the State of Small Business report, an incredible 46% of small businesses don’t track their inventory or use a manual process to do so. It’s not surprising, then, that about half of all new small businesses don’t survive past five years.

Despite these statistics, it appears that many small business owners don’t know how much money they leave on their shelves by not tracking inventory effectively. As noted by Marcus Lemonis of CNBC’s The Profit, inventory that sits around for years is like “burning money” and “bad inventory management can bankrupt your business.”

3 Benefits of an Inventory System

1) You’ll stop wasting money by balancing your inventory turnover ratio. As noted above, an unbalanced inventory ratio can mean ordering excess inventory when it isn’t needed or lacking the inventory necessary to fill an order when it is needed. Rather than tying up your cash in carrying costs and actual inventory, allow your money to go towards other aspects of your business, and commit only exactly what you need to inventory and only when you need it.


Definition =

Inventory turnover is a measure of the number of times inventory is sold or used in a time period such as a year.


2) You’ll increase efficiency, reduce human error and save time. Money is saved (and put to better use) in a variety of ways, not just in terms of writing checks for smaller amounts. TopGolf, a virtual golf entertainment facility with four U.S. locations, saves at least eight hours a week after instituting an inventory system that allows employees to complete orders without waiting on each other’s work. They also eliminated inventory inaccuracies and are able to teach new employees in a day what workers at other companies take weeks to learn. Allowing employees to focus their energies on non-menial tasks is a great way to maximize their potential and the earning potential of your business.

Precision Drilling Primes the Pump with Wasp Inventory Control
 
3) You’ll see a positive return on investment quickly. An upfront investment, for businesses big or small, shouldn’t scare you away from making the switch. Precision Drilling’s Siksu support center in Edmonton, Alberta recognized that a system such as Wasp Barcode’s Inventory Control Pro “easily” paid for itself in

 

less than six months, thanks to the elimination of excess inventory and avoiding rush shipping. The positive ROI far outweighs the hidden costs of doing business otherwise.

iStock_000015966119The bottom line is, whether due to ignorance, fear or inertia, nearly half of all business owners are looking past one of the major reasons for small business failure. Rather than wasting money, losing valuable time and worrying about sinking too much money into unfamiliar technology, embrace a better understanding of your inventory turnover with an automated inventory system and gain an edge on your competitors.

Have you noticed your business or organization is using outdated or inefficient technology to track your tools of the trade? Head over to the University of Oxford case study to see how the oldest university in the English-speaking world went from being overwhelmed by an inefficient tracking system, to a smooth inventory process befitting a prestigious institution.

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Paul Trujillo

Paul Trujillo

Paul Trujillo is a Product Marketing Manager at Informatics specializing in Inventory Warehouse Management and Supply Chain product lines. His nearly 15 years of experience has put him at the forefront of industry technology and developing trends.
  • Susan

    Informative article Jason. Understanding your inventory turnover ratio is essential to fully understand your business. Without it, you really don’t know what is selling and what isn’t.

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    • Jason Sentell

      Susan, thank you so much for your comment! We certainly agree that understanding these simple business metrics, like inventory turnover ratio, can greatly benefit small businesses.

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  • Chilly

    Inventory turnover is key – another great metric to follow that many small businesses neglect is the Carrying Cost of inventory which can be calculated as (Inventory carrying rate x Avg inventory value).

    The Carrying Cost of Inventory metric measures how much it costs your organization to store inventory over a given period of time. Use the following formula when calculating carrying cost of inventory.

    Inventory carrying rate * Average inventory value

    Every piece of inventory that you purchase and store in your inventory has some sort of cost associated with it, such as labour, risk/insurance, storage, and freight. This metric is used to figure out how much profit can be made on your current inventory, and it may also be used to help your suppliers map out their production cycles.

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