➢Inventory Management

Inventory is one of the most crucial aspects of any business model. A close tab on the
movement of inventory can make or break your business and that’s why entrepreneurs always
emphasise on effective inventory management. While a few business owners do understand the
significance and cruciality of tracking inventory on a regular basis, some fail to realise its
importance making their business fall through the unseen cracks.

Benefits and Importance of Inventory Management

The importance of inventory management cannot be stressed enough especially for
eCommerce and online retail brands. Accurate inventory tracking allows brands to fulfil orders
timely and accurately. Inventory management in businesses must grow as the company
expands. With a strategic plan in place that optimizes the process of overseeing and managing
inventory, including real-time data of inventory conditions and levels, companies can achieve
inventory management benefits that include:

Accurate Order Fulfilment

With an effective inventory management system, you can easily track the stock in the
warehouse. Bid goodbye to overstocking, stocking of obsolete items, understocking and start
focusing on making your brand become one of the key players in the market space. Develop a
robust plan with the help of an efficient accounting software and avoid inaccurately filled
orders, high return volumes and a loss of customer base.

Better Inventory Planning and Ordering

Striking a balance between the demand and supply is extremely crucial for businesses, thus,
inventory management provides aid in better planning and ordering of stock items. Imagine
having a huge demand for a particular product but not having enough material to supply the
same. Sounds like your worst nightmare, right? A detailed inventory management mitigates
these issues, allowing warehouse managers to refresh inventory only when needed. It’s both
space and cost-effective.

Increased Customer Satisfaction

Since a systematic and robust inventory tracking system will give you a comprehensive view of
your stock at-hand, it yields in an increased customer satisfaction. In retail sector, customers
resent late deliveries or “out of stock” notifications and eventually never return to the website to
fulfil their shopping needs. However, good inventory management leads to orders being fulfilled
more quickly and shipped out to customers faster. The enhanced processes can help
eCommerce and online retail brands build a strong repertoire with consumers – and keep them
coming back for more.
Organised Warehouse
A good inventory management strategy leads to an organized fulfilment centre. An organized
warehouse results in more efficient present and future fulfilment plans. This also includes cost-
savings and improved product fulfilment for businesses utilizing the warehouse for managing
inventory.

Minimise the Blockage of Financial Resources

The importance of inventory control is to minimise the blockage of financial resources. It
reduces the unnecessary tying up of capital in excess inventories and also improves the
liquidity position of the firm. With proper inventory tracking module, business owners can take
quicker decisions about the stock lying in the warehouse more wisely.

Why Inventory Management is Important?

• Cash Flow
Inventory control and planning allows small businesses to manage their cash flow
opportunities. SMEs aren’t always able to purchase large amounts of inventory, due to limited
capital. By having better control of their inventory, they can know exactly how much inventory
they will need and when they need it. This can free up other capital to re-invest in other areas of
the business.

• Business intelligence
An inventory control and planning solution allows small businesses to gain insights into the
fast-selling products. This allows them to adjust their product line and to make quick and smart
business decisions.

• Maximize profits
By being able to make better business decisions the inevitable outcome for a small business
will be an increase in profits. This is because the stock in their inventory will only be stock that’s
actually selling. Other stock that doesn’t grab customer’s attention can be deemed obsolete and
can be abandoned. This makes the general business practice more efficient.

• Limits employee mishandling

Inventory planning and control limits the ability of employees to steal from the inventory. Often
employees use items from a business’ inventory for personal use. Without inventory control, the
business owner would be none-the-wiser. This practice ultimately reduces the profitability of the
business. By limiting the ability of the employee to steal, the employer is reducing potential
‘hidden’ costs.
 • Reduce labour costs
Improved inventory planning and control techniques allow small businesses to reduce labour
costs associated with inventory. These include the time spent counting stock and the
transportation of stock. Employing an intelligent inventory planning and control solution can
significantly reduce all these labour-intensive activities.

➢ Inventory Costs - Meaning, Importance & Types

What is Inventory Costs?

Inventory costs are the costs associated with the procurement, storage and
management of inventory. It includes costs like ordering costs, carrying costs and
shortage / stock out costs. Inventory is one of the most important assets for a company
or a manufacturer. They need to handle it well and it requires cost for maintaining,
storing, replacing and moving inventory.

All these costs are collectively known as inventory costs.

In this article:

• Types of Inventory Costs

• Importance of knowing Inventory Costs
• Inventory costs example

Types of Inventory Costs

Inventory costs can be categorized into three main sub headings:
Ordering cost

Ordering cost of inventory refers to the cost incurred for procuring inventory. It includes
cost of purchase and the cost of inbound logistics.

In order to minimise the ordering cost of inventory we make use of the concept of EOQ
or Economic Order Quantity.
Carrying Cost
Carrying cost of inventory refers to the cost incurred towards inventory storage and
maintenance.

The inventory storage costs typically include the cost of building rental and other
infrastructure maintained to preserve inventory.

The inventory carrying cost is dependent upon and varies with the decision of the
management to manage inventory in house or through outsourced vendors and third
party service providers.
Shortage Costs

Shortage or stock out costs and cost of replenishment are the costs incurred in unusual
circumstances.

They usually form a very small part of the total inventory cost.

Apart from these 3 there are other types as well:

Holding Cost
Sometimes inventory can be held at a location which is different from the expected
location e.g. intermediate city or warehouse.

It can also be held because of formalities and clearances. The costs which is involved in
holding this inventory are called Holding Costs.
Perishability Costs

In industries where there is limited shelf life, products may get spoilt or out of its best
usage dates. Such inventory cannot be sold hence has to be disposed. These costs can
also include the mechanism which is required to keep these products fresh. Especially
in case of vegetables and some food products, air conditioning might be required to
keep them insulated from outside weather effects.
Miscellaneous Costs

Apart from these costs there would be other costs like administrative costs, labor costs,
software costs etc. These days software is used to manage inventory and manage
costs. There would be some cost incurred to run and maintain it also.

Importance of knowing Inventory Costs

Calculations and tracking of these inventory costs are very important because it helps
manage the inventory better. If we see that one of the costs defined above is going
high, we can manage that aspect of inventory in a better way. Let us say that a
company deals with tomatoes and ends up paying a lot of costs in carrying and
perishable costs.

This can help the company plan better so that the right amount of tomatoes can be
procured and transferred before the next lot moves in.

Inventory costs example

Let us take an example of a company which sells biscuits. They procure these biscuits
from a manufacturer and then sell it to retailers. Now a pack of 10 biscuits is assumed
to be the SKU (Stock Keeping Unit). Now these packages would need proper storage
so that the biscuits do not break or crumble before reaching the end customer.

There would be carrying costs involved in that. Then there would be a best before date
for these biscuits. The company needs to move the biscuits well before that date is
reached. Also the ordering cost in the beginning to buy or procure these biscuits is also
involved.

➢ What is Inventory
Management?
Benefits, Types, & Techniques

What Is Inventory Management?

Inventory management helps companies identify which and how much stock
to order at what time. It tracks inventory from purchase to the sale of goods.
The practice identifies and responds to trends to ensure there’s always
enough stock to fulfill customer orders and proper warning of a shortage.

Once sold, inventory becomes revenue. Before it sells, inventory (although

reported as an asset on the balance sheet) ties up cash. Therefore, too much
stock costs money and reduces cash flow.

One measurement of good inventory management is inventory turnover. An

accounting measurement, inventory turnover reflects how often stock is sold
in a period. A business does not want more stock than sales. Poor inventory
turnover can lead to deadstock, or unsold stock.

Why Is Inventory Management Important?

Inventory management is vital to a company’s health because it helps make
sure there is rarely too much or too little stock on hand, limiting the risk of
stockouts and inaccurate records.

Public companies must track inventory as a requirement for compliance with

Securities and Exchange Commission (SEC) rules and the Sarbanes-Oxley
(SOX) Act. Companies must document their management processes to prove
compliance.

Benefits of Inventory Management

The two main benefits of inventory management are that it ensures you’re
able to fulfill incoming or open orders and raises profits. Inventory
management also:

▪ Saves Money:
Understanding stock trends means you see how much of and where you
have something in stock so you’re better able to use the stock you have.
This also allows you to keep less stock at each location (store,
warehouse), as you’re able to pull from anywhere to fulfill orders — all of
this decreases costs tied up in inventory and decreases the amount of
stock that goes unsold before it’s obsolete.

▪ Improves Cash Flow:

With proper inventory management, you spend money on inventory that
sells, so cash is always moving through the business.

▪ Satisfies Customers:
One element of developing loyal customers is ensuring they receive the
items they want without waiting.

Inventory Management Challenges

The primary challenges of inventory management are having too much
inventory and not being able to sell it, not having enough inventory to fulfill
orders, and not understanding what items you have in inventory and where
they’re located. Other obstacles include:
 ▪ Getting Accurate Stock Details:
If you don’t have accurate stock details,there’s no way to know when to
refill stock or which stock moves well.

▪ Poor Processes:
Outdated or manual processes can make work error-prone and slow
down operations.

▪ Changing Customer Demand:

Customer tastes and needs change constantly. If your system can’t track
trends, how will you know when their preferences change and why?

▪ Using Warehouse Space Well:

Staff wastes time if like products are hard to locate. Mastering inventory
management can help eliminate this challenge.

Learn more about the challenges and benefits of inventory management.

What Is Inventory?
Inventory is the raw materials, components and finished goods a company
sells or uses in production. Accounting considers inventory an asset.
Accountants use the information about stock levels to record the correct
valuations on the balance sheet.

Learn more about inventory in the article “What Is Inventory?”.

Inventory vs. Stock

Inventory is often called stock in retail businesses: Managers frequently use
the term “stock on hand” to refer to products like apparel and housewares.
Across industries, “inventory” more broadly refers to stored sales goods and
raw materials and parts used in production.

Some people also say that the word “stock” is used more commonly in the
U.K. to refer to inventory. While there is a difference between the two, the
terms inventory and stock are often interchangeable.

In This Article
 • Why Is Inventory Management Important?
• What Are the Different Types of Inventory?
• Watch: What Is Inventory Management?
• Inventory Management Techniques and Terms
• How to Choose an Inventory Management System?
What Are the Different Types of Inventory?
There are 12 different types of inventory: raw materials, work-in-progress
(WIP), finished goods, decoupling inventory, safety stock, packing materials,
cycle inventory, service inventory, transit, theoretical, excess and
maintenance, repair and operations (MRO). Some people do not recognize
MRO as a type of inventory.

Learn more about the 12 different types of inventory.

Inventory Management Process

If you produce on demand, the inventory management process starts when a
company receives a customer order and continues until the order ships.
Otherwise, the process begins when you forecast your demand and then
place POs for the required raw materials or components. Other parts of the
process include analyzing sales trends and organizing the storage of products
in warehouses.

How Inventory Management Works

The goal of inventory management is to understand stock levels and stock’s
location in warehouses. Inventory management software tracks the flow of
products from supplier through the production process to the customer. In the
warehouse, inventory management tracks stock receipt, picking, packing and
shipping.

Inventory Management Techniques and Terms

Some inventory management techniques use formulas and analysis to plan
stock. Others rely on procedures. All methods aim to improve accuracy. The
techniques a company uses depend on its needs and stock.
Find out which technique works best for your business by reading the guide to
inventory management techniques. Here’s a summary of them:

▪ ABC Analysis:
This method works by identifying the most and least popular types of
stock.

▪ Batch Tracking:
This method groups similar items to track expiration dates and trace
defective items.

▪ Bulk Shipments:
This method considers unpacked materials that suppliers load directly into
ships or trucks. It involves buying, storing and shipping inventory in bulk.

▪ Consignment:
When practicing consignment inventory management, your business
won’t pay its supplier until a given product is sold. That supplier also
retains ownership of the inventory until your company sells it.

▪ Cross-Docking:
Using this method, you’ll unload items directly from a supplier truck to the
delivery truck. Warehousing is essentially eliminated.

▪ Demand Forecasting:
This form of predictive analytics helps predict customer demand.

▪ Dropshipping:
In the practice of dropshipping, the supplier ships items directly from its
warehouse to the customer.

▪ Economic Order Quantity (EOQ):

This formula shows exactly how much inventory a company should order
to reduce holding and other costs.

▪ FIFO and LIFO:

First in, first out (FIFO) means you move the oldest stock first. Last in, first
 out (LIFO) considers that prices always rise, so the most recently-
purchased inventory is the most expensive and thus sold first.

▪ Just-In-Time Inventory (JIT):

Companies use this method in an effort to maintain the lowest stock levels
possible before a refill.

▪ Lean Manufacturing:
This methodology focuses on removing waste or any item that does not
provide value to the customer from the manufacturing system.

▪ Materials Requirements Planning (MRP):

This system handles planning, scheduling and inventory control for
manufacturing.

▪ Minimum Order Quantity:

A company that relies on minimum order quantity will order minimum
amounts of inventory from wholesalers in each order to keep costs low.

▪ Reorder Point Formula:

Businesses use this formula to find the minimum amount of stock they
should have before reordering, then manage their inventory accordingly.

▪ Perpetual Inventory Management:

This technique entails recording stock sales and usage in real-time. Read
“The Definitive Guide to Perpetual Inventory” to learn more about this practice.

▪ Safety Stock:
An inventory management ethos that prioritizes safety stock will ensure
there’s always extra stock set aside in case the company can’t replenish
those items.

▪ Six Sigma:
This is a data-based method for removing waste from businesses as it
relates to inventory.
 ▪ Lean Six Sigma:
This method combines lean management and Six Sigma practices to
remove waste and raise efficiency.

Inventory vs. Cycle Counting

“Taking inventory” is the process of physically counting all stock, once a year
in most cases. Cycle counting is the practice of counting a selected set of
stock more often. Cycle counting serves as an important means of checks and
balances to ensure the amount of inventory represented in the inventory
management system is what you have on the shelf.

A cycle counting best practice is to count specific SKUs regularly and

integrate it into the daily tasks of warehouse staff. Companies may determine
different standards for different types of inventory, such as performing a cycle
count of top-moving SKUs or higher-value items. Learn more about
the benefits of cycle counting.

Demand Planning and Inventory

Management
Demand planning is an important part of successful inventory management. It
is the process of determining how much of each item you anticipate selling,
and when. Once demand is determined, inventory management follows the
flow of goods from the supplier through production and ultimately fulfilling
customer orders.

Find out more about how demand planning and inventory management work
together in the “Essential Guide to Inventory Planning.”
Inventory Management Formulas
Understanding inventory management formulas is crucial to optimizing stock
levels. Multiple inventory and accounting professionals have vetted formulas
to make inventory calculations easier.

Inventory Management KPIs

Effective inventory management plays an important role throughout the supply
chain. There are many key performance indicators for measuring inventory
management success throughout the different organizations in the business.
Understand which calculations return the most insight into your business
processes is important. To learn more, see inventory management KPIs.

How Is Inventory Management Different

From Other Processes?
People sometimes confuse inventory management with related practices.
Inventory management controls all stock within a company. Supply chain
management manages the process from supplier to delivering the product to
the customer. Warehouse management is a part of inventory control and
focuses on stock in a specific location.

Inventory Management vs. Inventory Control

inventory control is a part of the overall inventory management process.
Inventory control manages the movement of items within the warehouse.

Learn more about how these practices work together in our article on inventory
control vs. inventory management.

Inventory Management vs. Inventory Optimization

Inventory optimization is the process of using inventory in the most efficient
way, and as a result minimizing the dollars spent on stock and storing those
items.
You can also think about inventory optimization as seeing inventory across all
locations and selling channels, being able to use any of it to fulfill customer
orders—in doing so, you can hold less stock overall.

Inventory Management vs. Order Management

Inventory management is responsible for ordering and tracking stock as it
arrives at the warehouse. Order management is the process of receiving and
tracking customer orders. Software often combines both tasks.

Inventory management plays an important role in order management. As

orders are received, inventory can be allocated to specific orders, and then
the status can be changed in the inventory record to essentially put it “on hold”
for that order. Furthermore, when the order management system and
inventory system are integrated, the inventory system can recommend which
location should fulfill the order, based on where all the items in the order are
available—this eliminates multiple shipments for a single order.

Inventory Management vs. Supply Chain Management

Supply chain management is a process of managing supply relationships
outside a company and the flow of stock into and through a company.
Inventory management may focus on trends and orders for the company or a
part of the company.

Inventory management is essential for a properly running supply chain.

Inventory management follows the flow of goods to, through and out of the
warehouse. The supply chain includes demand planning, procurement,
production, quality, fulfillment, warehousing and customer service—all of
which require inventory visibility.

Inventory Management vs. Warehouse Management

Warehouse management complements inventory management. Warehouse
management organizes stock in a warehouse. Inventory management
manages stock and trends for many warehouses or an entire company.

The key to streamlining your warehouse operations is a thoughtfully laid out

and meticulously organized facility. When each product has a specific place in
the warehouse, it prevents staff from moving about inefficiently and maximizes
labor efficiency. But these processes are only as good as the inventory
records that drive them.

Learn more about how warehouse management and inventory management work
together.

Inventory Management vs. Logistics

Logistics is the practice of controlling processes in a warehouse and in the
replenishment and delivery systems. Inventory management maintains stock
levels and manages stock location.

Inventory management is a crucial part of how companies manipulate their

logistics. The relationship between inventory management and logistics is
interdependent. Logistics need inventory management to perform their
activities. Good logistics systems improve warehouse and operational
activities.

Find out more about this topic by reading “The Benefits of Integrating Your
Inventory Software With Your Accounting and Back-Office Processes.”

Inventory Management vs. ERP

An enterprise resource planning (ERP) system is software that manages
business activities such as accounting, purchasing, compliance and supply
chain operations. By contrast, inventory management is a part of a modern
ERP system, providing insight into stock levels, inventory en route and the
status of current inventory—this makes it visible across the organization in
real time.

Inventory management helps to properly plan a company’s replenishment

orders. ERP systems give companies accurate inventory data, so they have
the most current information for their inventory management plan. ERP
systems optimize the data so inventory management is successful.

Retail Inventory Management

Retail inventory is the stocking of products that you sell to consumers. Use the
system to set profitable prices and ensure you have the right amount of stock
to meet demand.

Learn more about retail inventory management.

Manufacturing Inventory Management

Manufacturing inventory management is the practice of keeping enough stock
on hand so production lines can fulfill orders. The process helps managers
see stock levels at a glance and tracks raw materials, parts, work-in-progress
and finished goods.

Find out more about manufacturing inventory management.

What Is Multi-Location Inventory

Management?
Multi-location inventory management is the process of managing stock across
multiple locations, warehouses, and retail stores or across multiple selling
channels. With multi-location management, you can watch stock levels in all
locations and optimize your inventory to fulfill orders.

What Is an Inventory Management System?

An inventory management system combines varying software packages to
track stock levels and stock movements. The solution can integrate with
multichannel sales systems or shipping systems.
An inventory management system optimizes inventory levels and ensures
product availability across multiple channels. It provides a single, real-time
view of items, inventory and orders across all locations and selling channels.
This enables businesses to carry less inventory on hand and frees up cash to
be used in other parts of the business. An inventory management system
helps keep inventory costs low while delivering on customer expectations.

Learn about all inventory management system features and how to pick a solution
that’s right for your company.

How to Choose an Inventory Management

System?
Choosing an inventory management system is a matter of identifying the
features your business needs. Do you need to track stock movements and
location within a warehouse, or plan inventory and track trends, or both?

Read “Choosing the Right Inventory Management System” for answers to your
research questions. When evaluating a system, remember to look for three
key features: real-time demand planning functionality, data analysis tools
and near- and real-time data reporting. Learn about each by reading “Three
Must-Haves for Your Inventory Management Software Shopping List.”

Inventory Management FAQs

There are many questions in a broad and complicated topic like inventory
management. Here are answers to a few:

What Are the Objectives of Inventory Management?

One objective of inventory management is to keep enough stock to satisfy
customers. Another is to invest as little as possible in stock while still earning
the most profit.
Why Inventory Management Is Important in the Supply Chain
Inventory management is vital in the supply chain because a company must
balance customer demand with storage space and cash limitations. Inventory
management provides visibility into the supply chain (procurement,
production, fulfillment, etc.) so managers can coordinate lead times for
deliveries with production timetables.

How Can Inventory Management Be Improved?

Keeping accurate accounting records and taking regular physical stock counts
can improve your inventory management efforts. A system that provides your
organization with real-time visibility into inventory can help stakeholders make
critical business decisions. You should also be aware of a stock’s condition,
especially if you’re dealing with perishables.

How Inventory Management Affects the Working Capital

Real goods in warehouses tie up working capital until they sell. Making the
supply chain more efficient keeps you from holding too much stock. Improving
inventory management processes helps you prevent storing, picking and
shipping errors that reduce sales.

What Are Inventory Management Policies?

Inventory management policies are plans for how to use inventory to make
customers happy and reduce costs. Policies outline such things as the stock
management method the company uses.

What Are the Types of Inventory Management Systems?

There are several types of inventory management systems that businesses
use depending on how they operate. Three examples are manual inventory,
periodic inventory and perpetual inventory. Manual methods are the least
sophisticated and least accurate, and perpetual systems are the most
sophisticated and most accurate.

▪ Manual Inventory System: This involves physically counting items and

recording them on paper or in a spreadsheet. Small businesses may use
manual systems.
 ▪ Periodic Inventory System: Periodic inventory systems include manual and
periodic counts. Periodic counts record item details as items move in and
out of stock. Barcodes simplify stocktaking. A database contains the
records of stock levels and locations.

▪ Perpetual Inventory System: Perpetual inventory systems provide real-time

stock data, as they rely on active radio frequency identification (RFID)
tags that are always on and sending updates on item movements.
Passive RFID tags, meanwhile, use a scanner to send stock information
to the database.

What Is Service Level in Inventory Management?

A service level for inventory management is how much a company believes it
can successfully store a particular stock.In other words, it’s the probability a
company will avoid stockouts and support sales.

How Does ERP Help in Inventory Management?

Enterprise resource planning (ERP) is helpful for inventory management
because it tracks and provides insights into supply chain operation,
accounting and purchasing, consolidating the information and making it visible
in one place.

What Is Poor Inventory Management?

Poor inventory management is an imbalance between keeping too much and
too little stock. The definition of a perfect balance can change as demand
changes: Sales change when trends or seasons change. Poor stock
management increases costs and thereby reduces profits.
 ➢ Inventory Turnover Ratio
Defined: Formula, Tips, &
Examples

Sometimes a product flies off the shelf. Other times, you can’t discount deeply
enough. Generally, however, items drift along somewhere in the middle,
meaning all companies need a handle on what’s moving and how quickly.
That inventory turnover calculation informs everything from pricing strategy
and supplier relationships to promotions and the product lifecycle.

Turnover ratio also reveals a lot about a company’s forecasting, inventory

management and sales and marketing expertise. A high ratio implies strong
sales or insufficient inventory to support sales at that rate. Conversely, a low
ratio indicates weak sales, lackluster market demand or an inventory glut.

Either way, knowing where the sales winds blow will inform how to set your
company’s sails.

What Is Inventory Turnover?

Inventory turnover refers to the amount of time that passes from the day an
item is purchased by a company until it is sold. One complete turnover of
inventory means the company sold the stock that it purchased, less any items
lost to damage or shrinkage.

Successful companies usually have several inventory turnovers per year, but
it varies by industry and product category. For example, consumer packaged
goods (CPG) usually have high turnover, while very high-end luxury goods,
such as luxury handbags, typically see few units sold per year and long
production times.
A number of inventory management challenges can affect turnover; they include
changing customer demand, poor supply chain planning and overstocking.

Key Takeaways
▪ Inventory includes all goods, raw or finished, that a company has in stock
with the intent to sell.
▪ Inventory turnover is the rate that inventory stock is sold, or used, and
replaced.
▪ The inventory turnover ratio is calculated by dividing the cost of goods by
average inventory for the same period.
▪ A higher ratio tends to point to strong sales and a lower one to weak
sales. Conversely, a higher ratio can indicate insufficient inventory on
hand, and a lower one can indicate too much inventory in stock.
In This Article

• What Is Inventory Turnover?

• What Is Inventory Turnover Ratio?
• Inventory Turnover Ratio Explained
• How Inventory Turnover Ratio Works
• How to Calculate Inventory Turnover Ratio (ITR)?
• Why Do Inventory Turns Matter?
• What Is the Best Inventory Turnover Ratio?
• What Should I Do About a Low Inventory Turnover Ratio?
• Why Is a Higher Inventory Turnover Ratio Better?
• Can Inventory Turnover Ever Be Too High?
• Ideal Inventory Turnover Ratio
• 5 Inventory Turnover Optimization Techniques
• Improving Inventory Turnover With Inventory Management Software

What Is Inventory Turnover Ratio?

The inventory turnover ratio is the number of times a company has sold and
replenished its inventory over a specific amount of time. The formula can also
be used to calculate the number of days it will take to sell the inventory on
hand.

The turnover ratio is derived from a mathematical calculation, where the cost
of goods sold is divided by the average inventory for the same period. A
higher ratio is more desirable than a low one as a high ratio tends to point to
strong sales.

Knowing your turnover ratio depends on effective inventory control, also known as
stock control, where the company has good insight into what it has on hand.

Inventory Turnover Ratio Explained

Calculating and tracking inventory turnover helps businesses make smarter
decisions in a variety of areas, including pricing, manufacturing, marketing,
purchasing and warehouse management.

Ultimately, the inventory turnover ratio measures how well the company
generates sales from its stock. number of KPIs that can provide insights into
how to increase sales or improve the marketability of certain stock or the
overall inventory mix.

How Inventory Turnover Ratio Works

Average inventory is typically used to even out spikes and dips from outlier
changes represented in one segment of time, such as a day or month.
Average inventory thus renders a more stable and reliable measure.

For example, in the case of seasonal sales, inventories of certain items — like
patio furniture or artificial trees — are pushed abnormally high just ahead of
the season and are seriously depleted at the end of it. However, turnover ratio
may also be calculated using ending inventory numbers for the same period
that the cost of goods sold (COGS) number is taken.

Lastly, the formula can also be used to calculate how much time it will take to
sell all the inventory currently on hand. Days sales of inventory (DSI) it is
calculated like this for a daily context:

(Average inventory / cost of goods sold) x 365

How to Calculate Inventory Turnover Ratio

(ITR)?
Companies can calculate inventory turnover. This standard method includes
either market sales information or the cost of goods sold (COGS) divided by
the inventory.

Start by calculating the average inventory in a period by dividing the sum of

the beginning and ending inventory by two:

Average inventory = (beginning inventory + ending inventory) / 2

You can use ending stock in place of average inventory if the business does
not have seasonal fluctuations. More data points are better, though, so divide
the monthly inventory by 12 and use the annual average inventory. Then
apply the formula for inventory turnover:
 Inventory Turnover Ratio = Cost of Goods Sold / Avg. Inventory

Inventory Turnover Formula and

Calculations
Whatever inventory turnover formula works best for your company, you will
need to draw data from the balance sheet, so it’s important to understand
what these terms and numbers represent.

Cost of Goods Sold (COGS)

Cost of goods sold, aka COGS, is the direct costs of producing goods
(including raw materials) to be sold by the company.

Average Inventory (AI)

Average inventory smooths out the amount of inventory on hand over two or
more specified time periods.

Beginning Inventory + ending inventory / number of months in the accounting

period

Inventory Turnover Ratio

The inventory turnover ratio is a measure of how many times the inventory is
sold and replaced over a given period.
 Inventory Turnover Ratio = Cost of Goods Sold / Avg. Inventory

Inventory Turnover Ratio Examples

Cherry Woods Furniture is a specialized supplier of high-end, handmade
dining sets made from specialty woods. Over Q3, its busiest period, the
retailer posted $47,000 in COGS and $16,000 in average inventory. To find
the inventory turnover ratio, we divide $47,000 by $16,000. The inventory
turnover is 3.

In the second example, we’ll use the same company and the same scenario
as above, but this time compute the average inventory period — meaning how
long it will take to sell the inventory currently on hand. We already know the
inventory turnover ratio is 3. To calculate how many days it will take to sell the
inventory on hand at the current rate, divide 365 days in the year by 3, which
equals 121.67 days.

Why Do Inventory Turns Matter?

Inventory turns matter for several reasons. A slow turn can indicate decreased
market demand for certain items, which can help a company decide to change
pricing, offer incentives to deplete inventory faster or change the mix of goods
offered for sale in the future. These are all important decisions — for a
company to remain financially healthy and competitive, it needs to keep its
product mix aligned with customer demand.

Who sets the price? When a manufacturer dictates the minimum, or

maximum, amount you may sell an item for, that limits your ability to use price
as an inventory lever. Aim to negotiate flexibility.
Got capital + commitment? Do you enjoy “most-favored customer” status?
Companies that can afford to guarantee minimum purchases over the long
term from suppliers may tie up working capital, but in return they insulate
themselves from supply-chain disruptions that can wreak havoc with
inventory. If you are not in that group, you may go to the back of the line.
Carrying costs add up. Don’t forget to factor in the expenses associated with
buying and storing inventory — warehouse space, interest, insurance, taxes,
transport. It’s not just about the cost of the item.
A fast turn may indicate that a company’s purchasing strategy is not keeping
pace with market demand, that it’s experiencing delays somewhere in the supply
chain or that a particular item is seeing a surge in demand. This information
can help a company decide whether to raise prices, increase its orders,
diversify suppliers, feature a product prominently in its marketing or buy
additional related inventory.

Material requirements planning, or MRP, is a related process to understand

inventory requirements while balancing supply and demand.

What Is the Best Inventory Turnover Ratio?

In general, the higher the ratio number the better as it most often indicates
strong sales. A lower ratio can point to weak sales and/or decreasing market
demand for the goods.

However, there are exceptions to this rule. For example, high-end goods tend
to have low inventory turnovers. A farmer doesn’t need to purchase a new
tractor annually, and most people aren’t scooping up designer jewelry on a
whim.

A ratio that is too high, however, is self-defeating. It may mean your company
isn’t purchasing enough inventory to support the rate of sales. Or, you may
not be realizing as much profit as you could — see if inching up pricing
stabilizes the ratio while also improving your unit margins.

Differences in Inventory Turnover by Industry

High-volume, low-margin industries tend to have high inventory turnovers.
Conversely, low-volume, high-margin industries tend to have much lower
inventory turnover ratios.

For example, Super Coffee more caffeinated beverages at lower prices and
lower margins than a specialty supplier like Kali Audio professional-style
loudspeakers and monitors for recording studios at higher margins in the
same accounting period.

Retail inventory management is part art, part science and demands an

understanding of sales patterns, profit margin, seasonality and other factors.
In many cases, retailers use a vertical-specific inventory method, known as
cost-to-retail, that estimates the ending inventory value by using the ratio of
inventory cost to the retail price.

What Should I Do About a Low Inventory

Turnover Ratio?
A low ratio needs some inventory analysis to discover the cause. Are
competitors offering a lower price? Then revisit your pricing strategy. Is
market demand for these goods fading? Then a new stock mix is probably in
order. Is the purchasing strategy no longer working and inventory is piling up?
Then consider adapting your purchasing policy and processes accordingly to
prevent tying up too much capital in inventory.

Are salespeople underperforming? Consider training to address the way

purchasing decisions are now made, or stress the need for sales leaders to
come to the table with realistic, not overly optimistic, projections.

Why Is a Higher Inventory Turnover Ratio

Better?
Generally, a higher ratio is better because it means strong sales are depleting
your stock at a rapid pace. That’s good news for your company, right?

Maybe. It could also mean a surge in popularity of these goods — increased

market demand, in other words — so you may want to increase your orders to
suppliers before your competitors buy them out. However, it could also mean
you’re not buying enough inventory or you lack supply chain visibility, which is
limiting the sales you can make. That spells opportunity, if you can increase
your stock of popular items.

Can Inventory Turnover Ever Be Too High?

Yes, it can. If the inventory ratio is too high, meaning somewhere in the
double digits, then your company is limiting its revenue by curtailing sales to fit
a too-small inventory supply. It usually takes time for new stock to arrive and
be placed in the sales cycle. That’s lost time and lost opportunity, too.

Aim to increase inventory purchase amounts to bring your ratio down to a

more moderate, and profitable, range.

Ideal Inventory Turnover Ratio

For most industries, the ideal inventory turnover ratio will be between 5 and
10, meaning the company will sell and restock inventory roughly every one to
two months. For industries with perishable goods, such as florists and
grocers, the ideal ratio will be higher to prevent inventory losses to spoilage.

How Else Can Inventory Turnover Ratio Be

Used?
Inventory turnover ratios are used in several ways to improve inventory
management, pricing strategies, supply chain execution and sales and
marketing, among other company success factors.

Here are three common uses:

Turnover trends
Inventory turnover ratios are an effective way to spot both emerging trends
driven by market demand and obsolete, or slow-moving, inventory. That way you
can get an early and important clue on whether to scale up or down on any
product line or brand. This gives you much better control over inventory and a
better harvest of sales opportunities.

Segments and SKUs

Inventory turnover is typically measured at the SKU (stock-keeping unit) level,
or segment level for tighter controls on specific stock levels. Inventory
segmentation refers to segmenting, or classifying, SKUs based on metrics
that make sense for your business. As an example, a retailer might group
categories to see how products are performing against others in your portfolio.

Alternatively, inventory turnover can also be used at an aggregated level,

where you bundle disparate items by, for example, geographic location of
retail outlets.
The graphic shows the Inventory “when to reorder” process, with the reorder
point “sweet spot” falling along the demand/day curve.
80/20 rule
The Pareto principle applies to a lot of areas in business and life; when it
comes to inventory, it means 80% of your company’s sales, sales revenues are
likely generated by 20% of the SKUs you carry.

Loss leaders — products deliberately and strategically priced to drive little or no

profitability — will always be useful to drive customers into virtual and brick-
and-mortar stores, where they might be enticed to buy more, or more
profitable products, for example. It’s important to know what that stock
segment is so you can keep plenty of inventory on hand.
5 Inventory Turnover Optimization
Techniques
A primary way to apply inventory turnover ratios in a practical manner is
to optimize your inventory management.

Here are five ways you can do that:

1. Streamline the supply chain. Suppliers with the lowest prices may or
may not be the best choice. If a product is central to your sales or is
seeing a surge in market demand, faster or guaranteed delivery times for
those items or vital components may be more important. In any case,
streamlining the supply chain to eradicate inefficiencies will benefit your
sales, profits and overall margins.

2. Adjust your pricing strategy. Adjust pricing to realize larger margins on

items in high demand and to free capital by moving old inventory, also
known as dead or obsolete inventory, out. If items just won’t sell, consider
donating that stock to charity and taking a tax deduction or offloading it
through a secondary channel.

3. Check or change your ranking in your industry. Are your inventory

turnovers in line with the rest of your industry? Are there opportunities for
you to maneuver a better strategic position on competitive items when
you note emerging trends in your inventory ratios? You can grab more
market share and increase your ranking within your industry by managing
your inventory more strategically.

4. Improve forecasting. Sales numbers and inventory reports supply much

needed hard data that make inventory forecasting more accurate. This data
can also help with future sales planning, such as suggesting ways to
change your product mix or bundle items in creative ways to move slower
inventory at potentially a higher margin.

5. Automate purchase orders. Automation adds efficiencies and may cut

costs on its own. But when you couple it with an order management
 system that facilitates reordering of inventory that sells well so that it is
always in stock, you net even more wins. Consider using an inventory
system that will automatically generate purchase orders for your buyers to
review; the result will be better control and fewer errors.

Improving Inventory Turnover With

Inventory Management Software
Inventory management software comes with many features that will help you
modernize and optimize your inventory management processes and policies. For
example, such software enables your company to switch to the perpetual
inventory method in accounting with a continuous real-time record of
inventory. Computerized point-of-sale systems and enterprise asset
management software immediately reflect changes in inventory by tracking
sales and inventory depletion or restocking.

Companies that use the perpetual inventory method versus a periodic inventory
system can use a moving average inventory to compare mean inventory levels
across multiple time periods. Moving average inventory converts pricing to the
current market standard to enable a more accurate comparison of the periods.

When combined with an ERP system, inventory management software can help
in streamlining your supply chain, SKU assignment and management,
automated purchase orders and other functions and features. That will reduce
errors, add efficiencies, give you more control, increase customer satisfaction
and generally make your company more profitable.